Product Pricing Profit in Bottleneck Conditions Chapter 12 A200 Survey of Accounting University of Tennessee 2 Product Pricing Businesses typically set prices for their products using one of two methods Cost plus Pricing total cost method Product cost is known Product price is based on cost Market based Pricing target cost method Product price is determined by external market forces Product cost is derived from the price 3 Product Pricing Cost plus Cost plus Pricing The price set for a product must be high enough to cover total costs and provide a profit Price Total Cost Desired Profit Price per unit Total Cost per unit Desired Profit per unit Desired Profit A percentage of the assets Invested Assets that managers were given to make the product with Owners are always looking for a return on their investments and profit is the return they want on the assets they invested in making products 4 Product Pricing Cost plus Line Company has budgeted sales for 2012 of 10 000 units of Product A Managers need to set a price per unit for the product Line Company invested assets of 500 000 in making Product A Line s owners want a 15 profit on invested assets return on investment The budgeted costs for Product A are Direct Materials cost variable 175 000 Direct Labor cost variable 90 000 Factory Overhead cost variable portion 27 000 Factory Overhead cost fixed portion 52 000 Selling Administrative Expense variable portion 65 000 Selling Administrative Expense fixed portion 40 000 5 Product Pricing Cost plus Total Costs 449 000 Total Profit 75 000 Total Price 524 000 Product A s price per unit 524 000 10 000 units 52 40 per unit Profit is also called markup Markup Percentage Total Profit Total Cost 75 000 449 000 16 7 A 16 7 markup percentage means that cost was increased marked up by 16 7 to arrive at the selling price 6 Product Pricing Cost plus Some common markup percentages for retail businesses New cars 15 Used cars 75 Electrical Appliances 30 Clothing 50 Trend Clothing 59 Cosmetics Fragrances 80 Crystal Ware 60 Gifts and clocks 55 Restaurant Food 45 Restaurant Wine 100 Used Auto Parts 49 Greeting Cards 90 Mobile Food Vendors Cold food 100 Hot food 200 per Wikipedia and CCH Business Owner s Toolkit 7 Product Pricing Target Cost Market based pricing Selling price is set by the market outside forces Management must fit costs to the price it can charge for the product given the profit it wants Target Cost Pre set Price Desired Profit Line Company sells Product B in a highly competitive market It can sell only 6 000 units and it can charge only 30 00 per unit If management wants a return of 15 on the invested assets of 500 000 what is the maximum cost Line can afford to make Product B Target Cost Pre set Price Desired Profit Target Cost 30 00 per unit 12 50 per unit Target Cost 17 50 per unit 500 000 x 15 75 000 6 000 units 12 50 u 8 Product Profitability Production Bottleneck environment Bottleneck A constraint or limitation on production the weak link in the production process Theory of Constraints How do we adjust for the bottlenecks in our processes How do we judge which product is the most profitable Product Profitability When production processes are Normal unconstrained The product with the highest CM per unit recall from Ch 11 is the most profitable When production processes are Bottlenecked constrained The product with the highest CM per the bottleneck is the most profitable 9 Product Profitability Production Bottleneck environment Product 1 Product 2 Product 3 Selling price per unit Variable costs per unit CM per unit 25 u 40 u 15 u 18 u 8 u 10 u 26 u 12 u 14 u Under normal production conditions no bottlenecks Product 1 is the most profitable Management tends to invest in the most profitable product What if we have a production bottleneck 10 Product Profitability Production Bottleneck environment Bottleneck All three products have to go through a hand wrapping process This process is constrained by a shortage of trained employees Product 1 requires 5 hours of wrapping Product 2 requires 4 hours and Product 3 requires 2 hours Product 1 Product 2 Product 3 CM per unit 25 00 u 10 00 u 14 00 u Bottleneck hours per unit 5 hrs u 4 hrs u 2 hrs u CM per bottleneck hour 5 00 hr 2 50 hr Under constraint Product 3 is the most profitable 7 00 hr