PRODUCT PRICING and @ PROFIT ANALYSIS Saas eeeneSeeeenes Tae eanee eae ere : + Understand the importance of pricing as a business strategy. + _ Iilustrate the different models of product pricing. + Use the different cost-based pricing techniques and compute the mark-up rate. + Identify cost-based from non-cost based costs and expenses. + Relate product pricing to profitability. * Calculate the sales price variance, sales quantity variance, cost price variance, cost quantity variance, sales mix variance and final sales volume variance. * Explain the general causes of sales and cost variances affecting profit.CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 516 Product Pricing The operating profit or loss is not only affected by cost and expenses, but also by sales. In the previous chapters the techniques that we have studied deal with costs - their relevance toplanning and controlling functions of management. In this chapter, we will deal with selling price and its relevance to profit. Sales are affected by volume and unit sales directly controlled by manager but is influer financial and economic conditions, needs and wants, competition, price, The number of units sold is something not nced by various market factors such as general « technological developments, changes in customer's and other forces in the market place. Let us deal with competition as a force that influences the number of units sold. Among the variables of competition is price. Product pricing is a delicate, technical and strategic matter. If your product is priced too exorbitantly, the market would repudiate it. Ifthe product is priced too low, it may stir strong reactions from competitors that may lead to strenuous and unfavorable operational circumstances. Or, if the product is priced too low, customers may consider the product cheap and not worth their utility and possession, Still pricing a productis a decision that directly affects the profitability of business operations. This field of business management has been truly more of an art than a science. A sales price is determined by a host of factors that even experienced companies have been continually Monitoring to influence price trends which are affected not only by competition but by changing customer wants and needs, governmental regulations, changes in technology, and other external economic factors, toname a few. Because of this, the field of product pricing has generated various pricing models. Pricing models Setting the price of a product could be done in different perspectives, such as: + Traditional pricing + Economist's model + Premium pricing (perception-based prestige pricing) Controlled market-based pricing + Strategic pricing + Target pricing + Life-cycle-based pricing + Penetration-based pricing + Skimming-based pricing + Predatory pricing + Loss leader pricing + Product bundling + Pricing with additional features517 PRODUCT PRICING AND PROFIT ANALYSIS CHAPTER n + Tactical pricing * Time pricing + Material-based pricing + Distress pricing + Transfer pricing Cost-based pricing Traditional Pricing Models The traditional pricing models follows the basic methods of determining a unit sales price The Economist's model This pricing model is based on the principle of scarcity of resources and rationality of men. It anchors on the universal and basic laws of supply and demand which state that as the demand for a product increases, the price correspondingly increases, and vice-versa. Likewise, if the supply for a product increases or exceeds the market needs, the price correspondingly decreases, and vice-versa. Pricing in this model is fundamentally based on the reaction of the market. The change in price in relation to the change in the level of demand and supply could either be elastic or inelastic. There is demand elasticity if a minimal change in price greatly affects the demand of a product. And there is demand inelasticity if a minimal change in price in significantly changes the demand of a product. Fig. 11.1. Elasticity of Demand Theoretically, if the level of demand and supply does not change, price remains constant. Note that there is a negative relationship, or negative correlation, between price and demand. As price decreases, the level of quantity demanded tends to increase, and vice-versa. Given the downward, or negative, slope of the demand curve in relation to price, the negative sign inthe numerator has the effect of making the outcome positive, simply to more conveniently represent the relationship. If the elasticity of demand is greater than 1, demand is considered elastic. This meanstat a reduction in price would increase demand considgrably. And if the elasticit ; : . ie elasticity of demand is less than 1, demand is considered inelastic. This means that if pri id for the product would decline. ifprice increases the deman The importance of knowing the elasticity of demand i we / product in periods of hard business adjustments. coreramniee hen caiticaly prt than sales price inflation and the product's demand elasticity is positive y inflation oe for an enterprise to increase its sales price to level off the increase in cat cece unnecessary increase in sales price would adversely affect its uni Cost prices becau' ” revenues and consequently lower profit. 'S units sold resulting to low’CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 518 Factors affecting price elasticity There are multitudes of variables affecting price elasticity. Some of the most considered factors affecting price elasticity are as follows + Market definition. Competition and product availability Substitute products Complementary products Disposable income Product necessity Consumer habits Sample Problem 11.1. Demand Elasticity The following results were tabulated with respect to the relationship of changes in price and units sold with respect to product “Mozz” P,P, A Average Percentage A Sales price P100 P120 P20. P110 18.18% Quantity sold 2,000 1,500 (500) 1,750 28.57% A = Change Required: Determine the elasticity of demand Solutions/ Discussions: +‘ Applying the formula, we have: Elasticity of demand = Percentage A in Quantity Demanded. Percentage A in Unit Sales Price = 18.18% /-28.57% #64 + The -0.64 elasticity rate means that product Mozz is considerably elasticwith the change in its selling price. Stating more concretely, for every 1% change in price, the quantity demanded inversely changes by 64%. Premium pricing (or perception-based pricing) This pricing model resides on the psychology of the market participants. If a product offers good utility and value, buyers are willing to pay for more. That is, there satisfaction ig heightened. Otherwise, if the a product offers inferior value and use, the market would absorb the product if the price is