PricingProducts

andServices
l _c i l flr ||r g t tbJecl rvcs
Al(orl(rdt{o lhis.trtrerdix,Voushouldhc ablet0:
LOI CorrDlte tlrcproflririrxmrz[g priceoI a prodrcL
or servceusnglheDrice
!hst, ty al lenrand andvrrabe cosl
LO2 Corrpltethc se iftl trrceo{J prodlctusngtlreabsorphon coshngapproaclr.
to?
754

I Introduction
ome prducts have an establishedmarket price. Consumers will not
paymorethanthispriceandthereis no reasoo
for a supplier
to charge
less-it
cansell all that it producesat this price.Underthesecircumstances,
the company
simply chargesthe prevailingmarketprice for the product.Marketsfor basicraw
materialssuchas farm productsandminemlsfollow this pattem.
ln thisappendix,we areconcemedwith themorecommonsituationi whicha business is
facedwith theproble'nofsettingils own prices.Clearly,theprjcingdecisioncanbe critical.If
the priceis seltoo high,cus(omers won\ buy the oompany'sproductr.ll-the p ce is settoo
loq thecompany'scoslswon't be covercd,
The usualapproachin pricingis 10Dart up cost.rA product'smarkup is the dilllrence
betwecnits sellingpriceondils coslaDdis usuallyexpressed asa percenlage
ol cosl,
Scllingprico: (l l M.r*up pcrccntagc)
x Cost
For example,a companythal usesa markupof 50ol.adds50% to the costsof its produch
to determine sellingprices.Il a ploductcostsS10,thenthecompanywouldcharge$ l5 fbr
the product.This approachis called cost-pluspricing becausea predelenninedmarkup
percentage is appliedto a cost baseto determinethe selling price.
Ttvo key issuesmust be addressed wih the costplus approachto pricing. First, what
cosl shouldbe used?Sccond,how shouldthe markupbe determined?Severalalternative
approaches areconsidcrcdin lhis ppendix,startingwith the approachgener0llyfavoredby
economists,

TheEconomists'
Approach
to Pricing
LEARNING
OBJECTIVE
I lf a compaDyr'aisesthe priceof s producl,uDil salesordinarilyfall. Becauscol lhis, picing
Computetheproft- is a delicalebalnncingact in which the benelilsof higherrevenuesper unil are tmdedolT
priceof a
maximizing againslthe lower volumethal resultsliom charginga higherprice.The scnsitivityol unil
product
or service
using salesto changesin prioeis c^lledlhefiLe elusticit!ofdendnd.
thepriceelasticity
of
demandandvariab
e cost. Elasticity of Demand
A product'spdce elasricityshouklbcI key elementin settingits pricc.Thc price elasticity
ot d€mandneasuresthedegreeto which n changein priceaffectsthe unit salcsol a producl
or service.Demandfbra proclucris saidto be i/reldrlicifachange in pricehaslitlle cliecton
the numberof onits sold.The demnndfbr design€rperfumessold by lraincd personnelat
cosmeticcounlersin depannrentstorcsis relativelyinelastic-Raisingor lowcringpriceson
theseluxurygoodshaslittle effecton unit sales.On the otherhand,demandfora productis
ifa changein pricehasa substantial effecton the volumeof unils sold.An example
"/dsaic
of a productwhosedemandis claslicis gasoline.Ifa gasstationraisesils price lbr gasoline,
unil saleswill drop ascustomersseeklowerpriceselsewhere.
Priceelasticityis very imporranlin determiningprices.Managersshould set higher
markupsovercostwhencustonersarc relalivelyinsensitiveto price (i.e.,demandis inelas-
tic) and lower markupswhen cuslo ers are relativeiysensitiveto price (i.e., demandis

rTheredesomele8alreslricLionsotrp.ices.Andirlstlawspmhibit'predalorf"pices.whicharegenerully
iDteryr€lEdbylhecourtsromeun{pdccbelowlveragevriablecost.'Pricediscdminaiion'<hargingdilleF
cDtprlcesto cuslomesin thesane nru|tci lbr thestuneprodn.t or service-is alsol)|ohibitedby drehw.
 PricingProductsandServices

elastic).This principleis followed in depdrtmentstoros.Merchandjsesold iD the baryain

