Topic 5

➢ Still, pricing a product is a decision that directly affects the profitability of business
operations.
➢ This field of business management has been truly more of an art than 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, government
regulations, changes in technology and other external factors, to name a few.
➢ Because of this, the field of product pricing has generated various pricing models.
Setting the price of a product could be done in different perspectives, such as:
 Tactical Pricing

The traditional pricing models follow the basic

methods of determining in a unit sales price.
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 demand curve in relation to price, the
negative sign in the numerator has the effect on making the outcome positive, simply to
more conveniently represent the relationship.

✓ If the elasticity of demand is greater that 1, demand is considered elastic.

o This means that a reduction in price would increase demand considerably.
✓ And if the elasticity of demand is less than 1, demand is considered inelastic.
o This means that if price increases the demand for the product would decline.
 Factors affecting price
elasticity

▪ Market definition
▪ Competition and
product availability
▪ Substitute products
▪ Complementary
products
▪ Disposable income
▪ Product necessity
▪ Consumer habits
Sample Problem 10-1. DEMAND ELASTICITY

The following results were tabulated with respect to the relationship of changes in price and units sold
with respect to product “Mozz”
P0 P1 Average Percentage
Sales price P100 P120 P20 P110 18.18%
Quantity sold 2,000 1,500 (500) -1,750 -28.57%

= Change
Required: Determine the elasticity of demand.

Solutions/Discussions: • The -1.57 elasticity rate means

• Applying the formula, we have: that product Mozz is
considerably elastic with the
Elasticity of demand = Percentage in Quantity demanded change in selling price.
Percentage in Unit Sales Price

= -28.57%/ 18.18%
= -1.57
 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, their
satisfaction is heightened.
➢ Otherwise, 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.

Controlled-market based pricing

➢ This product pricing model based its prices on government regulations or implied
agreements among key players in the market. Gas and oil companies, mining companies and
utility companies use this method.
 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, process, activities, systems are established accordingly
to produce product not in excess of determined cost, otherwise, the profit will
suffer,
➢ Costs become targets of 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 survival.
❑ A price is established that would be applicable over the life-span of a product.
❑ The price is determined by dividing the total costs(locked-in costs and operational costs over the total estimated units to
be produce or sold. (TC/EUP)
❑ The life stages of a product are normally divided into four, namely:
1. Infancy stage 2. growth stage 3. expansion stage 4.maturity/decline stage
❑ In the life-cycle based pricing, another stage is included which is the pre-infancy(or conception) stage. This stage precedes
the infancy stage. During this pre-infancy stage.
✓ Strategic decisions are made and costs are locked-in.
✓ Locked-in costs(or designed-in costs) are not yet incurred but are expected to be incurred in the future, as
caused by decisions made during the infancy stage.
✓ To effectively reduce costs, locked-in costs should be minimized.

❑ life-cycle-based pricing includes all costs relative to a product

❑ These are costs in research and development, design, production, marketing, distribution, and
customer services.
❑ A significant portion of product's life –cycle costs are incurred even before the start of commercial
operations. And ignoring the effects of these costs incurred and committed prior to commercial
production would understate the true amount of costs and may lead to lower sales price and reduced
profitability.
❑ One of the pre-commercial expenditures that has a great impact on operational costs is the cost of
design. An excellent product design that meets customer’s acceptance effectively puts in place
efficient and economical manufacturing system that brings lesser costs relative to retraining,
retooling. Production setups, spoilage and design changes after production has started.
Problem sample- 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 pre-infancy P 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 P 34,000,000 1,000,000
The company would like to apply the life-cycle based costing and price its product based on the strategic life-cycle 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
It is also estimated that all units produced
would be sold
 Requirement 3
Scheme 1 Scheme 2
Life-cycle Production Unit Price Sales Production Unit Price Sales
Infancy & pre-infancy 50,000 40.80 2,040,000 50,000 374.00 18,700,000
Growth 250,000 204.00 51,000,000 250,000 374.00 93,500,000
Expansion 500,000 374.00 187,000,000 500,000 306.00 153,000,000
Maturity & Decline 200,000 37.40 7,480,000 200,000 37.40 7,480,000
Total Sales 247,520,000 272680,000
Less: Costs 34,000,000 34,000,000
Profit 213,520,000 238,680,000
• 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 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 bundling policy and the customers
reactions when products are unbundled later.
This is 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:

➢ Cost-based is anchored to the definition of cost.

