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Appendix A - Lecture Notes
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Appendix A
Lecture Notes
Main theme: This appendix focuses on pricing products
and services. It explains the economist’s approach to
pricing, the absorption costing approach to cost-plus
pricing, and the meaning of target costing.
I. The economist’s approach to pricing
Learning Objective 1: Compute the profit-maximizing
price of a product or service using the price elasticity
of demand and variable cost.
A. Elasticity of demand
i. 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.
1. Demand for a product is said to be inelastic
if a change in price has little effect on the
number of units sold. For example:
a. The demand for designer perfumes
sold at cosmetic counters in
department stores is relatively
inelastic.
2. Demand for a product is said to be elastic if
a change in price has a substantial effect on
the volume of units sold. For example:
a. 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.
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3. Managers should set higher (lower)
markups over cost when demand is
inelastic (elastic).
4. The price elasticity of demand for a product
or service can be estimated using the
formula as shown.
ii. Nature’s Garden: Part I
1. Assume the information as shown with
respect to the company’s two products –
apple-almond shampoo and strawberry
glycerin soap.
a. The price elasticity of demand for the
apple-almond shampoo (-1.71) would
be computed as shown.
b. The price elasticity of demand for the
strawberry glycerin soap (-2.34) would
be computed as shown.
(1). 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.
B. The profit-maximizing price
i. Under certain conditions, the profit-
maximizing price can be determined by
marking up variable cost using the formula
as shown.
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ii. Nature’s Garden: Part II
1. Assuming the apple-almond shampoo has a
variable cost of $2.00 per unit, the profit-
maximizing price for apple-almond
shampoo of $4.82 would be computed as
shown.
2. Assuming the strawberry glycerin soap has a
variable cost of $0.40 per unit, the profit-
maximizing price for strawberry glycerin
soap of $0.70 would be computed as shown.
a. The 75% markup for the strawberry
glycerin soap is lower than the 141%
markup for the apple-almond
shampoo. This is because the demand
for strawberry glycerin soap is more
elastic than the demand for apple-
almond shampoo.
3. The graph that is shown depicts how the
profit-maximizing markup is generally
affected by how sensitive unit sales are to
price.
a. For example, if a 10% increase in
price leads to a 20% decrease in unit
sales, then the optimal markup on
variable cost according to the exhibit is
75% – the figure computed for the
strawberry glycerin soap. Notice:
(1). The optimal selling prices
computed using this approach
are based on two factors –
the variable cost per unit
and how sensitive unit sales
are to changes in price.
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(2). While fixed costs are relevant
when deciding whether to
offer a product, they are not
relevant when deciding how
much to charge for the
product.
iii. Nature’s Garden: Part III
1. Assuming the information as shown, we can
verify that a 10% price increase makes sense
for Nature’s Garden as follows:
a. The contribution margin earned at the
current selling price of $0.60 is
$40,000.
b. The contribution margin earned at a
selling price of $0.66 is $41,600.
(1). Although the number of units
sold decreases by 20% (from
200,000 to 160,000), the 10%
increase in selling price (from
$0.60 to $0.66) results in a
$1,600 increase in
contribution margin.
II. The Absorption Costing Approach to Cost-Plus Pricing
Learning Objective 2: Compute the selling price of a
product using the absorption costing approach.
A. The cost base
i. Under the absorption approach to cost-plus
pricing, the cost base is the absorption
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costing unit product cost rather than the
variable cost.
1. The cost base includes direct materials,
direct labor, and variable and fixed
manufacturing overhead.
B. Setting a target selling price
i. Ritter Company: Part I
1. Assume that Ritter Company intends to
manufacture 10,000 units of a redesigned
product that has the cost estimates as shown.
Also, assume that the company typically
uses a 50% markup percentage.
a. The first step in the absorption costing
approach to cost-plus pricing is to
compute the unit product cost. For
Ritter, the unit product cost of $20
would be computed as shown.
b. The second step is to calculate the
target selling price ($30) by assigning
the appropriate markup ($10) to the
unit product cost ($20).
C. Determining the markup percentage
i. A markup percentage can be based on an
industry “rule of thumb,” company tradition,
or it can be explicitly calculated.
1. The equation for calculating the markup
percentage on absorption cost is as shown.
Notice:
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a. The markup must be high enough to
cover S, G & A expenses and to
provide an adequate return on
investment.
ii. Ritter Company – Part II
1. Assume that Ritter Company: (1) must
invest $100,000 to produce the redesigned
product mentioned above, and (2) requires
an ROI of 20%.
2. The markup percentage of 50% mentioned
earlier would have been calculated as
shown.
a. If Ritter actually sells 10,000 units at a
price of $30 per unit, the ROI on this
product will indeed be 20%. However,
if more than (less than) 10,000 units
are sold the ROI will be higher than
(less than) 20%.
D. Problems with the absorption costing approach
i. 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.
ii. Ritter Company: Part III
1. Assume that Ritter only sells 7,000 units at
a price of $30, instead of 10,000 units.
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a. In this case, Ritter would have a loss of
$25,000 on the product instead of a
profit of $20,000.
b. The absorption costing approach to
pricing is a safe approach only if
customers choose to buy at least as
many units as managers forecasted
they would buy.
III. Target costing
Learning Objective 3: Compute the target cost for a
new product or service.
A. Key concepts
i. 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.
1. The equation for computing a target cost is
as shown.
2. 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.
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B. Reasons for using target costing
i. 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.
ii. Target costing was developed in recognition
of these two characteristics. More
specifically:
1. Target costing begins the product
development process by recognizing and
responding to existing market prices.
a. Other approaches allow engineers to
design products without considering
market prices.
2. Target costing focuses a company’s cost
reduction efforts in the product design
stage of production.
a. 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.
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Helpful Hint: A new mountain bike with a carbon-fiber
frame can be used as an example of target costing.
Discuss the traditional development of such a new
product. Engineers would draw up a design, perhaps
build a prototype, and then “throw it over the wall” to
the production department. After the production
department figures out how to make the product, a
price is set based on cost. Now ask students to describe
what would happen under target costing. With target
costing, the price would be set first based on what the
market is likely to pay for this new bike. The target, or
allowable, cost is determined by subtracting the desired
profit from the market price. The design team then
designs a product that can be made and sold for no
more than the target cost.
C. Handy Appliance Company – an example
i. Assume the facts as shown with respect to a
new product—a hand mixer with special
features.
ii. The target cost per mixer ($22.50) would be
calculated as shown.
1. This amount would be broken down into
target costs for the various functions:
manufacturing, marketing, distribution,
after-sales service and so on.
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