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22-1 Pricing Pricing and and Profitabi Profitabi lity lity Analysis Analysis Prepared by Douglas Cloud Pepperdine University
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Pricing and Pricing and Profitability Profitability
AnalysisAnalysisPrepared by
Douglas Cloud Pepperdine University
Prepared by Douglas Cloud
Pepperdine University
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1. Discuss basic pricing concepts.2. Calculate a markup on cost and a target cost.3. Discuss the impact of the legal system and
ethics on pricing.4. Explain why firms measure profit, and
calculate measures of profit using absorption and variable costing.
5. Determine the profitability of segments.
ObjectivesObjectivesObjectivesObjectives
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
ContinuedContinuedContinuedContinued
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6. Compute the sales price, price volume, contribution margin, contribution margin volume, sales mix, market share, and market size variances.
7. Discuss the variations in price, cost, and profit over the product life cycle.
8. Describe some of the limitations of profit measurement.
ObjectivesObjectivesObjectivesObjectives
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Economic Pricing ConceptsEconomic Pricing ConceptsEconomic Pricing ConceptsEconomic Pricing Concepts
Quantity
P*
Q*
Price Supply
Demand
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Market Structure and PriceMarket Structure and PriceMarket Structure and PriceMarket Structure and Price
Perfect Competition—Many buyers and sellers; no one of which is large enough to influence the market.
Monopolistic Competition—Has both the characteristics of both monopoly and perfect competition.
Oligopoly—Few sellers.
Monopoly—Barriers to entry are so high that there is only one firm in the market.
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Market Structures and Market Structures and CharacteristicsCharacteristics
Market Structures and Market Structures and CharacteristicsCharacteristics
Market Number of Expenses
Structure Firms in Barriers Uniqueness Related to
Type Industry to Entry of Product Structure Type
Perfect
Competition Many Very low Not unique No special expenses
Monopolistic Many Low Some unique Advertising, coupons,
Competition features costs of differentiation
Oligopoly Few High Fairly unique Costs of
differentiation,
advertising, rebates,
coupons
Monopoly One Very High Very unique Legal and lobbying
expenditures
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Two Approaches to PricingTwo Approaches to PricingTwo Approaches to PricingTwo Approaches to Pricing
1. Cost-based prices are established using “cost” plus markup.
2. Target prices are influenced by market conditions.
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Cost-Plus PricingCost-Plus PricingCost-Plus PricingCost-Plus Pricing
AudioPro Company sells and installs audio equipment in homes, cars, and trucks. AudioPro’s
income statement for last year is as follows:Revenues $350,350Cost of goods sold:
Direct materials $122,500Direct labor 73,500Overhead 49,000 245,000
Gross profit $105,350Selling and administrative expenses 25,000Operating income $ 80,350
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Cost-Plus PricingCost-Plus PricingCost-Plus PricingCost-Plus Pricing
The firm wants to earn the same amount of profit on each job as was earned last year:
Markup on COGS = (Selling and administrative expenses + Operating income)/COGS
Markup on COGS = ($25,000 + $80,350)/$245,000
Markup on COGS = 0.430.43
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Cost-Plus PricingCost-Plus PricingCost-Plus PricingCost-Plus Pricing
The markup can be calculated using a variety of bases. The calculation for markup on direct
materials is as follows:Markup on DM = (Direct labor + Overhead + Selling and
administrative expense + Operating income)/Direct materials
Markup on DM = ($73,500 + $49,000 + $25,000 + $80,350)/$122,500
Markup on DM = 1.861.86
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Cost-Plus PricingCost-Plus PricingCost-Plus PricingCost-Plus Pricing
AudioPro wants to expand the company’s product line to include automobile alarm systems and electronic car door openers. The cost for the sale and installation of one electronic remote car door opener is as follows:
Direct materials (component and two remote controls) $ 40.00
Direct labor (2.5 hours x $12) 30.00
Overhead (65% of direct labor cost) 19.50
Estimated cost of one job $ 89.50
Plus 43% markup on COGS 38.49
Bid price $127.99
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Target Costing and PricingTarget Costing and PricingTarget Costing and PricingTarget Costing and Pricing
Target costing is a method of determining the cost of a product or service based on the price that the customers
are willing to pay.
Target costing is a method of determining the cost of a product or service based on the price that the customers
are willing to pay.
Target costing involves much more upfront work than cost-
based pricing. However, if the cost-plus pricing turns out to be higher than what customers will accept, additional work or lost
opportunity will result.
Target costing involves much more upfront work than cost-
based pricing. However, if the cost-plus pricing turns out to be higher than what customers will accept, additional work or lost
opportunity will result.
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Predatory PricingPredatory PricingPredatory PricingPredatory Pricing
Predatory pricing is the practice of setting prices below cost for the purpose of injuring competitors
and eliminating competition.
