Pricing and Profitability Analysis Topic 5

1. Pricing and Profitability Analysis Topic 5

2. Major Influences onPricing Decisions Customerdemand Political, legal, and image issues Competitors Costs PricingDecisions

3. Price Elasticity The impact ofprice changes onsales volume Demand iselasticifa price increase has alarge negative impacton sales volume. Demand isinelasticifa price increase haslittle or no impact on sales volume.

4. How Are Prices Set? Costs MarketForces Prices are determined by the market, subjectto costs that must be covered in the long run. Prices are based on costs, subject toreactions of customers and competitors.

5. Economic Pricing Concepts Price Supply P* Demand Q* Quantity

6. Market Structure and Price Perfect Competition—Many buyers and sellers; no one of which is large enough to influence the market. Monopolistic Competition—Has both the characteristics of both monopoly and perfect competition. Oligopoly—Few sellers. Monopoly—Barriers to entry are so high that there is only one firm in the market.

7. Market Structures and Characteristics Market Number of Expenses Structure Firms in Barriers Uniqueness Related to Type Industry to Entry of Product Structure Type Perfect Competition Many Very low Not unique No special expenses Monopolistic Many Low Some unique Advertising, coupons, Competition features costs of differentiation Oligopoly Few High Fairly unique Costs of differentiation, advertising, rebates, coupons Monopoly One Very High Very unique Legal and lobbying expenditures

8. Two Approaches to Pricing 1. Cost-based prices are established using “cost” plus markup. 2. Target prices are influenced by market conditions.

9. Cost and Pricing Policies Cost Plus Pricing Markup is a percentage applied to base cost; it includes desired profit and any costs not included in the base cost. Markup on COGS = (Selling and administrative expenses + Operating Income)/COGS Markup on DM = (Direct Labor + Overhead + Selling and administrative expense + Operating Income)/ Direct Materials

10. Revenues $350,350 Cost of goods sold: Direct materials $122,500 Direct labor 73,500 Overhead 49,000 245,000 Gross profit $105,350 Selling and administrative expenses 25,000 Operating income $ 80,350 Cost-Plus Pricing AudioPro Company sells and installs audio equipment in homes, cars, and trucks. AudioPro’s income statement for last year is as follows:

11. Cost-Plus Pricing The firm wants to earn the same amount of profit on each job as was earned last year: Markup on COGS = (Selling and administrative expenses + Operating income)/COGS Markup on COGS = ($25,000 + $80,350)/$245,000 Markup on COGS = 0.43

12. Cost-Plus Pricing The markup can be calculated using a variety of bases. The calculation for markup on direct materials is as follows: Markup on DM = (Direct labor + Overhead + Selling and administrative expense + Operating income)/Direct materials Markup on DM = ($73,500 + $49,000 + $25,000 + $80,350)/$122,500 Markup on DM = 1.86

13. Direct materials (component and two remote controls) $ 40.00 Direct labor (2.5 hours x $12) 30.00 Overhead (65% of direct labor cost) 19.50 Estimated cost of one job $ 89.50 Plus 43% markup on COGS 38.49 Bid price $127.99 Cost-Plus Pricing AudioPro wants to expand the company’s product line to include automobile alarm systems and electronic car door openers. The cost for the sale and installation of one electronic remote car door opener is as follows:

14. Target Costing and Pricing Target costing is a method of determining the cost of a product or service based on the price that the customers are willing to pay. Target costing involves much more upfront work than cost-based pricing. However, if the cost-plus pricing turns out to be higher than what customers will accept, additional work or lost opportunity will result.

15. Cost and Pricing Policies • Other Pricing Policies • Penetration pricing: the pricing of a new product at a low initial price to build market share quickly • Not like predatory pricing because it is not meant to destroy competition • Price skimming: a higher price is charged when a product or service is first introduced • Price gouging: occurs when firms with market power price products ‘too high’

16. Predatory Pricing Predatory pricing is the practice of setting prices below cost for the purpose of injuring competitors and eliminating competition. Predatory pricing on the international market is called dumping. Competition

17. Customer Prices per Case Cases Sold Large drug store chain $200 125,000 Small local pharmacies 232 100,000 Individual health clubs 250 25,000 Price Discrimination Price discrimination refers to the charging of different prices to different customers for essentially the same product. Cobalt, Inc. manufactures vitamin supplements that costs an average of $163 per case. Cobalt sold 250,000 cases last year as follows: Cobalt is practicing price discrimination!

