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Pricing is not a problem for some businesses. They make products or provide a service that is in competition with others, identical products or services for which a market price already exists. Customers will not pay more that this price, and there is no reason to charge less. Under these circumstances, the company simply charges the prevailing market price. Markets for basic raw materials such as farm products and minerals follow this pattern. Here we are concerned with the more common situation in which a company is faced with the problem of setting its own prices. Clearly, the pricing decision can be critical. If the price is too high, customers will avoid purchasing the company's products. If the price is set too low, the company's costs may not be covered. the usual approach in pricing is to mark up cost. A product's markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. This approach is called cost plus pricing because the predetermined markup percentage is applied to the cost base to determine a target selling price. Selling price = Cost + (Markup Cost) For example, if a company uses a markup of 50%, to the costs of its products to determine the selling price. If a product costs $10, then it would charge $15 for the products. Two key issues must be addressed when the cost plus approach to pricing is used. First, What cost should be used? Second, how should the markup be determined? Several alternatives approaches are considered here, starting with the generally favored by economists.
For example, suppose that the managers of Nature's Garden Inc. believe that every 10% increase in the selling price of their apple-almond shampoo will result in a 15% decrease in the number of bottles of shampoo sold. The Calculation of the price elasticity of demand for this product would be as follows: Price elasticity of Demand = In(1 + ( (0.15)) / In(1 + (1.10)) In(0.85) / In(1.10) = 1.71
The estimated change in unit sales should take into account competitor's responses to a price change.
For comparison purposes, the managers of Nature's Garden Inc. believe that another product, strawberry glycerin soap, will experience 20% drop in unit sales if its price is increased by 10%. (Purchasers of this product are more sensitive to price than the purchasers of the apple-almond shampoo). The calculation of the price elasticity of demand for the strawberry glycerin soap is: Price elasticity of Demand = In(1 + ( (0.20)) / In(1 + (1.10)) In(0.80) / In(1.10) = 2.34 Both of these products, like other normal products, have a price elasticity that is less than 1.Not also that the price elasticity of demand for the strawberry glycerin soap is larger (in absolute value) that the price elasticity of demand for the apple-almond shampoo. The more sensitive customers are to price, the larger (in absolute value) in the price elasticity of demand. In other words, a larger (in absolute value) price elasticity of demand indicates a product whose demand is more elastic. The price elasticity of demand will be used to calculate selling price that maximizes the profits of the company.
Using the above markup is equivalent to setting the selling price using this formula: [Profit-maximizing price = (Price elasticity of demand / 1 + Price elasticity of demand) Variable cost per unit] The profit maximizing prices for two Nature's Garden products are computed below using these formulas: Apple-Almond Shampoo Price elasticity of demand Profit maximizing markup on variable cost (a) 1.71 Strawberry Glycerin Soap 2.34
( 1.71 / 1.71 + 1) ( 2.34 / 2.34 + 1) 1 1 2.41 1 = 1.41 or 141% 1.75 1 = 0.75 or 75% $0.40 0.30 ----------$0.70 =======
$4.82 =======
Note that the 75% markup for the strawberry glycerin soap is lower that 140% markup for the apple almond shampoo. The reason for this is that the purchasers of strawberry glycerin soap are more sensitive to price than the purchasers of apple-almond shampoo. This could be because strawberry glycerin soap is a relatively common product with close substitutes available in nearly every grocery store.
Caution is advised when using these formulas to establish a selling price. The assumptions underlying the formulas are probably not completely valid, and the estimate of the percentage change in unit sales that would result from a given percentage change in price is likely to be inexact. Nevertheless, the formulas can provide valuable clues regarding whether prices should be increased or decreased. Suppose, for example, that the strawberry glycerin soap is currently being sold for $0.60 per bar. The formula indicates that the profit maximizing price is $0.70 per bar. Rather than increasing the price by $0.10, it would be prudent to increase the price by a more modest amount to observe what happens to unit sales and to profits. The formula for the profit maximizing price also convey a very important lesson. The optimal selling price should depend on two factors--the variable cost per unit and how sensitive unit sales are to changes in price. In particular, fixed costs play no role in setting the optimal price. If the total fixed costs are the same whether the company charges $0.60 or $0.70, they cannot be relevant in the decision of which price to charge for the soap. Fixed costs are relevant when deciding whether to offer a product but are not relevant when deciding how much to charge for the period. Incidentally we can directly verify that an increase in selling price for the strawberry glycerin soap from the current price of $0.60 per bar is warranted, based just on the forecast that a 10% increase in selling price would lead to a 20% decrease in unit sales. Suppose, for example, that Nature's Garden is currently selling 200,000 bars of the 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, the effect on profits of increasing the price by 10% can be computed as follows: Percent Price Selling price Unit sales Sales Variable cost $0.60 200,000 $120,000 80,000 ---------Contribution margin $40,000 Higher Price $0.60 + (0.10 $0.60) = $0.66 200,000 (0.20 200,000) = 160,000 $105,600 64,000 ---------$41,600
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Despite the apparent optimality of prices based on marking up variable costs according to the price elasticity of demand, surveys consistently reveal that most managers approach the pricing problem from a completely different perspective. They prefer to mark up some version of full, not variable, costs, and the markup is based on desired profits rather than on factors related to demand.