basementhasa much lower markupthanmerchandise sold elsewherein the storebecause
customerswho shopin the bargainbasemenlaremuchmoresensitiveto prjce (i.e.,demand
is elastic).
The price elasticityof demandfor a produclor seftice, €,, can b€ estimatedusingthe
following fornruta.r3
In(l + ',6changein quantitysold)
ln(l + 7. changein price)
Forexample, suppos€thatthemanagers of Naturc'sGardenbelievethata l0% incrcasein
thesellingpriceoftheirapple"almond
shampoo wouldresultin a l5% decreasein thenum-
berof bottlesof shompoo sold.aThepriceelasticityof demandfor thisproductwouldbe
compuled asfollows;
Inll ( 0.ls)l ln (0 . 8 s )
'/
lnll I t0.10)l ln (1 . 1 0 )
For comparisonpurposes, the managers of Nature'sCafdenbelievethat another
product,strawbenyglycerinsoap,wouldexperiencc a 20%dropin unit salesif ils price
is increasedby l0%. (Purchasersofthis productaremoresensitiveto pricethanthepor-
chasers oftheapple-olmond shanpoo.) Thepriceelasticity ofdemandfor thestrawbery
glycerirsoapis:
lnIl - (-0.20)l ln(0.80)
-'r I'rtl + (0.10)l ln(1.10)
Bothof thescproducts,
likeothernormalproducts,havea priceelasticitythatis lessthan- l.
Notethalthep ce elaslicityol'demandIbr theslrawberry glycerinsoapis laryer(i0
absolutevalue)thanthe priccelasticityof demandlbr theapple-almond shampoo. This
indicarcsthatthedemandfbr struwberryglycerinsoirpis mor! elasticthanthedemandlbr
apple-almond shampfi).
thepriceelasticity
ln thenextsubsection, ofdemand will bcusedto compule theselling
pricethatmaximizeslhe proiihoflhe compnn,

T he Prcfi t -MaximiTingPr ice

Under certainconditions,the prolit-maximizingprice can be delerminedby markingup
t,ariablecost\rsingthe 1'ol
lowing fbrmulai5

co* = l
I'roht-mrximizingmarkupon var;.rtrte

Using the abovemarkup,the sellingpricewouldbe setusingthe formula:

Prolit'maximizingpricc:(| l Plolit-Draxinrizing cost)X
rn rkuponvariablc
Variablccostpcr uDil

'ln( )" is thenaturallo8 funclion.You cancompule$e n.rumllog of any numberusingrhe

'? The tem
LN or lu k€yon yourc{lculatof.Fof exanple,Iu(0.85)= -0.1625.
I This formula.ssumesthal the price€lasticityofdemandis conshnt.This o@u6 whenfte rclslion
in thefollowingform: ln({) = d +
berwcenthe sellingpricc,p, nnd tho unit sales,I, canbe oxpr€ssed
€r'ln(/r).
Eveniflhis is notprechclyhue,thc formulaprovidesa uselLrlway Loestimaleu productkpric!

1 The estimated chrngein unit salesshouldlakeinroaccounlcomp€titors' responscsto a pricechange.

J The toimulaassumes tlat (0) fte priccclasLicilyofdemandis constantr (b) Totalcost = Totalfixcd
cost + Vdiabl€ ost per unit x Quantity soldt md (c) the pricc of the producthasno elTecton the salesor
costsof ey otherproducl.Thefomula canbederiv€dNing calculDs.
756

WHATDIDTHATSALMON
DISHCOST?
Restauranismarkupfoodcostsbyanaverage of300% to coverthe ardgenerate
r overhead a proft,
butthemarkup isfotthesame forallitems
onthemenu, Somengredlents-especialyprmecutsof
beefandexotcsealood suchasfreshscallops-are socostly thatdiners
woudngttoleratea 300%
rnarkup.Sorestaurantsmakeit uponthecheap stuff-vegetables,pasta,
andsamon.Whysalmon?
Thelarmed varietys only52.50p€rpound wholesale, muchcheaper tharprimerestaurant-qua
iU
beef.AttheDocks restaurant
inNewYorkCty,a 1o-ounce samondinrergarnishedwth potatoes
and
coleslawisS19.50.Theactualcostoftheingred entsisoflySI.90.
Totakeanoiherexampe, thelngredentsofthebesi-selrg Angus beeiterdedoln
attheSunsetGrl
inNashvile,
Tennessee,coststheresiaurant
58.42.Applying theaverage300% theprceofthe
markup,
rneal
would beS33.68. Butfewdiners woudorderthemeaat thaiprce.Soinstead therestaurant
chargesjust525.lncontrasi,
therestaurant
charges59foritsGrllvegetabe pate-whose ingred
ents
costonlySi.55.
Source:E
e€nDaspin,'Entrd€
Econanrics,"
IheWall
She€t
Jorrnal, 10,2000pp.WlandW4.
fi,lafclr

]'hc proliG|naxiizingtriccs lbr thc two Nalurc'sCNdcn products

afc compu(cdbclow
usingihcscloflnulas:

Apple-Almond
Shampoo
Profit-max cost= f-
mizingmarkuponvariable = 1.41
1 +^)
( t71)t
ng price= (1 + 1.41)$2.00
Pfofit-maximiz = $4.82

StrawberryGlycerlnSoap
/-1 \
P'ofil-Iax mizrngmarkupon var ablecost = { :-----==; I - 0.75
| - {-z o4l

l:.rll:T""1:i: 49= $0
0:751$9
"slli* : !l I J0
NotcthrttheT5%nrfkuptofthestftwberyglycednsoapisloworthrnthel4l%mr&upfol
rhc rpple-:rlmondshrmpoo.The feasonfor this is that the purchaseffof strrwbeffyglyccfil
so p arc lnoro sensitiveto price thanlhe purchrseI1\
of.rpple-alnondshamp()o. Stfawbeffy
glyccrir solp is rel.rtivelycommonproductwith closesubstitules av.rilablein nea y every

