Pricing and Profitability Analysis. Prepared by Douglas Cloud Pepperdine University. Economic Pricing Concepts. Price. Supply. P*. Demand. Q*. Quantity. Market Structure and Price. Perfect Competition —Many buyers and sellers; no one of which is large enough to influence the market.
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Pricing and Profitability Analysis Prepared by Douglas Cloud Pepperdine University
Economic Pricing Concepts Price Supply P* Demand Q* Quantity
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.
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
Two Approaches to Pricing 1. Cost-based prices are established using “cost” plus markup. 2. Target prices are influenced by market conditions.
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:
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
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
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:
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.
Types of Pricing (1)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
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 (2) 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!
Measuring Profit • Absorption Costing • Variable Costing • Activity-Based Costing
Lasersave, Inc., a company that recycles used toner cartridges for laser printers. During August the firm manufactured 1,000 cartridges at the following costs: Direct materials $ 5,000 Direct labor 15,000 Variable overhead 3,000 Fixed overhead 20,000 Total manufacturing cost $43,000 During August, these cartridges were sold at $60 each. Variable marketing cost was $1.25 per unit. Fixed expenses were $12,000.
Produce Sales September: 1,250 units 1,000 units October 1,250 units 1,300 units Annual OH $825,000 on the basis of DLH Marketing expense = 10% of sales Administration exp. = 2 million (based on sales proportion)
Variable OH($) Fixed OH($) Total ($) Setup 40,000 Maintenance 120,000 Supplies 80,000 Power 280,000 Machine depreciation 250,000 Other factory costs 55,000 Total 360,000 465,000 825,000
Absorption-Costing Income Statement Percent of Sales Sales $ 60,000 100.00 % Less: Cost of goods sold 43,000 71.67 Gross profit $ 17,000 28.33 % Less: Variable marketing expenses -1,250 -2.08 Fixed marketing and administrative expenses -12,000-20.00 Operating income $ 3,750 6.25 % Lasersave, Inc. for August
Absorption-Costing Income Statement Percent of Sales Sales $ 60,000 100.00 % Less: Cost of goods sold 39,000 65.00 Gross profit $ 21,000 35.00 % Less: Variable marketing expenses -1,250 -2.08 Fixed marketing and administrative expenses -12,000-20.00 Operating income $ 7,750 12.92 % Lasersave, Inc. for September
Variable-Costing Income Statement For the Month of August For the Month of September Sales $ 60,000 $ 60,000 Less: Variable expenses 24,250 24,250 Contribution margin $ 35,750 $ 35,750 Less: Fixed manufacturing overhead -20,000 -20,000 Fixed marketing and admin. exp. -12,000 -12,000 Operating income $ 3,750 $ 3,750 Lasersave, Inc.
Comparative Statements for October Absorption Costing Sales $ 78,000 Less: Cost of goods sold 50,700 Gross profit $ 27,300 Less: Variable marketing expenses -1,625 Fixed marketing and administrative exp. -12,000 Operating income $ 13,675 Lasersave, Inc. Continued
Comparative Statements for October Variable Costing Sales $ 78,000 Less: Variable expenses 31,525 Contribution margin $ 46,475 Less: Fixed manufacturing overhead -20,000 Fixed marketing and administrative exp. -12,000 Operating income $ 14,475 Lasersave, Inc.
Changes in Inventory under Absorption and Variable Costing If Then Production > Sales Absorption NI > Variable NI Production < Sales Absorption NI < Variable NI Production = Sales Absorption NI = Variable NI
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
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
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
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
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
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