CompetitionCompetition
Predatory pricing on the international
market is called dumping.
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Price DiscriminationPrice DiscriminationPrice DiscriminationPrice Discrimination
Price discrimination refers to the charging of different prices to different customers for essentially the same
product. Cobalt, Inc. manufactures vitamin supplements that costs an average of $163 per case.
Cobalt sold 250,000 cases last year as follows: Customer Prices per Case Cases Sold
Large drug store chain $200 125,000Small local pharmacies 232 100,000Individual health clubs 250 25,000
Cobalt is practicing price discrimination!Cobalt is practicing price discrimination!
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Lasersave, Inc., a company that recycles used toner cartridges for laser printers. During August the firm manufactured 1,000 cartridges at the following costs:
Direct materials $ 5,000Direct labor 15,000Variable overhead 3,000Fixed overhead 20,000 Total manufacturing cost $43,000
During August, these cartridges were sold at $60 each. Variable marketing cost was $1.25 per unit.
Fixed expenses were $12,000.
Absorption-Costing Income StatementAbsorption-Costing Income Statement
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Absorption-Costing Income StatementAbsorption-Costing Income Statement
Percent Percent of Salesof Sales
Sales $ 60,000 100.00 %
Less: Cost of goods sold 43,000 71.67
Gross profit $ 17,000 28.33 %
Less: Variable marketing expenses -1,250 -2.08
Fixed marketing and administrative
expenses -12,000 -20.00
Operating income $ 3,750 6.25 %
Lasersave, Inc. for August
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Absorption-Costing Income StatementAbsorption-Costing Income Statement
Sales $ 60,000 100.00 %
Less: Cost of goods sold 39,000 65.00
Gross profit $ 21,000 35.00 %
Less: Variable marketing expenses -1,250 -2.08
Fixed marketing and administrative
expenses -12,000 -20.00
Operating income $ 7,750 12.92 %
Lasersave, Inc. for September
Percent Percent of Salesof Sales
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Variable-Costing Income StatementVariable-Costing Income StatementVariable-Costing Income StatementVariable-Costing Income Statement
Sales $ 60,000 $ 60,000
Less: Variable expenses 24,250 24,250
Contribution margin $ 35,750 $ 35,750
Less:
Fixed manufacturing overhead -20,000 -20,000
Fixed marketing and admin. exp. -12,000 -12,000
Operating income $ 3,750 $ 3,750
Lasersave, Inc.
For the Month For the Month of Augustof August
For the Month For the Month of Septemberof September
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Comparative Statements for OctoberComparative Statements for OctoberComparative Statements for OctoberComparative Statements for October
Lasersave, Inc.
Absorption CostingAbsorption Costing
Sales $ 78,000
Less: Cost of goods sold 50,700
Gross profit $ 27,300
Less:
Variable marketing expenses -1,625
Fixed marketing and administrative exp. -12,000
Operating income $ 13,675
ContinuedContinuedContinuedContinued
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Comparative Statements for OctoberComparative Statements for OctoberComparative Statements for OctoberComparative Statements for October
Sales $ 78,000
Less: Variable expenses 31,525
Contribution margin $ 46,475
Less:
Fixed manufacturing overhead -20,000
Fixed marketing and administrative exp. -12,000
Operating income $ 14,475
Lasersave, Inc.
Variable CostingVariable Costing
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Changes in Inventory under Changes in Inventory under Absorption and Variable CostingAbsorption and Variable Costing
Changes in Inventory under Changes in Inventory under Absorption and Variable CostingAbsorption and Variable Costing
Production > Sales Absorption NI > Variable NI
Production < Sales Absorption NI < Variable NI
Production = Sales Absorption NI = Variable NI
IfIf ThenThen
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Segment ReportingSegment ReportingSegment ReportingSegment Reporting
Alden Company manufactures two products: basic fax machines and multi-function fax machines. The multi-function fax uses more advanced technology;
therefore, it is more expensive to manufacture.