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Setting a target selling price using the absorption costing approach. Determining and calculating markup percentages. Problems with the absorption costing approach.
The first step in the absorption costing approach to cost plus pricing is to compute the unit product cost. For Ritter Company, this amounts to $20 per unit at a volume of 10,000 units as calculated below: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($70,000 / 10,00 units) $6 4 3 7 ------Unit product cost $20
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Ritter company has a general policy of marking up unit product costs by 50%. A price quotation sheet for the company prepared using the absorption costing approach is presented below: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead (based on 10,000 units) $6 4 3 7 -------Unit product cost Markup to cover selling, general, and administrative expenses and desired profit--50% of unit manufacturing cost 20 10 -------Target selling price $30
Note that selling, general and administrative (SG&A) costs are not included in the cost base. Instead, the markup is supposed to cover these expenses. Let us see how some companies compute these markup percentages.
Markup percentage on absorption cost = (20% 100,000) + ($2 10,000 + $60,000) / 10,000 $20 = ($20,000) + ($80,000) / $200,000 50% This markup of 50% leads to a target selling price of $30 for Ritter company. As verified by the following calculations: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($70,000 / 10,000 units) $6 4 3 7 ------Unit product cost $20 ======
INCOME STATEMENT AND RETURN ON INVESTMENT ANALYSIS--RITTER COMPANY ACTUAL UNIT SALES PRICE = 10,000 UNITS; SELLING PRICE = $30 Ritter Company Absorption Costing Income Statement Sales ($30 per unit 10,000 units) $300,000 Less cost of goods sold ($20 per unit 10,000 units) 200,000 -------------Gross margin Less selling, general, and administrative expenses
unit 10,000 units + $60,000) ($2 per
$20,000 =======
Return on investment ROI Return on investment (ROI) = Net operating income / Average operating assets = $20,000 / $100,000 = 20% If the company actually sell 10,000 units of the product at this price, the company's return on investment (ROI) on this product will indeed be 20%. If it
turns out that more than 10,000 units are sold at this price, the ROI will be greater than 20%. If less than 10,000 units are sold. the return on investment (ROI) will be less than 20%. The required return on investment (ROI) will be attained only if the forecasted unit sales volume is attained.
INCOME STATEMENT AND RETURN ON INVESTMENT ANALYSIS--RITTER COMPANY ACTUAL UNIT SALES PRICE = 7,000 UNITS; SELLING PRICE = $30 Ritter Company Absorption Costing Income Statement Sales ($30 per unit 7,000 units) $210,000 Less cost of goods sold ($23 per unit 7,000 Units) 161,000 -----------Gross margin 49,000
74,000 ------------
$(25,000) =======
Return On Investment (ROI) Return on investment (ROI) = Net operating income / Average operating assets = $25,000 / $100,000 = 25% Rather than focusing on costs--which can be dangerous if forecasted unit volume does not materialize--many managers focus on customer value when making pricing decisions. In Business | Setting in the Customer's Seat--(Real Business Example): The ticket-services manager of the Washington Opera Company, Jimmy Legarreta, faced a difficult decision. After a financially unsuccessful season, he knew he had to do something about the Opera company's pricing policy. Friday and Saturday performance were routinely sold out, and demand for the beast seats far exceed supply. Meanwhile, tickets for midweek performances were often left unsold. "Legarreta also knew that no all seats were equal, even in the soughtafter orchestra section. So the ticket manager and his staff sat in every one on the opera houses 2,200 seats and gave each a value according to the view and the acoustics...In the end, the Opera raised prices for its most covered seats by as much as 50 % but also dropped the prices of some 600 seats. The gamble paid off in a 9% revenue increase during the next season."
Source: Susan Greco, "Are your prices right?" Inc., January 1997, p.88.
target costing, including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT, NEC, andToyota etc. The target costing for a product is calculated by starting with the product's anticipated selling price and then deducting the desired profit. Following formula or equation further explains this concept: Target Cost = Anticipated selling price Desired profit The product development team is then given the responsibility of designing the product so that it can be made for no more than the target cost. Following set of activities further explains the concept of target costing technique: TARGET COSTING PROCESS DIAGRAM Determine Customer Wants and Price Sensitivity
Costs are Considered Throughout this Process. The Process Requires Trade-offs to Meet Target Costs
Once Target Cost is Achieved the Manufacturing Begins and Product is Sold
This $22.5 target cost would be broken into target cost for the various functions: manufacturing, marketing, distribution, after-sales service, and so on. Each functional area would be responsible for keeping its actual costs within target.