➢ If the sales price is based on absorption cost, then cost-based pricing includes the costs of materials,
labor, variable overhead, and fixed overhead.
➢ If the cost is defined as prime cost, then the cost-based is the sum of direct materials and direct labor.
Costs and expenses Prime cost Cost is defined as Absorption cost
Materials Px Cost-based
Labor x Cost-based
Variable overhead x
Fixed overhead x Non-cost-based
Variable expenses x Non-cost-based
Fixed expenses x
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. It is 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
Markup ratio = ( Non-cost-based + Profit) / Cost-based
To illustrate, let us assume the data given below.

Sample problem 10.3 Sales price setting using cost-based model.

The Accounting department of Baguio Corporation has assembled the following data relative to the product
Cold:
Per Unit
Direct materials P10.00
Direct labor 20.00
Variable overhead 5.00
Fixed overhead 6.00
Variable Expenses 5.00
Fixed Expenses 4.00
Total costs and expenses P50.00
The company wants a 20% return on is 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 (marginal costing) method.
3. Prime Cost.
4. Conversion cost.
5. Material cost.
Solutions/discussions:
• Basically, the sales price is computed in details as follows:
Per Unit
Direct materials P10.00
Direct labor 20.00
Variable overhead 5.00
Fixed overhead 6.00
Variable Expenses 5.00
Fixed Expenses 4.00
Total costs and expenses P50.00
Add : Profit (P3 million x 20%/ 40,000 units) 15.00
Unit sales price P65.00
• The sales price under various cost definitions are:

(1) (2) (3) (4) (5)

Absorption Cost Marginal Cost Prime Cost Conversion Cost Material Cost

Cost-based P41.00 P40.00 P30.00 P31.00 P10.00

Markup*
(P41 x 58.54%) 24.00
(P40 x 62.50%) 25.00

(P30 x 116.67%) 35.00

(P31 x 109.68%) 34.00

(P10 x 550.00%) 55.00

Unit sales price P65.00 P65.00 P65.00 P65.00 P65.00

*Markup = Cost-based
x markup ratio
• Markup ratio is profit plus non-cost based divided by cost-based. The markup ratios are calculated
below:
Absorption Cost Marginal Cost Prime Cost Conversion Cost Material Cost

Profit P15.00 P15.00 P15.00 P15.00 P15.00

Non-cost based*
(P50-41) 9.00
(P50-40) 10.00
(P50-30) 20.00
(P50-31) 19.00
(P50-10) 40.00
Markup 24.00 25.00 35.00 34.00 55.00
/ Cost-based 41.00 40.00 30.00 31.00 10.00
Markup ratio 58.54% 62.50% 116.67% 109.68% 550.00%

*Non-cost based = Total costs and expenses (50-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 cot-based in as much 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.
The gross profit variance is the 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 budgeted data, industry averages, or a chief competitors data. For purposes of our illustration, we will
use the last years data as the basis of computing a gross profit variance. The gross profit variance may be
summarized as follows:
This Year Last Year Net Variance
Sales Px Px Px
Less: Cost of goods x x x
sold
Gross profit Px Px Px
Data treated as Actual Standard
The net cost variance is composed of cost price variance and cost quantity variance. These variances are
computed as follows:
CPV = (UCPTY – UCPLY) QSTY = UCP x QSTY
CQV = (QSTY – QSLY) UCPLY = Q x UCP
where:
CPV = Cost price variance
CQV = Cost quantity variance
UCPTY = Unit cost price this year (actual price)
QSTY = Quantity sold this year (actual quantity)
QSLY = Quantity sold land year (standard quantity)
The gross profit variance may also be classified as price factor and quantity factor (volume factor) :
Price factor:
Sales price variance Px
Cost price variance x Px
Quantity factor:
Sales qty. variance x
Cost qty. variance x
Net quantity variance x
Gross profit variance Px