ExhibitA-l showshow the proficmrximizing mafkupis generally !ffectedby how

sensiliveunit salesafe to price.For exarnple,if 0 l0% increasein price lerds to a 20,/. de'
crersein unit s.rles, thentheoplimalmafkupon v.rriable costaccofding to the exhibitis
75%-the ligur€ coDrputedabovefor the stl.lwbenyglycerin solp. Note that the optinlal
mrrkup dropsas uDilsalesbeconre|noresensitiveto price.
Cautionis advisedwhenusingtheseformulasto est.rblisha sellingpfice.The fonnulas
rely on silnplifyirg assumptionsandthe estimrteofthe tefcentagechangein unit srlesthat
would resultfrom a eivenpefcentagechangein price is likely to be lnexact.Ncvedheless,
the formulascan providevaluablecluesregffdi'rg whetherpricesshouldbe increase.lof
decreased. Suppose,for exanple.that the strawberfyglycerinsoapis curfentlybeing sold
Ior S0.60per bar The formnla inclicates that the pfofit-maximizingpfice is $0.70per bar.
Ratherthan increasingthe price by $0.10,it would be prudentto increasethe price by a
morc modestamountto obseNewhat happensto unit srlesandio profits.
The fofmulafor theprofitmaximizingpriceconveysa very importantlesson.lf the total
fixed costsafe the samewhetherlhe companychargesS0.60or 11j0.70. theycannotbe rcle
vant in the decisionof which priceto chargcfor the soap.Thc oplinal sclling pricc should
dependon two factors thevariablecostperunit andhow sensitive nit salesareto changcs
in price.Fjxedcostsplay oo role io seitingthe optimalprice.Fixcdcostsarerelevantwhen
Ir.--
I

PrcngProdlcts
ardServces

500% E X HI B I TA -I
Theoptimallvafkup on
450% Variable
Costasa FLrnction
400% oi theSensitivtyoi Unit
Saesto Price
350%

300%

250%

2ao%
E
150%
E
100%

50% |
I
a% I
10% 15ao 20% 257. 30"/. 35%
Percenldecreaseln unit sales
due to a 107oIncreasein prlce

dcci(lingwhcrhcfl{rollcr ir p()ducrbul irfcno(rclcvrutwhcndceiding howIruchto ehlrgc

lin lhc pfoducl.
wc crn dirccllyvcfily llrarrn irrcrcrsc in scllingpdccli)f lhc slrlwbcrygllccrinsr)ll
lio'r rhc cunlnl Dicc ol :li0.an) per birf is w.r.rn tcd, llascdiusl on lhc li'rccllsllhal r 10,l
ircfcnscin \cllingpricowouldlcrd 1or 20%dccfclscin unilsllcs.SLrfposii. li)r ci(flllflc.
thrl Nrtur! s (ir(lcn is cuncDllyscllin! 200.000l) ff ol lhc sorf poryc.r lt lhc pficc('l'
$i0.60a buf.Il lhc chr gc iI pricchirsno clltcl olr lhc cornprnys lixcdcostsor ou olllcr
prxlucls. lhc clltct on p ol iic'cnsirg lhc pticc by I{)7.cflt be co"rtNlcdrs li)|k)ws:
'lils

Higher

Sellingp ce . . . - . . . - - . - - - . . . . - - . $0.60 $0.60+ (0.10!$0.60)

= $0.66
Unil sa ss . . . . . . . . . . . . . . . . . . . . . . 200,000 200,000- (0.20x 200,000)
: 160,000
Sales.... - - - -................. $120,000 $105,600
Variablecosl ($0.40per unit). . . . . . . 80,000 64,000
Contribution margin.............. $ 40,000 $ 41,600

Despitcthc lpparcrrloplimrlityol pricesbrsc(lonnurkingup !ari blecosts.rocord

ing to thc price elaslicilyLrl-demund,surveysconsistenlly
rcvealthnl rrosl nanilgcrs
l|ppr'orchthc pricingpfoblonrtioDra completcl)ditTerenlpcfspeclivc.Ii
l'het trrcl-cflo

