CHAPTER 8 Pricing Decisions Analyzing Customer Profitability and
CHAPTER 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing
The Profit Maximizing Price Economic Theory § § The quantity demanded is a function of the price that is charged Generally, the higher the price, the lower the quantity demanded Pricing § Management should set the price that provides the greatest amount of profit
Example Exercise #1 § The editor of Spunk Magazine is considering three alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are: Price $6. 95 $5. 95 $4. 95 Quantity 20, 000 25, 000 32, 000 Monthly costs of producing and delivering the magazine include $80, 000 of fixed costs and variable costs of $1. 50 per issue. § Which price will yield the largest monthly profit?
Example Exercise #1 Solution § Profit @ $6. 95 Revenue (20, 000 x $6. 95) Variable Costs (20, 000 x $1. 50) Contribution Margin Fixed Costs Profit $139, 000 ($30, 000) $109, 000 ($80, 000) $ 29, 000
Example Exercise #1 Solution § Profit @ $5. 95 Revenue (25, 000 x $5. 95) Variable Costs (25, 000 x $1. 50) Contribution Margin Fixed Costs Profit $148, 750 ($37, 500) $111, 250 ($80, 000) $ 31, 250
Example Exercise #1 Solution § Profit @ $4. 95 Revenue (32, 000 x $4. 95) Variable Costs (32, 000 x $1. 50) Contribution Margin Fixed Costs Profit $158, 400 ($48, 000) $110, 400 ($80, 000) $ 30, 400 § A price of $5. 95 yields the largest monthly profit.
Pricing Special Orders In some cases, it may be beneficial for a company to charge a price lower than its full cost § Only if the order will not affect demand for its other products
Special Orders – Premier Lens Example Given the following information, should Premier Lens produce 20, 000 lenses to be sold to Blix Camera for $73 per lens?
Special Orders – Premier Lens Example The incremental analysis shows that it should. Note that the fixed costs are not incremental and need not be included in the decision making.
Cost-Plus Pricing Company estimates cost of production § Adds a markup to cost to arrive at price which allows for a reasonable profit Benefits § Simple approach Limitations § What % markup to use? § Inherently circular for manufacturing firms § Requires considerable judgment and experimentation
Study Break #1 To determine the profitmaximizing price a manager must: a. Estimate the quantity demanded for various prices b. Estimate variable costs c. Both a and b are correct d. None of the above are correct
Study Break #1 To determine the profitmaximizing price a manager must: a. Estimate the quantity demanded for various prices b. Estimate variable costs c. Both a and b are correct d. None of the above are correct
Study Break #2 Cost-plus pricing: a. Leads to profit maximization b. Is inherently circular for manufacturing firms c. Is difficult to perform d. None of the above are correct
Study Break #2 Cost-plus pricing: a. Leads to profit maximization b. Is inherently circular for manufacturing firms c. Is difficult to perform d. None of the above are correct
Commonwealth Edison
Target Costing
Analyzing Customer Profitability Measurement System (CPM) § Indirect costs of servicing customers are assigned to cost pools – For example the cost of processing orders and handling returns § Costs are allocated to specific customers using cost drivers to determine customer profitability
Customer Profitability Measurement System
Example Exercise #2 § Delta Products has determined the following costs: Order processing/order Additional handling cost per rush order Customer service calls/call Relationship management costs/customer § In addition to theses costs, product costs amount to 90% of sales. In the prior year, Delta had the following experience with Johnson Brands: Sales Number of orders Percent of orders marked rush Calls to customer service § $5. 00 $8. 50 $10. 00 $2, 000. 00 $53, 800 200 60 140 Calculate the profitability of the Johnson Brands account.
Example Exercise #2 Solution § Profitability of Johnson Brand account Sales $53, 800 Less: Cost of good sold (. 9 × $53, 800) $48, 420 Order processing (200 × $5. 00) $1, 000 Rush handling (. 6 × 200 × $8. 50) $1, 020 Customer service (140 × $10. 00) $1, 400 Relationship management costs $2, 000 Profitability of Johnson Brands account $53, 840 $(40)
“Display-Ready” Pallets
Activity-Based Pricing § Customers are presented with separate prices for services they request in addition to the cost of goods purchased § Customers will carefully consider the services they request § Example
Study Break #3 Target costing: a. Requires specification of desired level of profit b. Targets specific costs for reduction c. Is used primarily with products that are already in production d. Leads to profit maximization
Study Break #3 Target costing: a. Requires specification of desired level of profit b. Targets specific costs for reduction c. Is used primarily with products that are already in production d. Leads to profit maximization
Study Break #4 Customer profitability is measured as: a. Revenue – cost of goods sold b. Revenue – indirect manufacturing costs c. Revenue – cost of goods sold – indirect service costs d. Revenue – cost of goods sold – indirect manufacturing costs
Study Break #4 Customer profitability is measured as: a. Revenue – cost of goods sold b. Revenue – indirect manufacturing costs c. Revenue – cost of goods sold – indirect service costs d. Revenue – cost of goods sold – indirect manufacturing costs
Study Break #5 With activity-based pricing: a. Customers face a menu of prices for various services b. Customers are encouraged to consider the costs they impose on a supplier c. Customers may be charged less if the request less product variety in their orders d. All of the above are correct
Study Break #5 With activity-based pricing: a. Customers face a menu of prices for various services b. Customers are encouraged to consider the costs they impose on a supplier c. Customers may be charged less if the request less product variety in their orders d. All of the above are correct
Maximize Profit
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