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

2. 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

3. 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
$ ,000
$ ,000
$ ,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?

4. Example Exercise #1 Solution
$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

5. Example Exercise #1 Solution
$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

6. Example Exercise #1 Solution
$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.

7. 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

8. 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?

9. 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.

10. 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

11. 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

12. 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

13. 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

14. 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

15. Commonwealth Edison

16. Target Costing

17. 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

18. Customer Profitability Measurement System

19. 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
Percent of orders marked rush
Calls to customer service
Calculate the profitability of the Johnson Brands account.

20. 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)

21. “Display-Ready” Pallets

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. Maximize Profit

30. Copyright
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