qmprni.s $rvcyed usc(Lsnne tbnn ol liLlL

" one slldy liNnd Ih.I ll.l7 ol the 50.1hrgc drnuJicLlririt
()sr (eilhe. rhsrl)rior cosr or xbsoiprio. cosl plus sellirs oxl rdmiiisliii!c crpenscs)rs lhe bNis ll,t l)ric
itrs.'lhe rcn inine 177. u\cd orly variablecosts!\ a brsis h, rricnrg {10(i\ion!.Scc V. (tuvindrftirf ord
Rohen N. Anr hor)'. Hou,FirDi U$Corl Ddr in Pricin! Dccisions. lr?trr4z,,rnl1.r o/,tn|, Jul! I')83.
ft :10 36. r\ nrft rcccnt.bur Lcssexten\nc. \uner b.v [!n$,t Shi'n.nd EphLaimlr Sudir. H,Nv vrnu
l1r.tffe6 Pricc l)roducts,' Mr ru|dnent Ai atutirs, rebttrfy I 995. pp. ]? 39, found similar !c$LlLs.
On thc or]tr h0nd,a {nc! ofsmdlcoiltJr.r executivc\\unnMrizcd i0 rr. nuglzi)c. Nolcmher L!96,
I il!t. r$caleil rhrr only :11% scr p icesbalcd on cosr.TIc olherscharycwhrl lhcy rhink cusloDcr re \!illnr!
() ryor$.h{ lhc nr liet detrrdds.
758 Appendix
A

nark up solne version of full. not variatrlc.costs.and the markup js basedon desircd
prolits ratlrerthan on factorsrelatedto denand. This approachis called the ubsor?tion
orting approachb cos!-plu.tt1rici1g.

T
I TheAbsorption
CostingApproach
to Cost-Plus
Pricing
T.€ARNING
OBJECTIVE
2 The .rbsorptioncostingapprcachlo cost pluspricing diffe|s from thc cconomists'approach
Computethesellingprice bothin whxt coslsarc markcdup tlndin how the nrafknpis delennincd.Undcrthe abso4r-
ofa product
usfgthe ti(ntatpfoachto cosl'plusp.icing,thecostbaseis the absoelioncoslingunil producrcost S
absorption
costing de6nedin Chaptcrs2. l. and4 rathefthanvariablecost.
approach,
Setting a Target Selling Price Using the Absorption
Costing Approach
To illuslriL(c.
ilssumethal lhe m.uagementol'ltittcf ConrpanywanN to setlhe sellingpfrce
on a produ0tlbath.rsjust undeEonesomcdcsignnrodilicirtionls. TheAccounlingDefarl-
rncnthasprovided costestin leslbf thercdcsigncd p(xluotrs shownbelow:

PerUnit Total
Directmaterials $6
Directa b o r, , , . , , , , . . $4
Variablemanufacturing overhead ................ $3
Fixed'ra rJ la c u ilg o v e rh e a. d. . . . . . . . . , . , . , , , , $70,000
Variableselling andadminislrative oxpenses ....... $2
FixedselingandadminislraUve
expenses......... $60,000

Thc 1ifflstcpin lhc rbs(rl])lion pficingis lo conrputc

coslingapp() ch lo cost-plLrs lhc
unil pRxluctcost.Fof liittcf Company,this.rntuulsro :120pof unitlt I voluntco1'10.000
unils,asconrlnrtcd
bclow:

Direclralerials $6
Direcllabor
Variable
manufaclur
ngoverhead 3
Fxedmanuiacturing : 10,000unils) . . . . . .
($70,000
overhead 7
Unt product
cost $20

Rillef Companyhasa gcncmlpolicy ol llr king up unit produclcostsby 507.. A p co

quotationsheetfof the companyprop,rrcdusiDgthe absofplionrppfoach is prcscntcdin
lxbibilA-2. NotethalscllingandadminisLrrlive expenses.ueno1iucluded in thccoslbrsc.
Instead,the mafkupis supposcdto coverficse expenses.

EXHIBIT A-2
Direcimalerials $6
PriceQuotation
Sheet-
D rectlabof
Bass (10,000
Absorptor Unts) Variablemanulacturingoverhead 3
Fixedmanufacturing overhead(basedon 10,000unils) . . . J
Unitproductcosi 20
lMarkup10coverse lingand administrative
expenses
anddesredproft*50% of unt manufacturing cosl ........ 10
Tarqetselinqprce.....
930
 Pricrng
Products
andServrces 759

Detennining the Ma;rkup Percentdge

Ritter Companys markuppercentngc of50% could bc a widely uscdrul€ ol rhunb in rlrc
industryofjust companytfaditior that seemsto work. The nl rkup percenrage may also
be thercsultolan cxplicilcomputaliolr.
As we havcdiscussed.thenarlup overcostshouldbc
largelydctermincdby markctconditions.Howevcr,tl)anycompaniesbasetheir markrp o|r
oostand desircdprofit.Thc reasoDing goeslikc ihis. Thc markupnrustbe largccnoughto
cover sclliDgand ndmiri$lmtiveexpensesand provjde an adequalcrcturn on investnent
(ROI).Civen thc lbrecastcdunit salcs,the markupcanbe conrpu@d as litlows:
(l.tcqrlircd
ltOI x Invcstncnl)I
Mrrk t pclccntgc ScllirrstmdrllrinislLrli!eerPlrrscs
oI rbsonlrl)ncosr ll il pr(xtLrel
cosrX lJnits tcs
To $howhow lhis fornrulais 0pPlicd,assumeRillcr Companyinleslstj 100,000in oper-
ating nssctssuchnscquipnrcnlto pr)duccandnurkct | 0,000unils of tlrc productcachyear
If Ritter Comprny rcquifesa 20% ROl, thcn the m rkup lbr lhe prodrct would bc deteF
nrinedrs lbllows:
Markupperccntge (20% x $ 100,000)+ (Xi2pcr unit x 10.00{)lnirs + $60.000)
on :IrsofplL' cosr g;20pcr unit X 10.000units
q?!!q.lL|.1l!0.(xxr
| _ ...,
\ , l l) . 0 r l

