Appendix A - Solution Manual

Appendix A Pricing Products and Services
Appendix A
Pricing Products and Services
Solutions to Questions
A-1 In cost-plus pricing, prices are set by adding a markup to a products cost. The
markup is usually a percentage.
A-2 The price elasticity of demand measures the degree to which a change in price
afects unit sales. The unit sales of a product with inelastic demand are relatively insensitive
to the price charged for the product. In contrast, the unit sales of a product with elastic
demand are sensitive to the price charged for the product.
A-3 The proft-maimi!ing price should depend only on the variable "marginal# cost per
unit and on the price elasticity of demand. $ied costs do not enter into the pricing decision.
$ied costs are relevant in a decision of whether to ofer a product or service at all, but are
not relevant in deciding what to charge for the product or service once the decision to ofer
it has been made. %ecause price afects unit sales, total variable costs are afected by the
pricing decision and therefore are relevant.
A-4 The markup over variable cost depends on the price elasticity of demand. & product
whose demand is elastic should have a lower markup over cost than a product whose
demand is inelastic. If demand for a product is inelastic, the price can be increased without
as drastically reducing unit sales.
A-5 The markup in the absorption costing approach to pricing is supposed to cover selling
and administrative epenses as well as providing for an ade'uate return on the assets tied
up in the product. $ull cost is an alternative approach not discussed in the chapter that is
used almost as fre'uently as the absorption approach. (nder the full cost approach, all costs
)including selling and administrative epenses)are included in the cost base. If full cost is
used, the markup is only supposed to provide for an ade'uate return on the assets.
A-6 The absorption costing approach assumes that consumers do not react to prices at all
)consumers will purchase the forecasted unit sales regardless of the price that is charged.
This is clearly an unrealistic assumption ecept under very special circumstances.
A-7 The protection ofered by full cost pricing is an illusion. &ll costs will be covered only
if actual sales e'ual or eceed the forecasted sales on which the absorption costing price is
based. There is no assurance that a su*cient number of units will be sold.
A-8 Target costing is used to price new products. The target cost is the epected selling
price of the new product less the desired proft per unit. The product development team is
charged with the responsibility of ensuring that actual costs do not eceed this target cost.
This is the reverse of the way most companies have traditionally approached the
pricing decision. +ost companies start with their full cost and then add their markup to
arrive at the selling price. In contrast to target costing, the traditional approach ignores how
much customers are willing to pay for the product.
AppA-1
Exercise A-1 ",- minutes#
.. /imio makes more money selling the ice cream cones at the
lower price, as shown below0
$1.79
Price
$1.39
Price
(nit sales............................. 12- .,,3-
4ales.................................... 5.,6,7.3- 5.,128.2-
9ost of goods sold : 5-.3... ,68.2- 637.3-
9ontribution margin............. .,.12.1- .,,.,.8-
$ied epenses.................... 386.-- 386.--
;et operating income.......... 5 <2..1- 5 111.8-
8. The price elasticity of demand, as defned in the tet, is
computed as follows0
d
=
ln". > ? change in 'uantity sold#
ln". > ? change in price#
=
.,,3- - 12-
ln". > #
12-
..,7 - ..<7
ln". > #
..<7
@ A
B
C
B
C
B C
D E
@ A
B
C
B
C
B C
D E
=
ln". > -.661.3#
ln". - -.88,32#
=
ln"..661.3#
ln"-.<<263#
=
-.33,37
--.8687.
= -..<6
AppA-2
Exercise A-1 "continued#
,. The proft-maimi!ing price can be estimated using the
following formulas from the tet0
d
-.
Froft-maimi!ing
=
markup on variable cost
. > G
-.
= = ..,,,
. > "-..<6#
" #
Froft-maimi!ing Froft-maimi!ing Hariable cost
= . > I
price markup on variable cost per unit
= ". > ..,,,,# I 5-.3. = 5-.72
This price is much lower than the prices /imio has been
charging in the past. Jather than immediately dropping the
price to 5-.72, it would be prudent to drop the price a bit and
see what happens to unit sales and to profts. The formula
assumes that the price elasticity is constant, which may not be
the case.