The gross profit variance analysis follows the direct materials variance
analysis
 Contribution margin variance analysis
The procedure used in analyzing contribution margin variance follows that of the gross profit variance
analysis.
The comparative partial income statement data of Crispy corporation in 2014 and 2015 is shown below:

Crispy Corporation
Comparative Income Statement data
For The Years Ended, December 31, 2014 and 2015(in thousands)
2014 2015 Increase (Decrease)
Sales P90,000 P96,000 P6,000
Less: Variable costs 54,000 52,000 (2,000)
Contribution Margin P36,000 P44,000 P8,000
Units sold 3,600 4,000 400
Unit sales price P25 P24 P(1)
unit variable costs 15 13 (2)
Analyze the contribution margin variance analysis using the 2-way analysis.

Solutions/ discussions:
✓ The contribution margin variances are computed as follows.

Sales variances:
Sales price variance [(P1) UF x 4,000 units] P 4,000 UF
Sales quantity variance (400 F x P25) 10,000 F P 6,000 F

Variable costs variances:

Variable cost variance [(P2) F x 4,000 units] 8,000 F
Variable quantity variance ( 400 UF x P15) 6,000 UF 2,000 F

Net contribution margin variance P 8,000 F

Sales price variance

Sales quantity variance

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)

The cost variance s are analyzed as follows

Cost this year = QSTY x UCPTY
Cost price variance
Applied cost this year = QSTY x UCPLY
Cost quantity variance
Cost last year = QSLY x UCPLY

If the given is Then,

1.Cost price variance rate : CTY @ USPLY = Cost this year/ (1+ Cost price variance ratio)
2.Cost quantity variance rate : CTY @ USPLY = Cost last year x (1+ Cost quantity variance ratio)
Sample problem 10,6 Gross profit variance analysis with only a variance ratio given

Arabian Corporation decreased its sales price by 10% in 2015 as compared with 2014. Its gross profit data are provided below.

2014 2015 Change +(-)

Sales P2,000,000 P2,340,000 P340,000
Less: Cost of goods sold 1,400,000 1,911,000 511,000
Gross profit P 600,000 P 429,000 P(171,000)

Compute the gross profit variances.

Solutions /Discussions:
Sales price variance:
Sales this year P2,340,000
-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 sales prices last year 1,820,000 (3) 91,000 U

Cost quantity variance:

Costs this year at unit sales prices last year
(P1,400,000 x 130%) 1,820,000 (4)
-Sales last year 1,400,000 420,000 U
Gross profit variance P 171,000 U
 Variance rates
Sales price variance rate
Sales quantity variance rate
Cost price variance rate
Cost quantity variance rate
Formulas
Sales price variance / STY@USPLY
Sales quantity variance / Sales last year
Cost price variance / CTY@UCLY
Cost quantity variance/Cost last year

where : STY@USPLY also means Applied Sales This Year

CTY@UCLY also means Applied Cost This Year
Sales price variance = USP x QSTY Px
Cost price variance = UCP x QSTY x
Sales mix variance :
Gross profit this year at UGP last year Px
- Gross profit this year @ Average unit gross profit last year x
Sales mix variance x
Sales yield variance (FSVV):
Gross profit this year @ Average unit gross profit last year x
-Gross profit last year x
Sales yield variance x
Net gross profit variance P x