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Proactive approach to cost management. Orients organizations towards customers. Breaks down barriers between departments. Implementation enhances employee awareness and empowerment. Foster partnerships with suppliers. Minimize non value-added activities. Encourages selection of lowest cost value added activities. Reduced time to market.
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Effective implementation and use requires the development of detailed cost data. its implementation requires willingness to cooperate Requires many meetings for coordination May reduce the quality of products due to the use of cheep components which may be of inferior quality.
In Business | Target Costing Approach--An Iterative Process: Target costing Technique is widely used in Japan. In the automobile industry, the target cost for a new model is decomposed into target costs for each of the elements of the car--down to a target cost for each of the individual parts. The designers draft a trial blueprint, and a check is made to see if the estimated cost of the car is within reasonable distance of the target cost. If not, design changes are made, and a new trial blueprint is drawn up. This process continues until there is sufficient confidence in the design to make a prototype car according to the trial blueprint. If there is still a gap between the target cost and estimated cost, the design of the car will be further modified. After repeating this process a number of times, the final blueprint is drawn up and turned over to the production department. In the first several months of production, the target costs will ordinarily not be achieved due to problems in getting a new model into production. However after that initial period, target costs are compared to actual costs and discrepancies between the two are investigated with the aim of eliminating the discrepancies and achieving target costs.
Source: Yasuhiro Monden and Kazuki Hamada, "Target Costing-Kaizen Costing in Japanese Automobile Companies," Journal of Management Accounting Research 3, pp. 16-34.
Time Component:
The time component is typically expressed as a rate per hour of labor. The rate is computed by adding together three elements:
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The direct costs of the employee, including salary and fringe benefits. A pro rata allowance for selling, general, and administrative expenses of the organization. An allowance for a desired profit per hour of employee time.
In some organizations (such as a repair shop), the same hourly rate will be charged regardless of which employee actually works on the job; in other organizations, the rate may vary by employee. For example, in a public accounting firm, the rate charged for a new assistant accountant's time will generally be less than the rate charged for an experienced senior accountant or for a partner.
Material Component:
The material component is determined by adding a material loading charge to the invoice price of any materials used on the job. The material loading charge is designed to cover the costs of ordering, handling, and carrying materials in stock, plus a profit margin on the materials themselves.
Repairs Mechanics' wages Service manager--salary Parts manager--salary Clerical assistant--salary Retirement and insurance--16% of salary and wages Supplies Utilities Property taxes Depreciation Invoice cost of parts used 18,000 57,280 720 36,000 8,400 91,600 $300,000 40,000
Parts
The company expects to bill customers for 24,000 hours of repair time. A profit of $7 per hour of repair time is considered to be feasible, given the competitive conditions in the market. For parts, the competitive markup on the invoice cost of parts used is 15%. The following schedule shows the calculation of the billing rate and the material loading charge to be used over the next year. TIME AND MATERIALS PRICING Time Component: Repairs Total Per Hour* Parts: Material Loading Charge
Total
Percent**
Total cost For repairs--other cost of repair service. For parts--cost of ordering handling, and storing parts: Repairs service manager--salary Parts manager salary Clerical assistant salary Retirement and insurance (16% of salaries) Supplies Utilities Property taxes Depreciation
348,000
$14.5
40,000 $36,000 18,000 9,280 720 36,000 8,400 91,600 -------15,000 8,160 540 20,800 1,900 37,600 --------8.50 120,000 -------30%
Total cost
204,000 --------
Desired profit: 24,000 hours $7per hour 15% $400,000 ------Total amount to be billed ------168,000 7.00 60,000 ------15% ------45% ====
*Based on 24,000 hours **Based on $400,000 invoice cost of parts. The charge for ordering, handling,
and storing parts, for example, is computed as follows: $120,000 cost / $400,000 invoice cost = 30%
Note that the billing rate, or time component, is $30 per hour of repair time and the material loading charge is 45% of the invoice cost of parts used. Using these rates, a repair job that requires 4.5 hours of mechanics time and $200 in parts would be billed as follows:
Labor time: 4.5 hours $30 per hour Parts used: Invoice cost Material loading charge: 45% $200 $200 90 -------Total price of the job
$135
Rather than using labor hours as the basis for calculating the time rate, a machine shop, a printing shop, or a similar organization might use machine-hours. This method of setting prices is a variation of the absorption costing approach. As such, it is not surprising that is suffers from the same problem. Customers may not be willing to pay the rates that have been computed. If actual business is less that the forecasted 24,000 hours and $400,000 worth of parts, the profit objectives will not be met and the company may not even break even.