lowered. Reversing the perspective, we could say that if the price of a product is high, the value and utility (., quality) of that product is also high, and vice-versa. This reversed-market analysis led to the development of product branding, product differentiation, and similar marketing models.CHAPTER 11 519 PRODUCT PRICING AND PROFIT ANALYSIS Controlled-market-based pricing ment regulations or implied agreements This product pricing model based its prices on govern ing companies, and utility ini among key players in the market. Gas and oil companies, ™ companies use this model. Strategic Pricing Models Target pricing In this model, the company looks at the market, determines the prevailing market price, establishes its desired profit, then computes the should be amount of cost to be incurred in producing and selling a product. Once the cost is determined, processes, activities, systems are established accordingly to produce a product not in excess of the determined cost, otherwise, the profit will suffer. Costs become targets for improvement. To improve costs means to reduce it. To reduce costs, continuous improvements are needed. This model, like the life-cycle costing, is in line with the trend of increasing efficiency, productivity and competitiveness for long-term survival Life-cycle-based pricing Here, a price is established that would be applicable over the price is determined by dividing the total costs (i.e., locked-in o over the total estimated units to be produced and sold. life-span of a product. The ‘osts and operational costs) Thelife stages of a product are normally divided into four, namely: infancy (or start-up) stage, tage. In the life-cycle-based pricing, Life-cycle-based pricing includes all costs relative toaprod | and development, design, production, marketing, distibunt we are costs inreseatch significant portion of a product's life~ renllon and customer services. A nor even before of rior to c ! 'gnoring the effects of these Costs in the start PI ommercial production would understate the t curred and committed lower sales price and reduced profitability, Tue amount of costs and may lead to One of the pre-commercial expenditure: c s that. cost of design. An excellent product dear 2® 2" at impact oj i , lesign tt Nn Operator the putsin place efficient and economical manera meets Customer's mens wonal costs ist to retraining, retooling, production setups, ctur'"9 S¥Stem that brings ean eectivey has started. PS, spoilage, and d, gs lesser costs relative sign changes after productionCHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS Problem Sample 11.2. Life-cycle based pricing King Lion Company is contemplating to introduce a product which is expected to be sold in the market for five years. The product feasibility has been prepared and the following data were presented: [ Life-cycle stage Costs | Production Infancy and pré-infancy 20,000,000 50,000 Growth 8,000,000 250,000 Expansion 5,000,000 500,000 Maturity and decline 1,000,000 200,000 Total P34,000,000 1,000,000 | The company would like to apply the life-cycle-based costing and price its product based on the strategic life-cycie costs. It is studying the pricing strategy it has to adopt under each of the following schemes: Pricing strategy based on life-cycle costs Life-cycle stage ‘Scheme 1 ‘Scheme 2 Infancy and pre-infancy 20% higher 1,000% higher Growth 500% higher 1,000% higher Expansion 1,000% higher 800% higher Maturity and decline 10% higher 10% higher Itis also estimated that all units produced would be sold. Required: Determine for each of the schemes mentioned above the following: 1. Life-cycle costs per unit. 2. Unit sales prices under each scheme for each life cycle stages. 3. Product life-cycle profit under each pricing scheme. Solutions / Discussions: 1. The life-cycle cost per unit is computed as follows: Life-cycle cost per unit = P34,000,000 / 1,000,000 = 34.00CHAPTER 521 PRODUCT PRICING AND PROFIT ANALYSIS 7 cheme for each life cycle stages would be: 2. The ynit sales price under each s cones?) eo Scheme 1 _ Unitsales ee Computations price ife- mputations PI Life-cycle stage Comp ar inaoe PRTADD Infancy and pre-infancy P34 x 120% P40. ' sna Growth paax600% 204.00» P34x 1,100 0 P34 x 900% 306.00 Expansion P34 x 1,100% 374.01 — on Maturity and decline P34 x 110% 37.40 P34 x 3. The producttlfe cycle profit for each pricing scheme would be: eoeee Scheme 2 Unit sales Amount Unit sales Amount ut Life-cycle Production price (000's) © Production —_—price (000's) Infancy and 50,000 P40.80 P 2,040 50,000 3,400.00 P 170,000 pre-infancy, Growth 250000 170.00 ~=—« 42,500 += 250,000 3,400.00 850,000 Expansion 500,000 340.00 +~—«-170,000 + 800,000 272,00 136,000 Maturity and 200,000 40.80 8.16 200,000 37.40 _ 7.480 decline Total product sales 222,700 1,163,480 + Total product costs 34.00 34,000 Foot z B1a8 700 B1iz9.40 Apparently, Scheme 2 would bring more profit to the enterprise and therefore would be the better strategic option. Penetration-based pricing This pricing model is applied when a company wants to enter a market where entry is relatively easy due to minimal amount of investment needed, absence of high-level technological requirements, and a market not controlled by one or few players. To penetrate a market Pricing is set at a lower level to gain widespread market acceptance. Penetration pricing is most applicable in a buyers’ market where the behavior of t nt influenced by buyers than by sellers he|markete]stontiean Skimming pricing This pricing model is applicable in a sellers’ market. some entry barriers such as great amount of investmer technological applications, and presence of only a few the seller influences the level of pricing and normally pricing model gives more protection to sellers than th; This market is difficult to enter due t® nt requirement, need for a high-level Of Sellers in the market. At this instance. Sets the price at a higher level. This ‘at of the penetration pricing.CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 522 Predatory (or anti-competition) pricing inthis model, a company sets a very low price purposely to gain greater share of and ultimately control the market. The price set is so low that ordinary producers and sellers would not dare follow to avoid incurrence and recurrence of operational loss. This pricing model drives away operationally inefficient and financially insufficient players who do not have the critical financial string to absorb operational losses and maintain their market presence. This technique is considered not conducive to a healthy trade and developmental business environment. Other countries have laws against predatory pricing Loss leader pricing Loss leader pricing applies when there is a main product with subsequent sales of parts