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

Pricing Decisions Pricing decisions often the most difficult decisions that managers face Pricing Methods: - profit maximizing price using economic theory - Pricing of special orders - Cost Plus pricing - Target costing - 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 To calculate profit maximizing price: - Subtract variable costs from price to obtain the contribution margin - Multiply by the quantity demanded - Subtract fixed costs and estimate profits - Select the price with the highest profit Learning objective 1: Compute the profit maximizing price for a product or service

The Profit Maximizing Price Learning objective 1: Compute the profit maximizing price for a product or service

Exercise 1 Estimates of price and quantity demanded Price = $6.95, quantity demanded = 20,000 Price = $5.95, quantity demanded = 25,000 Price = $4.95, quantity demanded = 32,000 Variable cost = $1.50 per unit Fixed cost = $80,000 Find the profit maximizing price Learning objective 1: Compute the profit maximizing price for a product or service

Pricing Special Orders Special orders are for goods and services not considered part of a company’s normal business Price charged will not affect prices charged in normal course of business Price may deviate from what is common May charge a price less than full cost Learning objective 2: Perform incremental analysis related to pricing a special order

Pricing Special Orders Two alternatives: accept or reject Consider incremental revenues and expenses - Income before special order is the same for both alternatives, not incremental - Calculate incremental revenue - Calculate incremental expenses i.e., materials, labor and variable overhead Learning objective 2: Perform incremental analysis related to pricing a special order

Special Orders – Premier Lens Example Should Premier Lens accept special order of 20,000 lenses to be sold to Blix Camera for $73 per lens? Below is the full cost of $75 per lens Learning objective 2: Perform incremental analysis related to pricing a special order

Special Orders – Premier Lens Example Perform incremental analysis Fixed costs are not incremental, they will not change if the order is accepted Learning objective 2: Perform incremental analysis related to pricing a special order

Commonwealth Edison Learning objective 2: Perform incremental analysis related to pricing a special order

Review 1 Which of the following are relevant for a special order? Total company income before the order Fixed costs Incremental revenues and expenses Fixed manufacturing overhead Answer: c Learning objective 2: Perform incremental analysis related to pricing a special order

Cost-Plus Pricing Benefits Company estimates product cost and adds a markup to arrive at price which allows for a reasonable profit Benefits - Simple approach - Guarantees profit if sufficient quantity can be sold at the specified price Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Cost-Plus Pricing Limitations What markup percentage to use? Requires considerable judgment and experimentation Inherently circular for manufacturing firms: - Need to estimate demand to determine fixed manufacturing costs - Price affects the quantity demanded Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Cost-Plus Pricing Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Review 2 Cost-plus pricing: Leads to profit maximization Is inherently circular for manufacturing firms Is difficult to perform None of the above are correct Answer: b Is inherently circular for mfg firms Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Target Costing Once a product is designed it is difficult to make changes that reduce costs - 80% of a product’s costs cannot be reduced once it is designed - Product features drive costs Target costing - Integrated approach to determine features, price, costs and design to ensure a profit Learning objective 4: Explain the target costing process for a new product

Target Costing Learning objective 4: Explain the target costing process for a new product

Target Costing Slide 8-19 Learning objective 4: Explain the target costing process for a new product 19

Review 3 Target costing: Requires specification of desired level of profit Adds desired profit to existing costs Is used primarily with products that are already in production Leads to profit maximization Answer: a Requires specification of desired profit Learning objective 4: Explain the target costing process for a new product

Analyzing Customer Profitability Customer Profitability Measurement System (CPM) Indirect costs of servicing customers are assigned to cost pools: - cost of processing orders - cost of handling returns Costs are allocated to specific customers using cost drivers to determine customer profitability Learning objective 5: Analyze customer profitability

Review 4 Customer profitability is measured as: Revenue minus cost of goods sold Revenue minus indirect manufacturing costs Revenue minus cost of goods sold minus indirect service costs Revenue minus cost of goods sold minus indirect manufacturing costs Answer: c Learning objective 5: Analyze customer profitability

Customer Profitability Measurement System Learning objective 5: Analyze customer profitability

Cost Pools and Cost Drivers to Service Customers Slide 8-24 Learning objective 5: Analyze customer profitability 24

Customer Profitability Analysis Slide 8-25 Learning objective 5: Analyze customer profitability 25

Customer Profitability Analysis Slide 8-26 Learning objective 5: Analyze customer profitability 26

Exercise 2 Delta products has determined the following costs and drivers for the Johnson Brand customer: Calculate the profitability of the Johnson Brands customer. Learning objective 5: Analyze customer profitability

Exercise 2 Delta products has determined the profitability of the Johnson Brand customer: Slide 8-28 Learning objective 5: Analyze customer profitability 28

Customers Can Hurt Profitability Learning objective 5: Analyze customer profitability

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 - May lead them to impose less cost on the supplier Also called menu-based pricing Learning objective 6: Explain the activity-based pricing approach

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 - May lead them to impose less cost on the supplier Also called menu-based pricing Slide 8-31 Learning objective 6: Explain the activity-based pricing approach 31

Review 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 they request less product variety in their orders All of the above are correct Answer: d

Pricing Decisions Learning objective 6: Explain the activity-based pricing approach

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