Chapter 8

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

2. The Profit Maximizing Price • Economic theory focuses on the “demand function.” • Own-price elasticity: the higher the price, the lower the quantity demanded.

3. Pricing Special Orders • Generally, products are not sold for less than full cost. • In some cases it may be beneficial to charge a price less than full cost. • Special order. • Order will not affect demand for a firm’s other products (or current sales). • Company may be better off charging a price below full cost.

4. Pricing Special Orders: Example, Model A Standard Unit Costs Direct Material: $30 Direct Labor: $15 Variable Overhead: $10 Fixed Overhead: $20 Total: $75 Should Quality Lens Company accept (or reject) a bid for 20,000 lenses for $73 each? It depends on whether there is “excess capacity.”

5. Cost-Plus Pricing • Cost-Plus Pricing is simple, but limited. • Ignores demand for product. • Leads to circular pricing schemes for manufacturers. • Ignores own-price elasticity.

6. Cost Plus Pricing – You try it • Costs are as follows: Variable Mfg cost: $4/unit Variable Selling cost: $2/unit Fixed Mfg cost: $100,000/year Fixed S&A cost: $50,000/year

7. Questions • What price would need to be charged if volume is 25,000 units produced and sold and desired profit is $50,000? • What markup on full cost would be necessary to earn a profit of $75,000 at a volume of 50,000 units? • What markup on total cost would be necessary to earn a profit of $100,000 on a volume of 100,000 units?

8. Target Costing Process: Specify features and price. Determine desired profit. Target cost = price – desired profit. Design to meet the target cost. Change price and/or features if product cannot be designed to meet target cost. Target Costing

9. Customer Profitability System (CPM). Indirect costs of servicing customers assigned to cost pools. Returns Shipments Using cost drivers, costs are assigned to customers Customer revenues – product costs - indirect costs (above) = customer profitability. Analyzing Customer Profitability

10. Activity-Based Pricing uses the same information as customer profitability. Also called menu-based pricing. Examples include: Charge for Internet order: $1.25 Charge for phone, fax or mail order: $4.75 Charge per order line item: $1.00 Delivery charge per mile: $0.40 Per pound packing charge: $0.50 Per item restocking fee: $1.00 Activity-Based Pricing

11. Present Value Calculations • For Chapter 9 we need to be able to present value a single future payment and a stream of future payments • The present value of a single future cash flow is what would have to be deposited now earning i% interest to have that amount of money in n periods • The present value of a stream of payments is what would have to be deposited now to earning i% so that an equal periodic amount could be withdrawn each period for n periods, starting in one period from now

12. The Tables • We will use the tables in your book on pages 322 and 323 to do these calulations • Table 1 shows the present value of a single payment. • Table 2 shows the present value of an annuity (an equal periodic payment) beginning in one period

13. Try a couple • How much would have to be deposited now to have $10,000 in 6 years earning 12%? • First guess • Then calculate • This is the same question as “what is the present value of $10,000 discounted at 12% for 6 years?”

14. Answer 10,000 * PV 6/12% 10,000 * 0.5066 = $5066

15. Question 2 • What would have to be deposited now to be able to withdraw $10,000 per year for 8 years earning 9%? • Or what is the present value of an 8 year annuity earning 9%? • Start by guessing

16. Answer • First guess? • Use table 2 and multiply $10,000 by the factor for 8 years at 9% • PVA 8/9% = 5.5348 • 10,000 * 5.5358 = $55,358