and services. The main product is priced at a very low price that sometimes is lower than the cost of producing it but company would recover later by selling unique parts, consumables, rendering highly technical services that are priced at a much higher amount. Examples are low-priced computer printer with high-priced cartridges, low-priced gadget with high-priced supplies (eg, razor as the main product and razor blades as the “extra’ or supplies), and free or very low cost of installing phone connection with relatively expensive monthly fees. P. ig with additional features Main products are sometimes sold with additional features or “extras”. With the “extras” on the product, the price of the product would logically change. At what price level depends on the acceptability of the additional features to the customers, whether the “extras’ add value to their use of the product or not. Product bundling Product bundling is packaging the interrelated products together to make a complete set and offered to customers at a temptingly low price. This technically sets the average price and margin for all the products included in the bundle. It has the advantage of selling slow moving products and still maintain the desired overall financial performance of an enterprise. It also has an advantage of creating savings in product handling, packaging, and invoicing costs. Bundling is proven to be successful when used to matured products and customer loyalty is already high. However, issues are to be handled on the reaction of competitors on the bundling policy and the customers reactions when products are unbundled later. Tactical Pricing + Time pricing. This pricing model considers time as the basis in setting a price. This applies to professionals (such as lawyers, accountants, doctors, consultants)523 + Materials-based pricing. In this m + Transfer pricing. This pricing model applies w ANALYSIS CHAPTER 1, PRODUCT PRICING AND PROFIT and non-professionals (such as repairmen and technicians) alike. del, price is based on the expected amount of of materials to be used. For example, construction comParve’ estimate contract prices substantially based on materials to be used in a given construction project. ing technique is used when there is + i 1) pricing. This pricit i dane re Pesnd_ businesses have to sell hard their n ‘sales price is based not on the regular mental) costs to produce and sell a overability of cost and sustainability an idle capacity, competition is very stiff, a products to at least breakeven. In this case, production costs but on relevant (i.e., incre! product. Here, profitability is subordinated to rect of operations. hen there is an inter-company between affiliated companies and company based on their operating performances, arbitratry or dual oriented-divisional transfer of products or divisional managers are evaluated f Transfer prices may be based on market, cost, negotiated prices, prices. Cost-based pricing. This pricing model rationalizes that price equals cost plus markup. This model is explained more in the next three pages Cost-based pricing This is a traditional and simple technique of setting a sales price. You only have to determine the costs of producing a product and operating a business, then add your desired profit and you will arrive at a sales price. This relationship is depicted below: Costs (and expenses) P x Add: Profit Sales price 2 Costs have different meanings. A cost may pertain to materials costs, prime costs, comer ede total pee costs, variable production costs, variable costs and expenses, total costs and expenses or any other definitio " i sales price is restated as follows: of cnet Because of ths Cost-based is anchored to the definition of cost. If th i i . Ifthe sal i cost, then the cost-based pricing includes the costs of materials Inter ean absorption and fixed overhead. If the cost is defined as prime cost, then th or, variable ove ee of direct materials and direct labor. le cost-based is the S'CHAPTER 11, PRODUCT PRICING AND PROFIT ANALYSIS 524 Non-cost-based refers to all other costs and expenses not included in the cost-based. If the cost-based is prime cost, the non-cost-based includes variable overhead, fixed overhead, variable expenses and fixed expenses. To emphasize, consider the Classification of costs and expenses below, either as cost-based or non-cost-based, in relation to cost-based pricing analysis: Cost is defined as Costs and expenses Prime cost Absorption cost Materials Px Costbased Labor x _| Cost-based Variable overhead = x — Fixed overhead x Non-cost based Variable expenses x Non-costbased Fixed expenses ed The determination of cost-based and non-cost-based depends on the definition of cost used in the pricing model. Markup does not only refer to profit. Itis the sum of profit and non-cost based. Markup is computed by multiplying cost-based with markup ratio. Markup ratio is markup over cost-based. The summary of this mathematical relationship is given below: Sales price = Cost-based + Markup where: Markup = Cost-based x Markup ratio markup = _ non-cost-based+ profit Markup ratio = Markup / Cost-based or Markup ratio = (Non-cost-based + Profit) / Cost-based To illustrate, let us assume the data given on sample problem 1 below: Sample Problem 11.3. Sales Price Setting Using Cost-Based Model The Accounting Department of Baguio Corporation has assembled the following data relative to product Cold:Bas PRODUCT PRICING AND PROFIT ANALYSIS Direct materials Direct labor Variable overhead Fixed overhead Variable expenses Fixed expenses Total costs and expense The company wants a 20% return on its investment of P3 million. It expects to sell 40,000 units of Cold in the coming period Required: Determine the (a) unit sales price ‘and (b) markup percentage of product cost assuming that the cost-based model is used: 1. Absorption method. 2. Contribution margin (or marginal costing) method. 