Pricing Decisions Absorption Costing Cost Plus Pricing The Three Step Process 1 Calculate the unit product absorption cost direct materials direct labor variable manufacturing overhead and fixed manufacturing overhead 2 Determine the markup percentage based on the unit product absorption cost 3 Multiply the unit product absorption cost by the markup percentage to determine the product s selling price Step 1 Unit Product Absorption Cost Labor hours available Labor hours per pad 38 400 2 4 16 000 pads Unit Product Absorption Cost Direct materials Direct Labor Manufacturing overhead Unit product cost 10 80 19 20 30 000 60 00 Step 2 Determine the Markup Percentage The equation for calculating the markup percentage on absorption cost is shown below Markup on absorption cost Required ROI Investment S A expenses Unit sales Unit product cost The markup must be high enough to cover S A expenses and to provide an adequate return on investment Step 2 Determining the Markup Markup on absorption cost 24 1 350 000 9 00 16 000 732 000 16 000 60 Variable S A per unit Total fixed S A Markup on absorption cost 324 000 876 000 960 000 125 Step 3 Determine the Product s Selling Price Multiply its unit product cost by the sum of 1 the markup percentage Unit Product Absorption Cost Direct materials Direct Labor Manufacturing overhead Unit product cost Add markup 125 of unit product cost Selling Price 1 1 25 2 25 10 80 19 20 30 000 60 00 75 00 135 00 Income Statement Wilderness Product Income Statement Sales 16 000 pads x 135 per pad Less Cost of goods sold 16 000 x 60 per pad Gross margin Less S A expenses 16 000 x 9 732 000 Net operating income 2 160 000 960 000 1 200 000 876 000 324 000 Return on Investment ROI Return on Investment ROI 01 23 456 788 8 24 Profits Profit 1st Week Sales 1 800 x 3 50 Less Variable expenses 1 800 x 0 80 Fixed expenses Net Income Profit 2nd Week Sales 1 400 x 4 00 Less Variable expenses 1 400 x 0 80 Fixed expenses Net Income 6 300 1 440 2 675 2 185 5 600 1 120 2 675 1 805 Price Elasticity of Demand Elasticity of Demand The price elasticity of demand measures the degree to which the unit sales of a product or service are affected by a change in unit price Change in Price versus Change in Unit Sales Price Elasticity of Demand Elasticity of Demand 4 3 50 3 50 1 400 1 800 1 800 versus 14 29 22 22 Change in Price Change in Unit Sales Value Based Pricing Value Based Pricing An alternative to cost plus pricing Selling prices are established based on the economic value of the benefits that their products and services provide to customers Economic value to the customer EVC the price of the customer s best available alternative plus the value of what differentiates the product from that alternative Reference value the price of the best available alternative Differentiation value the value of what differentiates a product from the best available alternative Economic value to the customer Reference value Differentiation value Reference value Value based price EVC Value Based Pricing McDermott Reference Value 1 200 Competing Equipment IC 75 Cost of 2nd Component to achieve 4 000 hours of usage Preventive maintenance cost for 4 000 hours 200 x 4000 hours 2 000 hours 300 x 4 000 hours 4 000 hours Total Differentiation value 1 200 400 1 300 300 Economic value to the customer 1 200 1 300 2 500 Target Costing The process of determining the maximum allowable cost for a new product and then developing a prototype that can be made for that maximum target cost figure The equation for determining a target price is shown below Target cost Anticipated selling price Desired profit Once the target cost is determined the product development team is given the responsibility of designing the product so that it can be made for no more than the target cost Shimada Products Corporation Shimada Products Corporation of Japan plans to introduce a new electronic component to the market at a target selling price of 15 per unit The company is investing 5 000 000 to purchase the equipment it needs to produce and sell 300 000 units per year Its required rate of return on all investments is 12 Computer the component s target cost per unit Target Costing Solution Projected sales 300 000 units 15 Desired profit 5 000 000 12 Target cost for 300 000 units Target cost per unit 3 900 000 300 000 4 500 000 600 000 3 900 000 13 00 Each functional area within Shimada would be responsible for keeping its actual costs within the target established for that area
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