Basic Multi-Function
Number of units 20,000 10,000Direct labor hours 40,000 15,000Price $200 $350Prime cost per unit $55 $95Overhead per unit $30 $22.50
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Segment ReportingSegment ReportingSegment ReportingSegment Reporting
Alden CompanyAbsorption-Costing Income Statement, 2004
(In thousands of dollars)
Sales $ 4,000 $ 3,500 $ 7,500Less: Cost of good sold 1,700 1,175 2,875Gross profit $ 2,300 $ 2,325 $ 4,625Less: Marketing expense -400 -350 -750 Administrative exp. -1,067 -933 -2,000Operating income $ 833 $ 1,042 $ 1,875
Basic Multi-Function Total Basic Multi-Function Total
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Segment ReportingSegment ReportingSegment ReportingSegment ReportingAlden Company
Variable-Costing Income Statement, 2004(In thousands of dollars)
Sales $ 4,000 $ 3,500 $ 7,500Less: Variable COGS -1,362 -1,048 -2,410 Sales commissions -400 -350 -750Contribution margin $ 2,238 $ 2,102 $ 4,340Less: Fixed overhead -465 Administrative expenses -2,000Operating income $ 1,875
Basic Multi-Function Total Basic Multi-Function Total
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Overhead Overhead Cost CategoryCost Category
Cost Cost DriverDriver
Total Total CostCost
Overhead Activities and Drivers
Setups Number of setups $ 40,000
Maintenance Maintenance hours 120,000
Supplies Direct labor hours 80,000
Power Machine hours 280,000
Machine depreciation Machine hours 250,000
Other factory costs (None) 55,000
$825,000
ContinuedContinuedContinuedContinued
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Usage of Cost Drivers by ProductUsage of Cost Drivers by Product
Basic Multi-FunctionBasic Multi-Function
Overhead Activities and Drivers
Number of setups 10 30
Maintenance hours 2,000 8,000
Direct labor hours 40,000 15,000
Machine hours 10,000 90,000
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Alden CompanyAlden CompanyActivity-Based Costing Income Activity-Based Costing Income
StatementStatement(In thousands of dollars)(In thousands of dollars) Basic Multi-Function Total
Sales $4,000 $3,500 $ 7,500Less:
Prime costs -1,100 -950 -2,050Setups -10 -30 -40Maintenance -24 -96 -120Supplies -58 -22 -80Power -28 -252 -280Machine depreciation -25 -225 -250Sales commissions -400 -350 -750
Contribution margin $2,355 $1,575 $ 3,930Less: Other fixed overhead -55
Administrative expenses -2,000Operating income $ 1,875
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Divisional ProfitDivisional ProfitDivisional ProfitDivisional Profit
Alpha Beta Gamma Delta Total
Sales $ 90 $ 60 $ 30 $120 $300Cost of goods sold 35 20 11 98 164Gross profit $ 55 $ 40 $ 19 $ 22 $136Division expenses -20 -10 -15 -20 -65Corporate expenses -3 -2 -1 -4 -10 Operating income (loss) $ 32 $ 28 $ 3 $ -2 $ 61
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Sales Price and Price Sales Price and Price Volume VariablesVolume Variables
Sales Price and Price Sales Price and Price Volume VariablesVolume Variables
Sales price variance =
Actual price
–Expected
pricex
Quantity sold
Price volume variance =
Actual volume
– Expected volume
xExpected
price
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Contribution Margin VarianceContribution Margin VarianceContribution Margin VarianceContribution Margin Variance
Contribution margin
variance=
Annual contribution
margin–
Budgeted contribution
margin
Contribution Margin Volume VarianceContribution Margin Volume VarianceContribution Margin Volume VarianceContribution Margin Volume Variance
Contribution margin volume
variance=
Annual quantity
sold–
Budgeted quantity
soldx
Budgeted average unit contribution
margin
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Sales Mix VarianceSales Mix VarianceSales Mix VarianceSales Mix Variance
Sales mix variance = [(Product 1 actual units – Product 1 budgeted units) x (Product 1 budgeted unit contribution margin – Budgeted average unit contribution margin)] + [(Product 2 actual units – Product 2 budgeted units) x (Product 2 budgeted unit contribution margin – Budgeted average unit contribution margin)]
Birdwell sales mix variance = [($1,250 – 1,500) x ($4.00 – $6.75)] + [(625 –500) x ($15.00 – $6.75)] = $1,718.75 Favorable
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Market Share VarianceMarket Share VarianceMarket Share VarianceMarket Share Variance
Market share variance = [(Actual market share percentage – Budgeted market share percentage) x (Actual industry sales in units)] x (Budgeted average unit contribution margin)
Market Size VarianceMarket Size VarianceMarket Size VarianceMarket Size Variance
Market size variance = [(Actual industry sales in units – Budgeted industry sales in units) x (Budgeted market share percentage)] x (Budgeted average unit contribution margin)
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The Product Life CycleThe Product Life CycleThe Product Life CycleThe Product Life Cycle
Introduction Growth Maturity Decline
Positive Profit
Negative Profit
0
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The Product Life CycleThe Product Life CycleThe Product Life CycleThe Product Life Cycle
Product Life-Cycle PhaseProduct Life-Cycle Phase
ABC Category Introduction Growth Maturity DeclineABC Category Introduction Growth Maturity Decline
Unit-level costs High Lower Low to stable Low
Batch-level costs High Lower Higher Low
Product-level costs High Lower Low to stable Low
Facility-level costs High Low Low Low
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End ofEnd of
ChapterChapter
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