3. Prime cost. Solutions/Discussions: * Basically, the sales price is computed in details as follows: Direct material Direct labor Variable overhead Fixed overhead Variable expenses Fixed expenses Total costs and expenses Add; Profit (P3 million x 20% / 40,000 units) Unit sales price CHAPTER 11 Per Unit P 10.00 20.00 5.00 6.00 5.00 —4.00 Banoo 4. Conversion cost. 5. Material cost. Per Unit P 10.00 20.00 6.00 5.00 5.00 4.00 50.00 15.00 P 65.00 4 ' 4CHAPTER PRODUCT PRICING AND PROFIT ANALYSIS 526 he sales prices under various cost definitions are: 1) @ @) @ ©) Absorption Marginal Prime Conversion —Material Cost Cost Cost Cost Cost based P 41.00 P4000 P3000 —P 25.00 P 10.00, Markup* Pay 58.54%) 24.00 P40 x 62.50%) 25,00 P30 x 116 67%) 35.00 (P25 x 160.00%) 40.00 (P10 x 550.00%) 55.00 Unit sales price 65.00 Bs500 psson P6500 ‘sso “Markup ~ Costbased x markup ratio) Markup ratio is profit plus non-cost based divided by cost-based. The markup ratios are calculated below: Absorption Marginal Prime Conversion —Maaterial Cost Cost Cost Cost Cost Profit P15.00 P1500 15.00 P15.00 P1500 Non-cost-based* 9.00 (P50-P41) 10.00 (P50-P40) 20.00 (P50-P30) 25.00 (P50-P25) 40.00 (P50-P10) Markup 24.00 25.00 35.00 40.00 55.00 / Cost-based 41.00 40.00 30.00 28.00 10.00 Markup ratio SBSd%S 62502 lipsye anode SBQO0% (*Non-cost-based = Total costs and expenses (ie, P50) less cost-based) + Notice that the sales price remains the same regardless of the cost-based used. This is correct because the purpose of setting the markup ratio is not to change the sales price, neither to change the profit but to expedite and simplify the determination of the unit sales price. There are variations in the definition of cost-based inasmuch as the process of accumulating and the timing of accumulating accounting data vary from a company to another. Some companies can instantly determine cost-data on materials while others can quickly assemble data on conversion costs, or other costs data. This explains why cost-based is defined differently.1 527 PRODUCT PRICING AND PROFIT ANALYSIS CHAPTER 1} Gross Profit Variations Analysis ‘ b Profitability is determined not only to measure 2 department $ pero why pe ofa manager as well. It serves as a feedback information on the whe reopen a ating performance, productivity and profitability wise. Itgives a slime Se eparial tech (0 the business operations. It is also an indicator in identifying excellen fi Saad if He to sustain organizational effectiveness and in determining causes of operational failures, The first line of profitability is measured by the gross profit under the absorption costing method and contribution margin using the variable costing method. The gross profit variance analysis is illustrated in this chapter. The contribution margin variance analysis follows the pattern of analyzing the gross profit variations. Gross profit is the difference of sales and cost of goods sold. Ergo, a change in gross profit is caused by a change in sales and cost of goods sold. Sales is a factor of number of units sold and sales price. Therefore, a change in sales, which causes a change in gross profit, is affected by a change in units sold and unit sales price. Similarly, cost of goods sold is a factor of units sold and unit cost. Therefore, a change in cost, which also causes 4 change in gross profit, is affected by a change in units sold and unit cost price This relationship is presented on the next page. Sales P x (quantity sold x unit sales price) Cost of goods sold X (quantity sold x unit cost price) Gross profit : P_x Agross profit variance is a difference between the actual gross profit and a base gross profit. Normally, the base gross profit is the gross profit in the last year. The base in computing the gross profit variance may also be the budgeted data, industry averages, or a chief competitors data. For purposes of our illustration, we will use the last year’s data as the basis of computing a gross profit variance. The gross profit variance may be summarized as follows: The sales variances The net sales variance is composed of the sales ; Price vari: . ignce These variances are computed as follows: variance and sales quantity varian°®CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 528 The cost of sales variances The net cost variance is composed of cost price variance and cost quantity variance. These variances are computed as follows: The gross profit variances The gross profit variance is normally accounted for following the sources and operational classification of variances as follows:529 PRODUCT PRICING AND PROFIT ANALYSIS CHAPTER 1, The gross profit variance may also be classified as price factor and quantity factor (ie, volume factor): (You may also Say that gross profit is affected by at least three major variables - unit sales Price, unit cost price, and unit sold.) ‘ . The gross profit variance analysis follows the direct materials variance analysis Notice the formula used in the computing sales-and cost variances follow the same pattem as used in the direct materials price variance and quantity variance, discussed and reviewed below. Actual unit price = Unit sales price this year Standard unit price Unit sales price last year , Actual. quantity = > Quantity sold this year Standard quantity = Quantity sold last year By substitution, we have the sales variances as: SPV = (USPTY-USPLY) gsty) = = AUSP x QsTy sqv = = (QSTY - QSLY) USPLy) = AQx USPLY (The analysis of cost variances follow the patterns i as that of the sal is. Variances are normally identified as U for unfavorable and F for See To illustrate the applications of these formula, let us Consider the following:CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 530 Sample Problem 11.4. Basic gros profit variance analysis * The management of Triple Star Corporation is analyzing the factors that cause an increase in its gross profit in 2020. The information shown below is assembled for this purpose. Increase zone 2020 (Decrease) Sales P 2,640,000 P 2,750,000 P 110,000 Less: Cost of goods sold 1.760.000 2.125000 __365,000 Gross profit Bpagooo Buezson0 ec 2ssoom Units sold 22,000 25,000 3,000 Unit sales price P 12000 P -11000 P (10.00) Unit cost price P 8000 P 8500 P 5.00 Analyze the gross profit variation, using the: 1. 2-way variance analysis. 2. 3-way analysis. Solutions/Discussions: | 1. 2-way variance analysis. + The variances are calculated as follows (refer to formula guidelines on page 318) Price variances Sales price variance IP (10) UF x 25,000 units] P(250,000) _U Cost price variance (PSUF x 25,000 units) 125,000 U Net price variance (375,000) U Quantity variances: Sales quantity variance (3,000 F x P120) 360,000 F Cost quantity variance (3,000 UF x P 80) 240.000 U Net quantity variance 20,000 F Gross profit variance pigssoon) u Notice that the quantity variances, both for sales quantity variance and cost quantity variance, are based on the same quantities. Hence, when used in analysis, the term quantity variance refers to the net quantity variance, which in this case is P120,000 favorable.CHAPTER 11 531 PRODUCT PRICING AND PROFIT ANALYSIS 2. 