AppA-3
Exercise A-2 ".6 minutes#
..
" #
" #
Je'uired JKI 4elling and administrative
>
I Investment epenses
+arkup percentage
=
on absorption cost
(nit product cost I (nit sales
.1? I 56--,--- > 52-,---
=
5,- per unit I .8,6-- units
5.6-,---
=
5,<6,---
= 3-?
8. (nit product cost............... 5,-
+arkup0 3-? I 5,-.......... .8
Target selling price per
unit................................. 538
AppA-4
Exercise A-3 ".- minutes#
4ales "6-,--- batteries I 526 per
battery#................................................ 5,,86-,---
Less desired proft "8-? I 58,6--,---#. . 6--,---
Target cost for 6-,--- batteries.............. 58,<6-,---
Target cost per battery = "58,<6-,--- B 6-,--- batteries#
= 566 per battery
AppA-5
Prole! A-4 "36 minutes#
.. The postal service makes more money selling the souvenir
sheets at the lower price, as shown below0
$5 Price $6 Price
(nit sales...................................... 6-,--- 3-,---
4ales............................................. 586-,--- 583-,---
9ost of goods sold : 5-.2- per
unit............................................. ,-,--- 83,---
9ontribution margin...................... 588-,--- 58.2,---
8. The price elasticity of demand, as defned in the tet, is
d
=
=
3-,--- - 6-,---
ln". > #
6-,---
2.-- - 6.--
ln". > #
6.--
@ A
B
C
B
C
B
B C
D E
@ A
B C
B
C
BB C
D E
=
ln". - -.8---#
ln". > -.8---#
=
ln"-.1---#
ln"..8---#
=
--.88,.
-..18,
= -..88,7
AppA-6
Prole! A-4 "continued#
,. The proft-maimi!ing price can be estimated using the
d
-.
Froft-maimi!ing
=
. > G
-.
= = 3.322,
. > "-..88,7#
" #
= . > I
= ". > 3.322,# I 5-.2- = 5,.81
This price is much lower than the price the postal service has
been charging in the past. Jather than immediately dropping
the price to 5,.81, it would be prudent for the postal service to
drop the price a bit and observe what happens to unit sales and
to profts. The formula assumes that the price elasticity of
demand is constant, which may not be true.
AppA-7
The critical assumption in the calculation of the proft-
maimi!ing price is that the percentage increase "decrease# in
'uantity sold is always the same for a given percentage
decrease "increase# in price. If this is true, we can estimate the
demand schedule for souvenir sheets as follows0
Price
M
Quantity Sold
N
52.-- 3-,---
56.-- 6-,---
53..< 28,6--
5,.31 <1,.86
58.7- 7<,262
58.38 .88,-<-
58.-8 .68,611
5..21 .7-,<,6
5..3- 8,1,3.7
5...< 871,-83
MThe price in each cell in the table is computed by taking 6O2 of
the price Pust above it in the table. $or eample, 56.-- is 6O2 of
52.-- and 53..< is 6O2 of 56.--.
NThe 'uantity sold in each cell of the table is computed by
multiplying the 'uantity sold Pust above it in the table by
6-,---O3-,---. $or eample, 28,6-- is computed by
multiplying 6-,--- by the fraction 6-,---O3-,---.
AppA-8
The proft at each price in the above demand schedule can be
Price
(a)
Quantity
Sold (b)
Sales
(a) (b)
Cost of
Sales
$.6 (b)
Contributio
n !ar"in
52.-- 3-,--- 583-,--- 583,--- 58.2,---
56.-- 6-,--- 586-,--- 5,-,--- 588-,---
53..< 28,6-- 582-,286 5,<,6-- 588,,.86
5,.31 <1,.86 58<.,1<6 532,1<6 5886,---
58.7- 7<,262 581,,8-8 561,673 5883,2-1
58.38 .88,-<- 5876,3-7 5<,,838 5888,.2<
58.-8 .68,611 5,-1,881 57.,66, 58.2,2<6
5..21 .7-,<,6 5,8-,3,6 5..3,33. 58-6,773
5..3- 8,1,3.7 5,,,,<1< 5.3,,-6. 5.7-,<,2
5...< 871,-83 5,31,211 5.<1,1.3 5.27,1<3
AppA-9
The contribution margin is plotted below as a function of the
selling price0
The plot confrms that the proft-maimi!ing price is about
5,.81.
