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Pricing Products and Services Appendix A PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. Appendix A-2 Learning Objective A-1 Compute the profitmaximizing price of a product or service using the price elasticity of demand and variable cost. Appendix A-3 The Economists’ Approach to Pricing Elasticity of Demand The price elasticity of demand measures the degree to which the unit sales of a product or service are affected by a change in unit price. Change Change in versus in Unit Price Sales Appendix A-4 Price Elasticity of Demand Demand for a product is inelastic if a change in price has little effect on the number of units sold. Example The demand for designer perfumes sold at cosmetic counters in department stores is relatively inelastic. Appendix A-5 Price Elasticity of Demand Demand for a product is elastic if a change in price has a substantial effect on the number of units sold. Example The demand for gasoline is relatively elastic because if a gas station raises its price, unit sales will drop as customers seek lower prices elsewhere. Appendix A-6 Price Elasticity of Demand As a manager, you should set higher (lower) markups over cost when demand is inelastic (elastic) Appendix A-7 Price Elasticity of Demand Єd = ln(1 + % change in quantity sold) ln(1 + % change in price) Price elasticity of demand Natural log function I can estimate the price elasticity of demand for a product or service using the above formula. Appendix A-8 Price Elasticity of Demand Suppose the managers of Nature’s Garden believe that every 10 percent increase in the selling price of its apple-almond shampoo will result in a 15 percent decrease in the number of bottles of shampoo sold. Let’s calculate the price elasticity of demand. For its strawberry glycerin soap, managers of Nature’s Garden believe that the company will experience a 20 percent decrease in unit sales if its price is increased by 10 percent. Apple Almond Appendix A-9 Price Elasticity of Demand For Nature’s Garden apple-almond shampoo. Єd = ln(1 + % change in quantity sold) ln(1 + % change in price) Єd = ln(1 + (-0.15)) ln(1 + (0.10)) Apple Almond Єd = ln(0.85) ln(1.10) = -1.71 Appendix A-10 Price Elasticity of Demand For Nature’s Garden strawberry glycerin soap. Єd = ln(1 + % change in quantity sold) ln(1 + % change in price) Єd = ln(1 + (-0.20)) ln(1 + (0.10)) Єd = ln(0.80) ln(1.10) = -2.34 Appendix A-11 Price Elasticity of Demand The price elasticity of demand for the strawberry glycerin soap is larger, in absolute value, than the apple-almond shampoo. This indicates that the demand for strawberry glycerin soap is more elastic than the demand for apple-almond shampoo. Apple Almond Appendix A-12 The Profit-Maximizing Price Under certain conditions, the profit-maximizing price can be determined using the following formula: Profit-maximizing markup on = variable cost -1 1 + Єd Using the above markup, the selling price would be set using the formula: Variable -1 Profit-maximizing × cost per = 1 + price 1 + Єd unit Appendix A-13 The Profit-Maximizing Price Let’s determine the profit-maximizing price for the apple-almond shampoo sold by Nature’s Garden. The shampoo has a variable cost per unit of $2.00. Price elasticity of demand = -1.71 Apple Almond Profit-maximizing markup = on variable cost -1.00 1 + (-1.71) Variable cost per unit $ Markup ($2.00 × [1 + 1.41]) Profit-maximizing price $ = 1.41 or 141% 2.00 2.82 4.82 Appendix A-14 The Profit-Maximizing Price Now let’s turn to the profit-maximizing price for the strawberry glycerin soap sold by Nature’s Garden. The soap has a variable cost per unit of $0.40. Price elasticity of demand = -2.34 Profit-maximizing markup = on variable cost -1.00 1 + (-2.34) = 0.75 or 75% Variable cost per unit $ Markup ($0.40 × [1 + .75]) Profit-maximizing price $ 0.40 0.30 0.70 Appendix A-15 The Profit-Maximizing Price Apple Almond The 75 percent markup for the strawberry glycerin soap is lower than the 141 percent markup for the apple-almond shampoo. This is because the demand for strawberry glycerin soap is more elastic than the demand for applealmond shampoo. Appendix A-16 The Profit-Maximizing Price This graph depicts how the profit-maximizing markup is generally affected by how sensitive unit sales are to price. Optimal markup on variable cost 500% 450% 400% 350% 300% 250% 200% 150% 100% 50% 0% 10% 15% 20% 25% 30% 35% Percent decrease in unit sales due to a 10% increase in price 40% Appendix A-17 The Profit-Maximizing Price Nature’s Garden is currently selling 200,000 bars of strawberry glycerin soap per year at the price of $0.60 a bar. If the change in price has no effect on the company’s fixed costs or on other products, let’s determine the effect on contribution margin of increasing the price by 10 percent. Appendix A-18 The Profit-Maximizing Price Contribution margin will increase by $1,600. Sales price Units sales Sales Variable cost Contribution margin Present Price $ 0.60 200,000 Higher Price $ 0.66 160,000 $ $ $ 120,000 80,000 40,000 † $0.60 + (0.10 × $0.60) = $0.66 ‡ 200,000 - (0.20 × 200,000) = 160,000 $ 105,600 64,000 41,600 † ‡ Appendix A-19 Learning Objective A-2 Compute the selling price of a product using the absorption costing approach. Appendix A-20 The Cost Base Under the absorption approach to cost-plus pricing, the cost base is the absorption costing unit product cost rather than the variable cost. The cost base includes direct materials, direct labor, and variable and fixed manufacturing overhead. Appendix A-21 Setting a Target Selling Price Here is information provided by the management of Ritter Company. Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Variable S & A expenses Fixed S & A expenses Per Unit $ 6 4 3 Total $ 70,000 2 60,000 Assuming Ritter will produce and sell 10,000 units of the new product, and that Ritter typically uses a 50% markup percentage, let’s determine the unit product cost. Appendix A-22 Setting a Target Selling Price The first step in the absorption costing approach to costplus pricing is to compute the unit product cost. Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Unit product cost Per Unit $ 6 4 3 7 $ 20 ($70,000 ÷ 10,000 units = $7 per unit) Ritter has a policy of marking up unit product costs by 50%. Let’s calculate the target selling price. Appendix A-23 Setting a Target Selling Price The second step is to calculate the target selling price ($30) by assigning the appropriate markup ($10) to the unit product cost ($20). Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Unit product cost 50% markup Target selling price Per Unit $ 6 4 3 7 $ 20 10 $ 30 Appendix A-24 Determining the Markup Percentage A markup percentage can be based on an industry “rule of thumb,” company tradition, or it can be explicitly calculated. The equation for calculating the markup percentage on absorption cost is shown below. Markup % on absorption cost = (Required ROI × Investment) + S & A expenses Unit sales × Unit product cost The markup must be high enough to cover S & A expenses and to provide an adequate return on investment. Appendix A-25 Determining the Markup Percentage Let’s Let’s assume assume that that Ritter Ritter must must invest invest $100,000 $100,000 in in the the product product and and market market 10,000 10,000 units units of of product product each each year. year. The The company company requires requires aa 20% 20% ROI ROI on on all all investments. investments. Let’s Let’s determine determine Ritter’s Ritter’s markup markup percentage percentage on on absorption absorption cost. cost. Appendix A-26 Determining the Markup Percentage Markup % (20% × $100,000) + ($2 × 10,000 + $60,000) on absorption = 10,000 × $20 cost Variable S & A per unit Total fixed S & A Markup % on absorption cost = ($20,000 + $80,000) $200,000 = 50% Appendix A-27 Problems with the Absorption Costing Approach The absorption costing approach essentially assumes that customers need the forecasted unit sales and will pay whatever price the company decides to charge. This is flawed logic simply because customers have a choice. Appendix A-28 Problems with the Absorption Costing Approach Let’s assume that Ritter sells only 7,000 units at $30 per unit, instead of the forecasted 10,000 units. Here is the income statement. RITTER COMPANY Income Statement For the Year Ended December 31, 2011 Sales (7,000 units × $30) Cost of goods sold (7,000 units × $23) Gross margin SG&A expenses Net operating loss ROI = $ $ 210,000 161,000 49,000 74,000 (25,000) $ $ (25,000) = 100,000 -25% Appendix A-29 Problems with the Absorption Costing Approach Let’s assume that Ritter sells only 7,000 units at $30 per unit, instead of the forecasted 10,000 units. Here is the income statement. Absorption costing approach to pricing is a safe COMPANYchoose to buy at approach onlyRITTER if customers least as manyIncome units Statement as managers forecasted For the Year Ended December 31, 2011 they would buy. Sales (7,000 units × $30) $ 210,000 Cost of goods sold (7,000 units × $23) Gross margin SG&A expenses Net operating loss ROI = $ 161,000 49,000 74,000 (25,000) $ $ (25,000) = 100,000 -25% Appendix A-30 Learning Objective A-3 Compute the target cost for a new product or service. Appendix A-31 Target Costing Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be made for that maximum target cost figure. The equation for determining a target price is shown below: Target Target cost cost == Anticipated Anticipated selling selling price price –– Desired Desired profit profit Once the target cost is determined, the product development team is given the responsibility of designing the product so that it can be made for no more than the target cost. Appendix A-32 Reasons for Using Target Costing Two characteristics of prices and product costs include: 1. The market (i.e., supply and demand) determines price. 2. Most of the cost of a product is determined in the design stage. Appendix A-33 Reasons for Using Target Costing Target Target costing costing was was developed developed in in recognition recognition of of the the two two characteristics characteristics summarized summarized on on the the previous previous screen. screen. Target Target costing costing begins begins the the product product development development process process by by recognizing recognizing and and responding responding to to existing existing market market prices. prices. Other Other approaches approaches allow allow engineers engineers to to design design products products without without considering considering market market prices. prices. Appendix A-34 Reasons for Using Target Costing Target costing focuses a company’s cost reduction efforts in the product design stage of production. Other approaches attempt to squeeze costs out of the manufacturing process after they come to the realization that the cost of a manufactured product does not bear a profitable relationship to the existing market price. Appendix A-35 Target Costing Handy Handy Appliance Appliance feels feels there there is is aa niche niche for for aa hand hand mixer mixer with with special special features. features. The The marketing marketing department department believes believes that that aa price price of of $30 $30 would would be be about about right right and and that that about about 40,000 40,000 mixers mixers could could be be sold. sold. An An investment investment of of $2 $2 million million is is required required to to gear gear up up for for production. production. The The company company requires requires aa 15% 15% ROI ROI on on invested invested funds. funds. Let’s Let’s see see how how we we determine determine the the target target cost. cost. Appendix A-36 Target Costing Projected sales (40,000 units × $30) Desired profit ($2,000,000 × 15%) Target cost for 40,000 mixers $ 1,200,000 300,000 $ 900,000 Target cost per mixer ($900,000 ÷ 40,000) $ 22.50 Each functional area within Handy Appliance would be responsible for keeping its actual costs within the target established for that area. Appendix A-37 End of Appendix A