3-way variance analysis cluded in the analysis 0n top of nnalysis, the ‘joint variance” 'S "! When using the 3-way al pa y 2s, as follows: the basic price and quantity varianc Price variances ‘| (220,000) U Sales price variance [P (10) U x 22,000 units] ; (P.5U x 22,000 units) 110,000 (330,000) < Cost price variance Quantity variance: Sales quantity variance (3,000 F x P120) 360,000 _2a900 U 120,000 F Cost quantity variance (3,000 U x P 80) Joint variances Joint sales price-quantity variance [(P10)F x3.900F] (30,000) U Joint cost price-quantity variance (PSU x 3,000 UF) 15.000 U 45.000 U | Net decrease in gross profit Contribution margin variance analysis The procedures used in analyzing contribution margin variance follows that of the gross profit variance analysis. Sample Problem 11.5. Contribution Margin Variance Analysis The comparative partial income statement data of Crispy Corporation in 2019 and 2020 is shown below. Crispy Corporation Comparative Income Statement Data For The Years Ended, December 31, 2019 and 2020 (in thousands) Increase 2019 2020 (Decrease) Sales P90,000 96,000 —-P 6,000 Less: Variable costs - 54.000 _52,000 (2.000) Contribution margin 36,000 244000 p_go00 Units sold 3,600 4,000 Unit sales price P25 p24 “ Unit variable costs 15 13 =a (2) Analyze the contribution margin variance analysi sis using the 2. -Way analysis.CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 532 Solution/Discussions: The contribution margin variances are computed and presented below: Gross profit variance analysis... only a variance rate is given At times data are not all available. The unit sales price, unit cost price and units sold may not be given on their absolute values but are given in terms of percentage change. The variances to be computed shall be the same, but the procedural computations are slightly reconfigured. The sales variances may also be analyzed as follows: The sales this year and sales last year are normally available. The item to be calculated is the amount of sales this year at unit sales prices last year. To compute this amount we have to know a sales variance ratio. A sales variance ratio given may be a sales price variance ratio or a sales quantity variance ratio. For example, say the last year’s unit sales price is P200 and it increases by P40 this year, then, the sales price variance ratio is 20% (i.e., P40/P200). Assume again that the units sold last year was 40,000 units and decreases to 44,000, then, the sales quantity variance ratio is 10% (i.e., 4,000/40,0000, where 4,000 = 44,0000 less 40,000) The sales this year at sales prices last year (STY @ USPLY) is calculated as follows: If the given is Then, 1. Sales price variance rate: STY@USPLY = Sales this year/ (1+ Sales price variance ratio)| 2. Sales quantity variance rate : STY@USPLY = Sales last year x (1 # Sales quantity variance ratio)CHAPTER 1} ysis = PRODUCT PRICING AND PROFIT ANAL The cost variances are analyzed as follows: The cost this year and cost last year are normally available. The item to’be calculated is the amount of cost of goods sold this year at unit sales prices last year. To compute this amount we have to know a cost variance ratio. A cost variance ratio given may be a cost price variance ratio or a cost quantity variance ratio. The cost this year at cost prices last year (CTY @ UCPLY) is calculated as follows: If the given is Then, 1. Cost price variance rate. :CTY @UCPLY = Cost this year / (1 + Cost price variance ratio) 2 Cost quantity variance rate :CTY @ UCPLY = Cost last year x (1 + Cost quantity variance ratio) To illustrate, assume the following; Sample Problem 11.6. Gross profit variance analysis with only a variance ratio given Arabian Corporation decreased its sales price by 10% in 2020 i Its gross profit data are provided below. as compared with 2019. | i 2019 2020 Change + (-) ales _ P 2,000,000 P 2,340,000 *P 340,000 Less: Cost of goods sold 1.400.000 1.911.000 511.000 Gross profit B_so0.on0 2429.00 B(171,000) Compute the gross profit variances. fs ‘CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 534 Solutions/Discussions: Sales price variance: Sales this year P 2,340,000 ~ Sales this year at unit sales prices last year (P2,340,000 / 90%) 2.600.000 (1) — P(260,000) U Sales quantity variance: Sales this year at unit sales prices last year 2,600,000 (2) ~ Sales last year 2.000.000 600,000 F Cost price variance: Cost this year 1,911,000 ~ Cost this year at unit cost prices last year 820.000 (3) 91,000 U Cost quantity variance Cost this year at unit cost prices last year (P 1,400,000 x 130%) 1,820,000 (4) - Cost last year * 1,400,000 —420.000 U Gross profit variance Puzoon u (1) The sales price rate is given, so the computation starts from the sales price variance. Since the sales price variance rate is given at 10% decrease, then, STY @ USPLY = Sales this year / 90% (i.e., P2,340,000/90%) Q Consequently, the sales quantity variance is computed by getting the difference between theSTY at USPLY and sales last year. Inasmuch as the sales quantity variance is already taken, the sales quantity variance ratio may now be determined, as follows Sales quantity variance rate Sales quantity variance / Sales last year 600,000 F / P2,000,000 ADKE (Increase) A favorable sales quantity variance indicates the quantity sold this year is greater than the quantity sold last year. @ The quantity variance rate applies to both sales and cost of goods sold. Since the uantity variance rate is determined to be 30% increase, then the cost quantity variance May now be computed. In the computation of cost quantity variance, the CTY @ UCLY is unknown. This many now be calculated as, CTY @ UCPLY = Cost last year x 130%, This gives us an amount of P1,820,000. The cost quantity variance is now determined at P420,000 U (.e.,P1,800,000- 1,400,000) and the cost price variances subsequently computed at P91,000 U (i.e., P1,911,000 -P1,820,000).CHAP 535 PRODUCT PRICING AND PROFIT ANALYSIS TER 1] ce rate may ni After computing the cost price variance, the cost price varian y NOW be calculated as follows: Cost price variance / CTY @ UCPLY 91,000 U / P1,820,000 5% UF (Increase) Cost price variance rate An unfavorable cost price variance means that cost price this year is greater than the cost prices last year. As such, there is an increase in unit cost price. (4) Byusing the sales price variance of P260,000 unfavorable, we can check the percentage change in sales price as follows: Sales price variance / STY @ USPLY Sales price variance rate 260,000 U / P2,600,000 = 10% UF (Decrease) ‘An unfavorable sales price variance indicates that the sales price this year decreases compared that of last year. (8) The given variance rate indicates where to start the variance analysis. From the first computation of variance, the implied variance rates of prices and quantiaty may be determined as follows: a. Sales price variance rate ‘Sales price variance / STY @ USPLY | b. Sales quantity variance rate ‘Sales quantity variance / Sales last year | c. Cost price variance rate Cost price variance / CTY @ UCLY | 4. Cost quantity variance rateo Cost quantity variance / Cost last year___) where: STY @USPLY also means Applied Sales This Year CTY @UCLY also means Applied Cost This Year Multi-product Gross Profit Variances In many