AppA-10
3. If the postal service wants to maimi!e the contribution margin
and proft from sales of souvenir sheets, the new price should
be0
Froft-maimi!ing price = 6.322, I 5-.<- = 5,.1,
;ote that a 5-..- increase in cost has led to a 5-.66 "5,.1, Q
5,.81# increase in the proft-maimi!ing price. This is because
the proft-maimi!ing price is computed by multiplying the
variable cost by 6.322,. 4ince the variable cost has increased
by 5-..-, the proft-maimi!ing price has increased by 5-..- I
6.322,, or 5-.66.
4ome people may obPect to such a large increase in price as
RunfairS and some may even suggest that only the 5-..-
increase in cost should be passed on to the consumer. The
enduring popularity of full-cost pricing may be eplained to
some degree by the notion that prices should be RfairS rather
than calculated to maimi!e profts.
AppA-11
.. a. ;umber of Packets manufactured each year0
8.,--- labor-hours B ..3 labor-hours per Packet = .6,---
Packets.
4elling and administrative epenses0
Hariable ".6,--- Packets I 53 per Packet# 52-,---
$ied....................................................... 3<3,---
Total........................................................ 56,3,---
" #
" #
>
+arkup percentage
=
on absorption cost
83? I 57--,--- > 56,3,---
=
53- per Packet I .6,--- Packets
5<6-,---
=
52--,---
= .86?
b. Uirect materials......................................... 57.8-
Uirect labor............................................... .3.--
+anufacturing overhead........................... .2.1-
(nit product cost....................................... 3-.--
&dd markup0 .86? of unit product cost.... 6-.--
Target selling price.................................... 57-.--
AppA-12
c. The income statement is0
4ales ".6,--- Packets I 57- per
Packet#............................................ 5.,,6-,---
9ost of goods sold
".6,--- Packets I 53- per Packet#... 2--,---
Vross margin..................................... <6-,---
4elling and administrative epenses0
4hipping......................................... 52-,---
4alaries........................................... 7-,---
&dvertising and other..................... ,13,---
Total selling and administrative
epense.......................................... 6,3,---
;et operating income....................... 5 8.2,---
The companys JKI computation for the Packets is0
;et operating income 4ales
JKI = I
4ales &verage operating assets
58.2,--- 5.,,6-,---
= I = .2? I ..6 = 83?
5.,,6-,--- 57--,---
8. Hariable cost per unit0
Uirect materials................................................ 57.8-
Uirect labor....................................................... .3.--
Hariable manufacturing overhead ".O2 I
5.2.1-#........................................................... 8.1-
4hipping epense.............................................. 3.--
Total variable cost per unit................................ 5,-.--
If the company has idle capacity and sales to the retail outlet
would not afect the companys regular sales, any price above
the variable cost of 5,- per Packet would add to profts. The
company should aggressively bargain for more than this priceW
5,- is simply the rock bottom below which the company should
not go in its pricing.
AppA-13
Prole! A-6 "2- minutes#
.. 4upporting computations0
;umber of pads produced per year0
.--,--- labor-hours B 8 labor-hours per pad = 6-,--- pads
4tandard cost per pad0
53,---,--- cost of goods sold B 6-,--- pads = 51- cost per
pad
$ied manufacturing overhead cost per pad0
5.,<6-,--- B 6-,--- pads = 5,6 per pad
+anufacturing overhead cost per pad0
5< variable cost per pad > 5,6 fed cost per pad = 538 per
pad
Uirect labor cost per pad0
51- Q "5,- > 538# = 51
Viven the computations above, the completed standard cost
card follows0
Standard
Quantity
or #ours
Standard
Price or
$ate
Standar
d Cost
Uirect materials............ 6 yards 52 per yard 5,-
Uirect labor................... 8 hours 53 per hour M 1
+anufacturing
overhead.................... 8 hours
58. per
hour MM 38
Total standard cost per
pad............................. 51-
M 1 B 8 hours = 53 per hour.