To illustrate the applications of the above formulas, let us consider the ff. sample problem.
Sample Problem 10.7 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 2014 and 2015 are given on the next slide:
 2014 2015
Sales: A (8,000 units x P8) P64,000 (20,000 x P6) P120,000
B(26,000 units x 4) 104,000 (22,000 xP5) 110,000
C(12,000 units x 10) 120,000 (13,000 x P12) 156,000
288,000 386,000
Costs: A (8,000 units x P5) 40,000 (20,000 x P4) P80,000
B(26,000 units x 2) 52,000 (22,000 x P4) 88,000
C(12,000 units x 6) 72,000 (13,000 x P6) 78,000
164,000 246,000
Gross profit (46,000 x P2.69565) P124,000 (55,000 x P2.32727)P140,000

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 P140,000
Less: Gross profit last year 124,000
Increase in gross profit 16,000 F

• The increase in gross profit is analyzed as follows:

Sales price variance = USP x QSTY
A = (P2) U x 20,000 Units = . P(40,000) U
. B = P 1 F x 22,000 units = 22,000 F
C = P 2 F x 13,000 units = 26,000 F
Net sales price variance P 8,000 F

Cost price variance = UCP x QSTY

A = (P1) F x 20,000 Units = . (20,000) F
. B = P 2 U x 22,000 units = 44,000 U
C = 0 x 13,000 units = 0
Net sales price variance 24,000 U

Sales mix variance:

Gross profit this year at unit gross profit last year • *UPG last year = USP last year –
UC last year
A (20,000 units x P3)* 60,000 ➢ Product A(P8-P5) P 3
B (22,000 units x P2) 44,000 ➢ Product B (P4-P2) 2
C (13,000units x P4) 52,000 ➢ Product C (P10-P6) 4
Total 156,000
-Gross profit this year at average unit gross profit **UGP last year = GP last year/
last year (55,000 units x P2.69565)** 148,261 Total units sold last year
Net sales mix variance 7,739 F =P124,000/(8,000+26,000+12,000)
= P 2.69565
Sales yield variance:
Gross profit this year at average unit gross profit 148,261
last . Year
- Gross profit last year 124,000
Net yield variance 24,261 F
Net gross profit variance P 16,000 F
 • The sales mix variance may be alternatively computed as follows:

(a) (b) ( c) (d= b-c) (e) (f=d x e)

Product Actual Qty. Actual Qty. sold at Mix Var Unit gross profit Mix variance in
sold standard sales mix F(UF0 last year pesos – F(UF)

A 20,000 (55,000 x 8/46)= 9,565 10,435 F P3 P31,305 F

B 22,000 (55,000 x 26/46) =31,087 (9,087) U 2 ( 18,174) U
C 13,000 (55,000 x 12/46)= 14,348 (1,348) U 4 ( 5,392) U
55,000
Net sales mix P 7,739 F
variance

❑ The total units sold in 2012 is 55,000 units( 20,000+22,000+13,000).

❑ The fractions 8/46.,26/46 , and 12/46 were developed based on standard sales mix last year. ( where A=
8,000 units, B= 26,000 units, and C=12,000 units).
❑ The 3rd 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 standard sales mix, the mix
variance is unfavorable, otherwise, the sales mix variance is favorable.
• The sales yield variance may be alternatively computed as follows:
Quantity sold this year 55,000 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 P 24,261 F
• The sum of the sales mix variance and the sales yield variance is the net quantity variance:
Quantity variance = Q x unit gross profit rate last year
A = 12,000 F x P3 = P36,000 F
B = (4,000) U x P2 = (8,000) U
C = 1,000 F x P4 = 4,000 F
Net quantity variance P32,000 F
The changes in quantity are computed as follows:
A (20,000 units -8,000 units) = 12,000 units F
B (22,000 units – 26,000 units)= (4,000) U
C (13,000 units-12,000 units)= 1,000 F

To check we have:
Sales mix variance P7,739 F
Sales yield variance 24,261 F
Net quantity variance P32,000 F