instances, companies operate in a multi-product sales operations. In this case, the net quantity variance may be divided into sales mix variance and sales yield variance. The sales yield variance is sometimes called as the final sales volume variance. The eales orice variance and the cost price variance computations will stil be the same nee Ina sales mix analysis, the following variance computatio NS gross profit variation: ‘onstitute the accounting forCHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 536 Sales price variance = AUSP x QSTY a Cost price variance = AUCP x QSTY i Sales mix variance: Gross profit this year at UGP last year Px ~ Gross profit this year @ Average unit gross profit last year — Sales mix variance us Sales yield variance (Final sales volume variance) Gross profit this year @ Average unit gross profit last year x ~ Gross profit last year — Sales yield variance —<* | Net gross profit variance pix To illustrate the applications of the above formulas, let us consider the following sample problem Sample Problem 11.7. Multi-Product Profit Variances Android Corporation sells three products — A, B, and C. The sales, cost of goods sold, and gross profit of the three products in 2019 and 2020 are given below. 2019 2020 Sales A( 8,000 unitsxP8) P 64,000 (20,000 units x P6 ) P 120,000 B (26,000 units xP 4) 104,000 (22,000 units x PS) 110,000 (12,000 units xP10) 120,000 (13,000 units x P12) 156,000 288,000 —386.000 Costs A( 8,000unitsxP5) 40,000 (20,000 units x P 4) 80,000 B (26,000 units xP2) 2,000 (22,000 units x P.4) 88,000 C (12,000 units xP6) __72.000 (13,000 units x P 6) 78,000 164,000 246,000 Gross profit (46,000 x P2.69565) B.124.000 (55,000 units xP2.32727) 140,000 Required: Compute the sales price variance, cost price variance, sales mix variance, and sales yield variance Solutions/Discussions: + The change in gross profit variance to be analyzed is: Gross profit this year P 140,000 Less: Gross profit last year Increase in gross profit537 PRODUCT PRICING AND PROFIT ANALYSIS CHAPTER 1} +» The increase in gross profit is analyzed as follows: Sales price variance = AUSP x QSTY A = (P2)U x 20,000 units PC Ao aeye P1 F x 22,000 units oot P2 Fx 13,000units = 26,000 Net sales price variance P 8,000 F Cost price variance = AUCP x QSTY A = (P1)F x 20,000units = (20,000) F P2Ux 22,000units = 44,000 U 0 x 13,000units = ——2 Net cost price variance 24,000 U Sales mix variance: Gross profit this year at unit gross profit last year ‘A (20,000 units x P3)* 60,000 B (22,000 units x P2) 44,000 (13,000 units x P4) 52,000 Total 156,000 - Gross profit this year at average unit gross profit last year (55,000 units x P2.69565)** 148,261 Net sales mix variance 7,739 F Sales yield variance’ Gross profit this year at average unit gross profit last year.” 148,261 - Gross profit last year 124,000 Net sales yield variance 24261 F Net gross profit variance F *UGP last year = USP last year - UC last year enpoa eg., Product A (P 8-P5) P3 Product B (P 4-P2) 2 Product © (P10- P6) 4 ** UGP last year = GP last year / Total units sold last year P124,000 / (8,000 + 26,000 + P2,69565 van) You may refer to our previous discussions on sale F Ss price ice variance in sample problem no.1 for the formula guidetin Price variance and cost price varia! es.CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 538 The sales mix variance may be alternatively computed as follows: [_ b © (d=b0) e (f= dxe) | A unit | Mix Variance Product | Actual ctual qty. sold at MixVar | gross | inpesos-F ty. sold standard sales mix FUR) profit (UF) last year A 20,000 | (55,000 x 8/46) = 9,565 70435F | P3 P 31305F 8 22,000 | (55,000 x 26/46) = 31,087 (9,087) U 2 (18174)U c 13,000 | (55,000 x 12/46) = 14,348 (1,348) U 4 LS392)U 35.000 Net sales mix variance P2238 The total units sold is in 2012 is 55,000 units (i.e., 20,000 + 22,000 + 13,000). The fractions 8/46, 26/46, and 12/46 were developed based on the standard sales mix last year. (Where A=8,000 units, B=26,000 units, and C=12,000 units). The third column (quantity sold this year at standard sales mix) determines the expected quantity sold based on standard sales mix of the last year. If the actual quantity sold per product is greater than the actual quantity at standard sales mix, the mix variance is unfavorable, otherwise, the mix variance is favorable. + The sales yield variance may be alternatively computed as follows: Quantity sold this year 5,000 units ~ Quantity sold last year 46,000 Yield variance in units 9,000 F x Average unit gross profit last year 2.69565 Yield variance in pesos B24261 F + The sum of the sales mix variance and the sales yield variances the net quantity variance: Quantity variance = AQ x Unit gross profit rate last year ‘ A = 12000FxP3 = 36,000 F 8 (4,000) U x P2 (8,000) u c = 1000FxP4 = _ 4000 F Net quantity variance Bazgoo F The changes in quantity (AQ) are computed as follows: A (24,000 units - 8,000 units) = 12,000 units F 8 (22,000 units - 26,000 units) (4900) -u c (13,000 units - 12,000 units) = 1,000 F To check, we hav Sales mix variance P 7730.F Sales yield variance 24.261 F Net quantity variance pazong Fose PRODUCT PRICING AND PROFIT ANALYSIS: CHAPTER 1) STRAIGHT PROBLEMS 1. Target pricing. Agusan Corporation is in the process of determining the target selling price for one of its products. Cost data relative to the product are as follows: Per Unit Direct materials P10 Direct labor 14 Variable manufacturing overhead 6 Variable expenses 3 Fixed manufacturing overhead 5 4 Fixed expenses The costs above are based on an anticipated capacity of 180,000 units. The company uses cost-plus pricing, and it has a policy of establishing its sales price by adding a mark-up of 50% on absorption costs. Required 1. Compute the sales price per unit. 2. Compute the mark-up ratio on contribution margin costing. 2. Cost-based pricing. Dennis Company's cost structure for a certain item at a level of 20,000 units per month is as follows Manufacturing costs: Direct materials P1.00 Direct labor 1.20 Variable indirect cost 0.80 Fixed indirect cost 0.50 Selling and others: Variable 1.50 Fixed 0.90 Required: Determine the selling price per unit if the markup ratio is 1. 50% based on conversion costs. 4. 30% based on total (full) costs. 2. 40% based on full production costs. 5. 35% based on total variable costs. 3. 45% based on variable production costs. 6. 60% based on prime costs. 