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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
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.
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
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3. Managers should set higher (lower)
markups over cost when demand is
inelastic (elastic).
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.
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
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–
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%
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:
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(2). While fixed costs are relevant
when deciding whether to
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.
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
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costing unit product cost rather than the
variable cost.
1. The cost base includes direct materials,
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.
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.
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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
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
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.
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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.
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
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B. Reasons for using target costing
i. Two characteristics of prices and product
costs include:
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.
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
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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
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.
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