As show carlier.this Nrrkup o1 507. lcadslo a t.lrtcl sellingplice ol-$30lin Rillcr Conr-
O!11y. II th? , tl,tr luullr \?llt l),U)O u its ol thc prcductut this plicc, thc conrprny's
ROIon thisprodnctwill indccdbc 2l)%.Thisis vcriliccl in ExhilritA-3. I Iowcvcr.il it (ums
oul lhrl nn)rclhrn 10,(X)0uDitsafc soldal lhispricc,theROI will be grcllcrthnn20t?.11'
lcssth:u 10,{X)0 unirsarc sold.thc ROI will be lcssthrn 20%.Th! t"q id ROI vill Lr
tltt iI?ld yil ttulotu nkl nitsulc!volntlcis (ttuitt&|.

Dir e ct
m alerials ......... ..,.. E X HI B I T A -3
$6 lncome Siaternent
Direcllabor. . . . . . . . . . . 4 afdR0
Variable manulacturing overhead
............. 3 Analys/s-
{itter Company
Fix€dmanulacluring overhead + 10,000
($70,000 units)...... 7 ActLralUnitSales : 10,000
Units;
Seling Price : S30
pr
Un ii o duct
cost ................. $20

x1
S a l e s ( $ 3 0 p e ru n0
i l ,0 0 0 u n i ts ) ........ $300,000
costoi goods sold($20p"rrniti ro,ooo rnii"i.., . .... 200,000
Grossmargin 100,000
Sellingand administrativeexpensos
(S2per J1.t\ 10,000unils- $60.000) 80,000
Net operatingincome, , . $ 20,000

BOI
Notoperatingincome
ROI =
Average
operaUng
assets
$20,000 i
- $1oo,ooo I
I
= 2ov" I
 COST-BASED
ORMARKET-BASED
PRICES?
JerryBernsteli,
thedirector of Emerson EectricCo,'spricemprovement team,saysihatsetting
prcesusedto beeasyt "Youdeveloped a prodlct,looked atthecosts,andsard,, needto makeX
andyoumarked it upaccordingly-and peoplewoutd buyit."Nowthecompany charges based onwhat
customersarewllingto payrather thaniisowncosts,Forexampe, a newcornoait sensorlorfacto
res thatmeas!res theflowof fllidswould havebeenprcedat 52,650based or itscost.However.
carefuanaysisrevealed thatcustomers wo!d bewilrg to pay20%moreforthesensors thanthe
cornparyhadplanned to charge. Thecompany settedona priceoi 53,150.
Source:TimolhyAeppei,"SurvivalStrategies:
AiterCostCuttins.Companies
Iurn ]owad ftice Rrses. TheWa,j
StreetJoumal,
September 18,2002,pp.Al andAl2.

Problems with the Absorption Costing Apptoach

Thc rbsorplioncostingappft)lch makespricing (tecisiurstook deceptivetysirr)pte.All
conprnynccdslo do is conrputo ih unitlrcd ct cost,decidchow muchpfotitil wrnts.and
lhensetils pficc.It ppe.rBlhLtl comp ny crn ign(n.edcmrndAndrrr.ivear.Lpficc th.rtwill
sl|ltly yicld wh.ttevefprolitil wants.Howevcr.s notedabovc,thc.rbsorption coslinSap-
proachrclicson li)rccrslol unil srles.Ncilhcrltrc Drarkupnor lhc uDitp|oductcosl c.rDbc
corrlptlcdwirhouls ch tl forrcusl.
Thc rbso|pti(nlcostinSnppft)ach esscntirllyrssurnesrhalcusl(nncm/r.,.,z1rhc
li'ccastcd
urrilsrlcsllndwill paywhltcvcfpricethecomp ny decidcsro chlrgc.Ik)wcvcr:cuslonrc|\
h.rvctl choicc.Il thepdcc is t(\) high,lhcycanbuy l-foma corlpctil(n.or thcy nr.lychoosc
Doltohuy r all. SupDosc, t(n-cxrniDlc. lharwhcnRiltcf(1)D)plnysctsils pricclll 1];30. it
scllsonly 7.(){){)
Lrnils
r lhcf thrn thc 10.00(}
unilslirrcclslcd.As showniD tjxhitrilA-4. thc

EXHIBIT A- 4
IncorneStatement Dir€clmalerials
andR0 Dkect abor
Analysis-Rrtier
Cornpany Variabls
manulacturing
= 7,000 ovefiead
ActualUnt Sales Fixedmanufacluring
overhead(970,000
+ 7,000unils) 10
Units;
SellingP ce = S30
Unitproduclcosl $23