18. Measuring Profit Profit: a measure of the difference between what a firm puts into making and selling a product or service and what it receives • Profits are measured to: • Determine the capability of the firm • Measure managerial performance • Determine whether or not a firm adheres to government regulations • Signal the market about the opportunities for others to earn a profit

19. Measuring Profit • Absorption Costing Approach • Also called full costing • Required for external financial reporting • Assigns all manufacturing costs, direct materials, direct labor, variable overhead and a share of fixed overhead to each unit of product – thus, each unit of product absorbs some of the fixed manufacturing overhead in addition to its variable manufacturing costs

20. Measuring Profit • Variable Costing Approach • Called direct costing • Assigns only unit level variable manufacturing costs to the product- these costs include direct materials, direct labor, variable overhead • Fixed overhead is treated as a period cost and is not inventoried with the other product costs – it is expensed in the period incurred

21. Limitations of Profit Measurement • Limitations of profit include: • Focus on past performance • Uncertain economic conditions • Difficulty of capturing all important factors in financial measures • Successful firms measure far more than accounting profit.

22. Segment Reporting Alden Company manufactures two products: basic fax machines and multi-function fax machines. The multi-function fax uses more advanced technology; therefore, it is more expensive to manufacture. Basic Multi-Function Number of units 20,000 10,000 Direct labor hours 40,000 15,000 Price $200 $350 Prime cost per unit $55 $95 Overhead per unit $30 $22.50

23. Segment Reporting Alden Company Absorption-Costing Income Statement, 2004 (In thousands of dollars) Basic Multi-Function Total Sales $ 4,000 $ 3,500 $ 7,500 Less: Cost of good sold 1,700 1,175 2,875 Gross profit $ 2,300 $ 2,325 $ 4,625 Less: Marketing expense -400 -350 -750 Administrative exp. -1,067 -933 -2,000 Operating income $ 833 $ 1,042 $ 1,875

24. Segment Reporting Alden Company Variable-Costing Income Statement, 2004 (In thousands of dollars) Basic Multi-Function Total Sales $ 4,000 $ 3,500 $ 7,500 Less: Variable COGS -1,362 -1,048 -2,410 Sales commissions -400 -350 -750 Contribution margin $ 2,238 $ 2,102 $ 4,340 Less: Fixed overhead -465 Administrative expenses -2,000 Operating income $ 1,875

25. Absorption-Cost Pricing Formulas Advantages Price covers all costs. Perceived as equitable. Comparison with competitors. Absorption cost used for external reporting. Disadvantages Full-absorption unit price obscures the distinction between variable and fixed costs.

26. Variable-Cost Pricing Formulas Advantages Do not obscure cost behavior patterns. Do not require fixed cost allocations. More useful for managers. Disadvantage Fixed costs may be overlooked in pricing decisions, resulting in prices that are too low to cover total costs.

27. Product Cost Distortion High-volume products May be overcosted Low-volume products May be undercosted

28. Overhead Activities and Drivers Overhead Cost Category Total Cost Cost Driver Setups Number of setups $ 40,000 Maintenance Maintenance hours 120,000 Supplies Direct labor hours 80,000 Power Machine hours 280,000 Machine depreciation Machine hours 250,000 Other factory costs (None) 55,000 $825,000 Continued

29. Overhead Activities and Drivers Usage of Cost Drivers by Product Basic Multi-Function Number of setups 10 30 Maintenance hours 2,000 8,000 Direct labor hours 40,000 15,000 Machine hours 10,000 90,000

30. Alden Company Activity-Based Costing Income Statement (In thousands of dollars) Basic Multi-Function Total Sales $4,000 $3,500 $ 7,500 Less: Prime costs -1,100 -950 -2,050 Setups -10 -30 -40 Maintenance -24 -96 -120 Supplies -58 -22 -80 Power -28 -252 -280 Machine depreciation -25 -225 -250 Sales commissions -400 -350 -750 Contribution margin $2,355 $1,575 $ 3,930 Less: Other fixed overhead -55 Administrative expenses -2,000 Operating income $ 1,875

31. Divisional Profit Alpha Beta Gamma Delta Total Sales $ 90 $ 60 $ 30 $120 $300 Cost of goods sold 35 20 11 98 164 Gross profit $ 55 $ 40 $ 19 $ 22 $136 Division expenses -20 -10 -15 -20 -65 Corporate expenses -3 -2 -1 -4 -10 Operating income (loss) $ 32 $ 28 $ 3 $ -2 $ 61

32. Competitive Bidding High bidprice Low probabilityof winning bid High profit ifwinning bid Low bidprice Low profit ifwinning bid High probabilityof winning bid

33. Competitive Bidding Bidder hasexcess capacity Bidder hasnoexcess capacity Guidelines for Bidding • Low bid price • Any bid price in excess of incremental costs of job will contribute to fixed costs and profit. • High bid price • Bid price should be full cost plus normal profit margin as winning bid will displace existing work.