MM
538 B 8 hours = 58. per
hour.
AppA-14
8. a.
" #
" #
>
+arkup percentage
=
on absorption cost
83? I 5,,6--,--- > 58,.2-,---
=
51- per pad I 6-,--- pads
5,,---,---
=
53,---,---
= <6?
b. Uirect materials................... 5 ,-
Uirect labor......................... 1
+anufacturing overhead..... 38
(nit product cost................. 1-
&dd <6? markup................. 2-
Target selling price.............. 5.3-
c. 4ales "6-,--- pads I 5.3- per pad#..................
5<,---,--
-
9ost of goods sold "6-,--- pads I 51- per
pad#.................................................................. 3,---,---
Vross margin...................................................... ,,---,---
4elling and administrative epense.................... 8,.2-,---
;et operating income......................................... 513-,---
;et operating income 4ales
JKI = I
4ales &verage operating assets
513-,--- 5<,---,---
= I = .8? I 8 = 83?
5<,---,--- 5,,6--,---
AppA-15
,. Total fed cost0
+anufacturing overhead.......................................
5.,<6-,--
-
4elling and administrative
X58,.2-,--- Q "6-,--- pads I 56 variable per
pad#Y.................................................................. .,7.-,---
Total fed cost......................................................
5,,22-,--
-
Hariable cost per pad0
Uirect materials............................ 5,-
Uirect labor................................... 1
Hariable manufacturing overhead. <
Hariable selling............................. 6
Total variable cost......................... 56-
To achieve the 83? JKI, the company would have to sell at
least the 6-,--- units assumed in part "8# above. The break-
even volume can be computed as follows0
$ied epenses
%reak-even point
=
in units sold
(nit contribution margin
5,,22-,---
=
5.3- per pad - 56- per pad
= 3-,22< pads
AppA-16
.. FroPected sales "1- machines I 5,,<76 per
machine#........................................................... 5,-,,2--
Less desired proft "8-? I 56-,---#.................... .-,---
Target cost for 1- machines................................. 587,,2--
Target cost per machine "587,,2-- B 1-
machines#.......................................................... 5,,2<-
Less 9hoice 9ulinary 4upplys variable selling
cost per machine............................................... ,6-
+aimum allowable purchase price per machine. 5,,,8-
8. The relation between the purchase price of the machine and
JKI can be developed as follows0
Total proPected sales - Total cost
JKI =
Investment
5,-,,2-- - "5,6- > Furchase price of machines# I 1-
=
56-,---
The above formula can be used to compute the JKI for
purchase prices between 58,3-- and 5,,3-- "in increments of
5.--#0
Purc%ase
&rice $'(
58,3-- .2<.8?
58,6-- .6..8?
58,2-- .,6.8?
58,<-- ..7.8?
58,1-- .-,.8?
58,7-- 1<.8?
5,,--- <..8?
5,,.-- 66.8?
5,,8-- ,7.8?
5,,,-- 8,.8?
5,,3-- <.8?
AppA-17
(sing the above data, the relation between purchase price and
JKI can be plotted as follows0
AppA-18
,. & number of options are available in addition to simply giving
up on adding the new gelato machines to the companys
product lines. These options include0
Z 9heck the proPected unit sales. Ferhaps more units could be
sold at the 5,,<76 price. [owever, management should be
careful not to indulge in wishful thinking Pust to make the
numbers come out right.
Z +odify the selling price. This does not necessarily mean
increasing the proPected selling price. Uecreasing the selling
price may generate enough additional unit sales to make
carrying the gelato machines more proftable.
Z Improve the selling process to decrease the variable selling
costs.