Sales($30perunitx 7,000units) $210,000

Cosl of goods 161,000
Grossmargin 49,000
Selingandadminisiratvg
expenses
($2perunitx 7,000units+ $60,000) 74,000
Netoperatingincome $ (25,000)

ROI
Netoperatingincome
Averagooperatingassels
-$25,O00
$100,000
 PrcingProducts
andSeruices 761

7
companywoulil thenhavea lossof $25,000on the productinsleadof a pront of lj20'000
Somemanagersbelievethat the absorplioncostingapproachto pricing is safe.This is an
illusion.The absorptioncoslingapproachis safeonly ifcustomerschooseto buy at leastas
manyunits asmanagers folecastedthey wouldbuy.

TargetCosting
Our discussionthusfar haspresumedthal a producthasalrcadybeendeveloped,hasbeen LEARNING 3
OBJECTIVE
costed,andis readyto be marketedas soonasa priceis sel.In manycases,the sequence ot Comput€ costtor
thetarget
eventsisjust the revene.That ls, the comPanyalready/ooltr whatpriceshouldbecharged' a newproduct
orservice.
and the ploblem is to d?relol,a produclthatcanbe markeledprofitablyat lhc dcsiredprice
Evenin this situation.wherethe norl1lalsequence ofeventsis reversed, costis still a crucial
factor. The companycan use an approachcalled la ryet costing T^rget cosaingi s the pr'ocess
of detemining the maximumailowablecostfor a newproductandthendevelopinga prolo'
iype thal can be profitablymadefof that maximumtarge!cost6gure.A numberof compa_
nieshaveusodlargetcosting,includingCompaq,Culp,CumminsEngine.DaihatsuMotors,
Daimlerchryslcr, Ford, Isuzu Motors, ITT Aulomotive,Komatsu,M tsushitaElectric,
MitsubishiKasei,NEC, Nippodenso, Nissan,Olynrpus,Shary,TexasInstruments, and
Toyota.
The targetcostfor a produciis computedby slarlingwilh theprcducfs aniicip ted self
ing price andthendeductingthe desiredprofi1,as l'ollows:
Targctcost : Anticipaicdsellingpricc - Desifedprrriit
The pfoductdevelopmenlloam is thengivenlhe rcspo0sibiiilyol'designiDgthe produclso
that il can be nradelbr no morethanthe targotcost

for UsingTargetCosting
Reaso'ns
The largetcostingapproachwasdevelopedin recognilionoltwo imporlantchauctedstics
of marketsand costs,The firsl is that many companieshavelossconlrol over p ce than
theywould like to think.The markel(i.e.,supplyanddemand)reallydetermines price'
and a companythal altemptsto ignote this doesso at ils peril. Tbercl'oro,
tho aDticipaled
marketprice is iakenas a givenin largetcosting The secondobservalionis lhal mosl of a
producl'scost is determinedin the dcsign stage.Once a producl has beendesignedand
ias gone into production,not much can be done 10significantlyredllceits cosl. Most of
the opportunities10reducecost come from designingthe producl so that h is simple !o
make,uscsinexpensiveparts,and is robustand reliable.If the oompanyhaslitlle conlrol
over marketprice and little corlrol over cost once the producthas goneinlo produclion,
rhen it l'ollowsthat lhe major opporllrnitjesfor nllbcling profit cone in the designstage
wherevaluablefeaturesthat customersarewilling to pay for canbe addedandwheremost
oI the costsare really deternined.So that is wherelhe effort is conccntrated-in design-
ing and developingthe product. The differencebetweentargel costing and other ap-
pr;aches to productdevelopmentis profound.Insleadof designingthe pfoducl and then
finding out how mltch it costs,the targetcost is sel llrst andthen the productis designed
so that the targetcost is attained.

? lt hay be lnposrtrl?10breakevcnusinganabsoryno!coslingapPrcactwhenthecompanvhasmorc
thanoneproduct-elen Nhenil wouldbe posible to makesubstannal nsingthe ccononistsap
prol'iLs
proach10pricing.Fordetails.seeEric NoreenandDavidBugslahief,'FullCostPricingaDdthellhsionof
Satisn.lnC:' Jawnal af ManagebentAcuunting Rerearch,9 (1991)
762

