CHAPTER 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

The Profit Maximizing Price Economic Theory The quantity demanded is a function of the price that is charged Generally, the higher the price, the lower the quantity demanded Pricing Management should set the price that provides the greatest amount of profit

Example Exercise #1 The editor of Spunk Magazine is considering three alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are: Price Quantity $6.95 20,000 $5.95 25,000 $4.95 32,000 Monthly costs of producing and delivering the magazine include $80,000 of fixed costs and variable costs of $1.50 per issue. Which price will yield the largest monthly profit?

Example Exercise #1 Solution Profit @ $6.95 Revenue (20,000 x $6.95) $139,000 Variable Costs (20,000 x $1.50) ($30,000) Contribution Margin $109,000 Fixed Costs ($80,000) Profit $ 29,000

Example Exercise #1 Solution Profit @ $5.95 Revenue (25,000 x $5.95) $148,750 Variable Costs (25,000 x $1.50) ($37,500) Contribution Margin $111,250 Fixed Costs ($80,000) Profit $ 31,250

Example Exercise #1 Solution Profit @ $4.95 Revenue (32,000 x $4.95) $158,400 Variable Costs (32,000 x $1.50) ($48,000) Contribution Margin $110,400 Fixed Costs ($80,000) Profit $ 30,400 A price of $5.95 yields the largest monthly profit.

Pricing Special Orders In some cases, it may be beneficial for a company to charge a price lower than its full cost Only if the order will not affect demand for its other products

Special Orders – Premier Lens Example Given the following information, should Premier Lens produce 20,000 lenses to be sold to Blix Camera for $73 per lens?

Special Orders – Premier Lens Example The incremental analysis shows that it should. Note that the fixed costs are not incremental and need not be included in the decision making.

Cost-Plus Pricing Company estimates cost of production Benefits Adds a markup to cost to arrive at price which allows for a reasonable profit Benefits Simple approach Limitations What % markup to use? Inherently circular for manufacturing firms Requires considerable judgment and experimentation

Study Break #1 To determine the profit-maximizing price a manager must: Estimate the quantity demanded for various prices Estimate variable costs Both a and b are correct None of the above are correct

Study Break #1 To determine the profit-maximizing price a manager must: Estimate the quantity demanded for various prices Estimate variable costs Both a and b are correct None of the above are correct

Study Break #2 Cost-plus pricing: Leads to profit maximization Is inherently circular for manufacturing firms Is difficult to perform None of the above are correct

Study Break #2 Cost-plus pricing: Leads to profit maximization Is inherently circular for manufacturing firms Is difficult to perform None of the above are correct

Commonwealth Edison

Target Costing

Analyzing Customer Profitability Customer Profitability Measurement System (CPM) Indirect costs of servicing customers are assigned to cost pools For example the cost of processing orders and handling returns Costs are allocated to specific customers using cost drivers to determine customer profitability

Customer Profitability Measurement System

Example Exercise #2 Delta Products has determined the following costs: Order processing/order $5.00 Additional handling cost per rush order $8.50 Customer service calls/call $10.00 Relationship management costs/customer $2,000.00 In addition to theses costs, product costs amount to 90% of sales. In the prior year, Delta had the following experience with Johnson Brands: Sales $53,800 Number of orders 200 Percent of orders marked rush 60 Calls to customer service 140 Calculate the profitability of the Johnson Brands account.

Example Exercise #2 Solution Profitability of Johnson Brand account Sales $53,800 Less: Cost of good sold (.9 × $53,800) $48,420 Order processing (200 × $5.00) $1,000 Rush handling (.6 × 200 × $8.50) $1,020 Customer service (140 × $10.00) $1,400 Relationship management costs $2,000 $53,840 Profitability of Johnson Brands account $(40)

“Display-Ready” Pallets

Activity-Based Pricing Customers are presented with separate prices for services they request in addition to the cost of goods purchased Customers will carefully consider the services they request Example

Study Break #3 Target costing: Requires specification of desired level of profit Targets specific costs for reduction Is used primarily with products that are already in production Leads to profit maximization

Study Break #3 Target costing: Requires specification of desired level of profit Targets specific costs for reduction Is used primarily with products that are already in production Leads to profit maximization

Study Break #4 Customer profitability is measured as: Revenue – cost of goods sold Revenue – indirect manufacturing costs Revenue – cost of goods sold – indirect service costs Revenue – cost of goods sold – indirect manufacturing costs

Study Break #4 Customer profitability is measured as: Revenue – cost of goods sold Revenue – indirect manufacturing costs Revenue – cost of goods sold – indirect service costs Revenue – cost of goods sold – indirect manufacturing costs

Study Break #5 With activity-based pricing: Customers face a menu of prices for various services Customers are encouraged to consider the costs they impose on a supplier Customers may be charged less if the request less product variety in their orders All of the above are correct

Study Break #5 With activity-based pricing: Customers face a menu of prices for various services Customers are encouraged to consider the costs they impose on a supplier Customers may be charged less if the request less product variety in their orders All of the above are correct

Maximize Profit

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