3. Incremental pricing. Using the same data in problem 2, and that the company desires to enter a foreign market, in which price competition is keen. An order for 10,000 units © this product is being sought on a minimum unit price basis. It is expected that shipping costs for this order will amount to only P0.75 per unit but fixed costs of obtaining the contract will be P40,000. Domestic business will be unaffected. Required: Determine the minimum basis for breakeven price.CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 540 4. Mark-up ratios Davao del Sur Corporation is considering the introduction of a new product with following relevant costs: Number of units to be produced and sold 30,000 Estimated required investment P 6,000,000 Desired ROI 15% Costs and expenses: Direct materials P 20 Direct labor 15 Variable factory overhead 5 Fixed factory overhead 4 Variable expenses 3 Fired expenses 2 Required: Compute the mark-up ratio assuming the following cost bases: 1. Absorption costs. 2 Variable costs and expenses. 3. Variable production costs 4 Full costs. 5. Materials cost 5. Mark-up ratio, target sales price. Butuan Corporation is considering the production of a new product that needs P2.5 million investment. The company wants a 12% ROI on all products and uses the contribution margin approach to pricing. The costs shown below are traceable to the new product. Variable factory costs per unit P30 Fixed factory overhead 600,000 Variable expenses per unit 6 Fixed expenses 150,000 The company expects to sell 50,000 units a year. Required: 1. Mark-up ratio. 2 Target unit sales price 3. Assuming the expected sales 30,000 units instead of 50,000 units, what is the mark- up ratio? Time and material pricing. Camiguin Corporation provides electronics repair services and uses time and material pricing. The company has budgeted the following costs for the next year. Technicians’ wages and fringe benefits Other repair costs, except for parts-related costs Ordering, handling and storing costs of parts P 600,000 200,000 20% of invoice costS41 PRODUCT PRICING AND PROFIT ANALYSIS CHAPTER 11 urs of billable repair time and aims for In 2015, the company expects to serve 20,000 ho' p ‘on invoice cost is 40%. a profit of P20 per hour billed. The mark-up ratio Required: 1. Calculate the standard time and material loading ch ing jobs done 2. One of the company's technicians has j of time and P1,200 in parts. How muc! arge rate to be used in bill- ust completed a repair that required 4 hours fh should be billed for the job? ler Company produces and sells three products 7. Determining advertising costs. The Roll llowing actual results for the current year are -Economy, Standard, and Deluxe. The fol based on absorption costing: Economy Standard Deluxe Total Sales in units 2.500 2,000 3.500 8.000 Sales revenue 50,000 80,000 70,000 200,000 Cost of goods sold —30.000 40,000 50.000 120,000 Gross profit . p2oo90 p4oon0 p2.000 e.apo00 Operating expenses Sales commissions P 5000 P 8,000 P 7,000 P 20,000 Allocated head office expenses —2500 12.000 10,500 30,000 Total p12500 P2000 P_17,500 _50.000 Income from products ezs00 = =P.20,000 P2500 30,000 Unallocated head office expenses 20.000 Income before taxes 10,000 Income tax expenses (45%) —4500 Net income pssoo All head office expenses are fixed, and 60% of the manufacturing costs are fixed. The company is considering the implementation of an advertising campaign thatis expected to increase the sales of Deluxe by 40% and the sales of Standard by 80%; however, the increased sales volume of these two products will cause a 20% decrease in the sales volume of Economy. Required: Determine the maximum amount that the company can afford to spend on advertising if it wants to achieve a net income of P22,000. (smac)oy CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 542 8. Product pricing. Mercado Companyis considering changing the sales price of its product, Salien, which is presently set at P15. Increases and decreases of both 10% and 25%, as _well as increases in advertising and promotion expenditures, are being considered, with the following estimated results for 2014 and 2015: Estimated Advertising and Estimated Unit Sales Promotion Expenditures Price 2014 2015 2014 2015’ + 25% 190,000 200,000 200,000 210,000 = 10% 180,000 190,000 250,000 250,000 Nochange 160,000 170,000 300,000 300,000 +10% 140,000 150,000 400,000 450,000 + 25% 130,000 140,000 450,000 550,000 The company has the necessary flexibility in its production capacity to meet these volume levels. The variable manufacturing cost per unit of Salien is estimated to be P7.25 in 2014 and P7.80 in 2015. Required: Determine the recommended sales price {iera) 9. Contribution approachto pricing. Tammany Boats manufactures custom-made pleasure boats ranging in price from P10,000 to P25,000. For the past 30 years, the company has. determined each boat's sales price by estimating the costs of materials, labor, and a prorated portion of overhead and by adding 20% to these estimated costs. For example, a recent price quotation was determined as follows: Direct materials P 5,000 Direct labor 8,000 + Overhead —2.000 P 15,000 Plus 20% —3.000 Sales price Eu The overhead figure was determined by estimating the total overhead costs for the year and allocating it at 25% of direct labor. If a customer rejects the price and business is slack, the company is often willing to reduce the markup to as little as 5% over estimated costs. Thus, average markup for the year is estimated at 15%. The owner has just completed a pricing course and believes that the company could use some of the techniques taught in the course. The course emphasized the contribution margin approach to pricing, and management feels such an approach would be helpful in determining the sale prices of customer-made pleasure boats Total overhead (including marketing and administrative expenses for the year) has been estimated at P150,000, of which P90,000 is fixed and the remainder is variable in direct. Proportion to direct labor.543, 10. Required: 1. a. Compute the difference in profi UCT PRICII NALYSIS CHAPTER) PRODI it for the year, if a customer's offer of P1509, d. (000 quoted, is accepte ; b. Tore re num sales price the company could have quoted without reducing or increasing profit. ; 2. State the advantages that the contribution margin ap! the approach used by the company. | 3. Identify the pitfalls, if any, in contribution margin pricing, (icma) proach to pricing has over ny manufactures office equipment for sale to retai) posed that Kolesar introduce two new Jectric pencil sharpener. Product pricing. Kolesar Compal stores. The vice-president of marketing has pro! products to its line - an electric stapler and an él een requested to develop preliminary sales The Profit Planning Department is to follow potential sales prices, using as much deta lated by the Profit Planning Department Kolesar's Profit Planning Department has b prices for the two new products for review, the company’s standard policy for developing as are available for each product. Data accumu! are shown in the following tale: Electric Electric Pencil Stapler ‘Sharpener Estimated annual demand in units 12,000 10,000 Estimated unit manufacturing costs P10 P12 Estimated unit marketing and administrative expenses 4 notavailable Assets employed in manufacturing 180,000 _not available Kolesar plans to employ an average of P2,400,000 in assets to support its operations in the current year. The condensed pro forma operating income statement represents Kolesar’s planned goals with respect to cost relationships and return on capital employed for the entire company for all its products. Kolesar Company ro Forma Operating Income State For The Year Ending May 31, ocr Sales revenue Cost of goods sold . oe Gross profit Marketing and administrative expenses : a Operating income BP 4B0 Required: 1. Calculate a potential sales price for the follow) a. The electric stapler, using returnonea cra b. The electric sharpener, using grose-pref no ove pricing 2, Should a sales price for the electric pon pei ‘gin pricing. 