MANAGING
COSTS
IN THEPRODUCT
DESIGN
STAGE
TheBoerg Company ls bu dingthe airframe of its 787 Dreamnefjet usng carboniber renforced
pastic.Whiethstypeofplastchasbeenused n gof clubshaitsandtennisrackets,ihasneverbeen
usedto constructthe exteriorof an airplane,Boeings excitedaboutthrsinnovaUve rawmaterabe
causeit allowsenormous costsavings, Forexample, Boeing'sDreamlinershouldbe 20%mofefuel
eflicentthantheBoeng 767orArbusA330,itsmaintenance costsshoud be 30%lessthanallminum
panes,andthenumber offastenersneeded to assemble itsfuseageshouldbe80%lessthanconven
tofal airpanes,Inaddtion,aluminum a rplanes requirecostycoffoson inspeclons after6 yearsof
service, whiletheDreamliner canlly 12 years beforeit woudneeda comparable nspection. To
Boeing's de ght,theDreamlner's saeshave"takenoff"because "customers gettremendous banglor
theirblcks.ForS120milon-aboutwhattheypadforthecompafableBoengT6T300back nthe
1980s*airinesg€tanal-newaircraft thatfliesfasterthanthecompettion afd coslssubstantalyless
to ooerate,
Source:
Stanley
Honres,
"APastc Drcam
lvlaclrine,' June20,2005,pp 32 36.
Busi,ressweek,

An Extmple of Tmget Costing

'li] fr.ovide.L
sinrplccxflnplcol t.rgctcosting,.Lssurnc
lhc lbllowingsitu.r(i(: 1-landy
o)nr'
p.rnywishcsro in\,cstlj2,(X)0,000 to dcsign,dcvclot,rnd p()ducca ncw hrnd ffixcr.Thc
company's M.r (etingDcpr nrcnlsufvcycdlhc lcrtufcsirnclpriccsol conrpcling p(xlucls
.rncldctcrnincdth lr p|iccol lj30 wouldcnablcl-landyto scll rn cstinr.rlod 40.(X)0hrnd
nrixcrsfcfyclrSincclhccomprnydcsifcsrl5T.ROl,thcl!rgclcost lo nrrnuilc(ur0. scll.
disrrillutc,tlndscfvicconc|nixcfis :1j22.5{)
asco|npulcd Lrclow:

sales(40,000
Projected mixersx $30permixe0. . . . . . . . $1,200,000
Lessdesred proft(15%x $2,000,000) ............... 300,000
Targetcostlor40,000mixeTs. . . . . . . . . . . . . . . . . . . . . . . $ 900,000
Targetcosipermixer($900,000
+ 40,000mixers)....... $22.50

This 1i22.50largetcost would be bfokendown inlo larget0os1s1br the vafious lxnclions:

manulacluriDg, marketing.distfibulion,aftef-sales
service,.lndso o1r.Eachfunctiontl rfea
woukl bc fesponsibletbr keepingits .rctLr.rl
oostswithin trget.

Summary
fticin8 involvesadelicalebalarcingac!.Higherpricesresultin morerevctrucper unil bur driycdown
unit sales.Exactly wbe.eto set pricesto maximizetront is a dificult problenr,but. in general.the
marl p oacrcosrsbouldbe highesilbf thoseproductswherecustomenare leastsensiliveto p.ice.
Thc demandfor suchproductsis saidto befrice inelaslic.
Managcrsoftcn rely oD cost plus fbrmtrlasIo set targetprices.From the economists'pointof
vicw. fic costbascfor the markupsbouldbe vadablecost.In contrast.jn the absorptioncostlngap'
proachthc costbascis the absorytioncostinSunlt productcostand lhe markupis comtuledto cover
trothnonmanufacturing coslsaDdto providean adeqnateretur. on iDvestnent.Witb the absorytion
 PricingProductsand Servces 763

.rpproach,costs will not be coveredmd rcturn on invest,ncnl will nol be ad€qualeunlessthe unit sales
torccastusd in the cost plus formnlais accurate.Ifapplying the cost-plusfornula resultsin a price
th.t is too high,the unit salcsforecastwillnotbe altained.
SomccompaDies takea differentapplouchto pricing.Insljead ofstartirg with costsmd tho de,
l€rminingprices.they stan with pricesandthendeteflnineallowablecosts.Conpaniesthatusctdr'get
costingeslimal€\rhat a new product'smarketpriceis likely lo be ba^edon irs andcipnted fqturcs and
priccsofproducrsalrcadyon the mdkct. Theysubt.actdesiredprolit from th€eslimaledmarketprice
to rnive allhe producfstargetcosl.Thedesignanddcvclopnentreamh thengiventhc responsibility
ol'ersudngthat the aclualcostof the new prcducidoesnot exceedthc laryetcost.

Gtossary
|
Cost-pluspridng A pricinSmclhod nr whi€h a predelermined markupir appliedto a cosl basc1o
determincthe €rget sellingprice.(p. 754)
Msrkup Thc differencebetweenthe sellingpriceofr prodrctor serviceand its cost,The onrkup is
nsuallyexprerised aso percentageofco$l. (p.754)
Prtce clas.iclty ofd€nand A measureol thc degreero whicha changein pricc dfLcls the unir rales
of a producror seraice.(p. 754)
Ibrgct co6ling Th€ processol detemi'ringthe maximumallowablecostlbr a ncw producland then
devclopingr prototypcLhatcanbe prclitablymadefor that maximunrtargetcostfigu.e.(p. 761)