Z Jethink the investment that would be re'uired to carry this
new product. 9an the si!e of the inventory be reduced\ &re
the new warehouse ftures really necessary\
Z Uoes the company really need a 8-? JKI\ Uoes it cost the
company this much to ac'uire more funds\
AppA-19
Prole! A-8 "2- minutes#
.. The complete, flled-in table appears below0
Sellin"
Price
)sti*ate
d +nit
Sales Sales
,ariable
Cost
-i.ed
).&ense
s
/et
'&eratin
"
(nco*e
5.1.76 8-,--- 5,<7,--- 5..1,--- 5823,--- 5",,---#
5.<.-2 83,--- 53-7,33- 5.3.,2-- 5823,--- 5,,13-
5.6.,6 81,1-- 5338,-1- 5.27,78- 5823,--- 51,.2-
5.,.18 ,3,62- 53<<,2.7 58-,,7-3 5823,--- 57,<.6
5.8.33 3.,3<8 56.6,7.8 5833,216 5823,--- 5<,88<
5...8- 37,<22 566<,,<7 587,,2.7 5823,--- 5"83-#
5.-.-1 67,<.7 52-.,721 5,68,,38 5823,--- 5".3,,<3#
57.-< <.,22, 5237,71, 5388,1.8 5823,--- 5",2,187#
51..2 16,772 5<-.,<8< 56-<,,<2 5823,--- 5"27,237#
5<.,3 .-,,.76 5<6<,36. 52-1,16. 5823,--- 5"..6,3--
#
AppA-20
8. The following graph is based on the table in part ".# above0
%ased on this graph, a selling price of about 5.3 would
maimi!e net operating income.
AppA-21
,. The price elasticity of demand, as defned in the tet, is
d
=
=
ln". > -.8-#
ln". - -..-#
=
ln"..8-#
ln"-.7-#
=
-..18,8
--..-6,2
= -..<,
The proft-maimi!ing price can be estimated using the
d
-.
Froft-maimi!ing
=
.> G
-.
= = ..,<
. > "-..<,#
" #
= . > I
= ". > ..,<# I 56.7- = 5.,.71
;ote that this answer is consistent with the plot of the data in
part "8# above. The formula for the proft-maimi!ing price
works in this case because the demand is characteri!ed by
constant price elasticity. ]very .-? decrease in price results in
a 8-? increase in unit sales.
AppA-22
3. To apply the absorption costing approach, we must frst
compute the markup percentage, which is a function of the
re'uired JKI of 8? per month, the investment of 5.8-,---, the
unit product cost of 56.7-, and the 4V^& epenses of
5823,---.
" #
Je'uired JKI
> 4V^& epenses
I Investment
+arkup percentage
=
on absorption cost
"8? I 5.8-,---# > 5823,---
=
56.7- per unit I 8-,--- units
= 8.82 "rounded# or 882?
(nit product cost......... 5 6.7-
+arkup "56.7- I 8.82#. .,.,,
Target selling price....... 5.7.8,
9harging 5.7.8, for the software would be a big mistake if the
marketing manager is correct about the efect of price changes
on unit sales. The graph prepared in part "8# above strongly
suggests that the company would lose lots of money selling the
software at this price.
;ote0 It can be shown that the unit sales at the 5.7.8, price
would be about .7,333 units if the marketing manager is
correct about demand. If so, the company would lose about
53,1.8 per month0
4ales ".7,333 units I 5.7.8, per unit#.......... 5,<,,7-1
Hariable epenses ".7,333 units I 56.7- per
unit#............................................................. ..3,<8-
9ontribution margin....................................... 867,.11
$ied epenses.............................................. 823,---
;et operating income "loss#........................... 5 "3,1.8#
6. If the marketing manager is correct about demand, increasing
the price above 5.,.71 per unit will result in a decrease in net
operating income and hence in the return on investment. To
AppA-23
increase the net operating income, the owners should look
elsewhere. They should attempt to decrease costs or increase
the perceived value of the product to more customers so that
more units can be sold at any given price or the price can be
increased without sacrifcing unit sales.
AppA-24

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Appendix A Pricing Products and Services

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