7 retuin-on-capitabemployed pricing? Exoper ll Sharpener be calculated us"# lain your answer.CHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 544 3. Which of the two pricing methods (return-on-capital-employed or gross profit Margin) is appropriate for decision analysis? Explain. 4. _ The vice-president of marketing has received from the Profit Planning Department the Potential sales prices for the two new products (as calculated in requirement 1). Discuss the additional steps that the vice-president is likely to take to set an actual sales price for each of the two products. (icma) 11. Gross profit variances analysis. Brown Distributors presents the following data for two types of canned products, Tamis and Anghang, for 20PY and 20CY: 20PY 20cy Per Per Units Unit Amount Units Unit Amount Sales: Tamis: 8,000 P8.00 P 64,000 12,000 P10.00 P120,000 Anghang 8,000 4.00 32.000 20,000 6.00 120,000 P 96,000 240.000 Cost of goods sold Tamis 8,000 P6.00 P 48,000 12,000 P 9.00 P108,000 Anghang 8,000 3.00 —24,000 20,000 5.00 100,000 P 72.000 208.000 Gross profit 16,000 P1.50 B.24,000 32,000, P 1.00 2.32000 12. Required: Compute the price and volume variances for sales and costs, and the sales mix and final sales volume variances. (adapted) Gross profit variances analysis. Handy Home Products Company distributes two home- use power tools to hardware stores, a heavy-duty %-inch drill and a table saw. The tools are purchased from a manufacturer that attaches the Handy Home Products label on the tools. The wholesale selling prices to the hardware stores are P60 each for the drill and P120 each for the table saw. The budget for the current year and the actual results are presented in the following table. The budget was adopted late in the preceding year and was based on Handy Home Products’ estimated share of the market for the two tools.Sales in units PRODUCT PRICING AND PROFIT ANALYSIS CHAPTER 1} Handy Home Products Company Income Statement For The Year Ended December 31, 20cY (in thousands) Hand Drill Table Saw Total Budget Actual Budget Actual Budget Actual Variance 120 86 80 74 200 160 0 P7200 P5074 P9,600 P8510 16800 P13,584 P3,216U Revenues Costofgoodssold 6,000 4.300 6400 6,068 12400 10368 2032F Gross profit pio e774 paz e2ud2 P4000 P3216 PLis4u Unallocated costs Profit 13. * 1,000 1,000 Poo 1,000 1,060 6ou 400 406 6U —200 33g _S62F 3300 2804 __496F pling «= B.A12 BbBBl Selling Advertising Administration Income tax (45%) Total During the first quarter of the current year, Handy Home Products’ industry projections iniceted that the total market for these tools would actually be 10% below origina management estimates. In an attempt to prevent unit sales from declining as much as industry projections, management developed and implemented a marketing program Included in the program were dealer discounts and increased direct advertising The table-saw line was emphasized in this program. Required: 1. Analyze the unfavorable gross profit variance of P1,184,000 in terms of sales price variance, cost price variance, sales mix variance, and final sales volume variance 2. Discuss the apparent effect of the special marketing program (that is, dealer discounts and additional advertising) on actual operating results. Provide supporting numerical data where appropriate. (icra) Gross profit variance analysis. H. Paceris the general mana i ical ger for Servicemart Chemic Supply Company. The following is the company's gross er, i thousands of pesos: gross profit data for Novemb Actual Budget Sales 14,005 P12,600 Cost of goods sold 1.323 —2.850 Gross profit 26a Before receiving the statement, Pacer knew that sales we Before tne effect of recent Price increases on most Hed sti pals mattCHAPTER 11 PRODUCT PRICING AND PROFIT ANALYSIS 546 month. Upset on finding that income results were below budget while sales were more than 10% above budget, Pacer asked the Accounting Department for an explanation. The Accounting Department looked at the detailed budget and found the following data: Sales in Sales Cost,of Goods Gross Pound (in Price per Product thousands) Pound ee (Genus) 1 2,000 P 975 P. .60 P 750 2 5,000 762 65 560 3 7,000 20 20 oO 4 4,000 1.50 114 1.440 18,000 22750 (P2,750 / 18,000 = P0.1528 budgeted gross profit per pound) Sales in Sales Salesin CostofGoods Gross Pound Price per Pesos Sold per Profit Product __(inthousands) Pound _(inthousands) Pound _(in thousands) 1 2,845 P 735 P 2,091 P 1,692 P 399 2 3,280 1.023 3,355 3,240 5 3 7,340 195 1,431 991 440 4 4320 1.650 2128 5.400 L228 12785 214.005 P11.323 P2582 Required: Compute the price and volume variances for sales and cost, and the sales mix and final sales volume variances. (Management Accounting Campus Report) 14. Sales variance ratios. Sales last year of P5 million decreased to P4.5 million but sales quantity variance increased by 20% Required: Determine the following: 1. Sales quantity (volume) variance. 2. Sales price variance. 3. Sales price variance ratio. 15. Cost variance ratios. Cost of goods sold this year amounting to P6.6 million is 20% higher than that of last year. On the average, cost prices increased by 10%. Required: Compute the following: 1. Cost price variance. 2. Cost quantity variance. 3. Cost quantity variance ratio.547 PRODUCT PRICING AND PROFIT ANALYSIS CHAPTER 11 16. Sales and costs variances with incomplete data. The contribution margin of Tatamboy Corporation for 20PY and 20CY are given below: 20PY 20cy Sales P 8,000,000 12,000,000 Less: Variable costs 6.000.000 8,000,000 Contribution margin 2.000.000 2.4,0n0.000 The number of units sold increased by 5%. Required: Compute the following for the year 20CY: 1. Sales price variance and sales price variance ratio. 2. Sales quantity variance. 3. Variable cost price variance and variable cost price variance ratio. 4. Variable cost quantity variance.