Questions
A-l Whdl is cost-pluspficirgl
A-2 What doesthe priceel0slicityofdemandmeasurc?
Whal is inchsticdemand?Whrl is elastic

A-3 Accordingto the cconomists'approachto settingprices,ftc profir-maximizing price$hould

depcndon what Lwotirctors?
A-4 Which prodLrc!shouldbavea lArycrnarkup over vAriablccost,r productwhosedcmrnd is
elasticol r prodlct whosedemandis iDelaslic?
A.5 When rhe absorptioncosringapproachto cost,pluspricing is us€d,what is the markupsup-
posedto covef?
4.6 WhAl NsomptiondocsLheabso$tion co$tingapproachm8keobouthow consumeNre cr lo

A-7 Di$uss the following slatemenlr"Fullcostcn bc viewednsa ltoor of protectioD.

If a com-
pany alwayss€tsils pricesabovefrll cost.it will neverhaveto worry aboutopc.atinSat a

A -8 Wh t is targetcosting?How do t rgetcostson10fh1o thepricing decision?

'-| Y
irv Exercises
I
EXERCISEA-l TheEconomht' Approachto Pricing[LOl]
Kimio Nakimrra owns an ice crqm standthat she opcratesduring rhc summermonrhsin Jackson
Hole,Wyoming.Her sh.e cate.sprimarilyto tourkts passingrhrcnghlown on rhoirway toYellow-

Kinio i$ unsureof how sheshouldprice her ice creamcoDesrnd has expelimentedwith two
pricesin successive weeksduring the busyAugustseason.The numberof peoplewho enteredthe
slore was roughly fte sameeach week. Doring tfi€ first week, sh€ priced the con€sat $1.79 and 860
coneswere sold.During ftc secondweek.shepricedthe conesat $1.39and 1,340conesweresold.
The v iablecost of a concis $0.41and consistssolelyof thc coslsol the ice creirmand of the cone
itseli The ir(ed expenseiol the ice creamstandare$425per week.

L Did Kimio makemoremon€ysellingtheconesforSl.79 orfor$l-39?

2. f,nmatf rhcpriceelasticityoidemAndfo' the i.e c'em cones.
3. Estimatethe prolit-maximizingpricc lbr ice creamconcs.
 EXERCISE A-2 AbsontionCostingApproachto Settnga SellingPrice[LO2]
Naylor Companyis coDsidering the introductionof a new product.Managemenlhas galheredthe
followins information:

N u m beroluni l stobe produced andsol deachyear......... 12,5 00

Unilproducicosi . . . . . . . . . $30
P ro joctsd
annual ssl l i ns
andadmi ni stral ve €xpenses....... $60,0 00
E s ti mated
i nvesl menl
f€qui rsd byl hs company............ $500,000
Dest€d relurnon nvoslment(ROl). . . . . . . . . 18%

The companyusesthe absorytioncostingapproachto cost'pluspricing.

l. Computethe markupreqdrcd to achicvcthc desiredROi.

2. Complrtethe targetsellingpricepcr unit.

EXERCISE A"3TarsetCostins[LO3]
EasternAutoSnptly,Inc.,producesanddistributes aulosupplies.The companyis anxious|o enterthc
rapidlySfowingmarketlor longlile batteriestha{is basedon tithium tcohnology.Managcmcnlbc-
lievesthat to be lirlly compeiitive,the priceol lhe new barcry lhalthe companyis dcvclopingcrnnol
exceed$65.At this p ce, maDagement h conndert tha! the conpuny cun sell 50,000batteriespor
year The batterieswould requircan investtrrent oI $2,500,000, and the desiredROI is 20%.

Conrpulethe targetcostofone bdltery.

Problems
PROBLEM A-4 StandardCo$triAb$orptlon CGtinSApproachto SotlingPrico6[102]
Euclkl Fashions,hc., is introducingI sportsjackel.A standardcost cardhAsbeenpreparcdfbr the
nsw jackcr as $hownbelow:

Dlrcct
nato als,.,,, 2.0yads $4.60p6fyard $ 9.20
Dlr€ct|abor
...,..,,.,,,. $10.00psrhour 14.00
l\4anufaclulng
ovorhead (%variable)
....... $12.00psrhour 16.80
Totalslandard
coslpgrjackel,,,.,,,,,,,,. $40.00

The lollowing addilionalintbrmationrelaiingtothe newiackel is Availahle:

a. Thc oDlyvdrirblescllinganddninistmtive costwill be $4 perjacketfor shipping.Fixedselling
and adminishativc coslswill bc (pcr ycar):

Sa|a es . . . . . . . . . . . . . . . . . . S 90,000
Adverlsingand olher . . . . . . . 384,000
To| a .................... $474,000

Sincethecompanymanufaciures manyproducls.no morelhan21.000direcllabor'hoursper year

can be devotedto production of the new j ackets.
An investment of$900,000will be necessary to carryinvenlodesand accounlsreceivableand 1o
purchasesomenew equipment. The conpany'srcquiredrateofrclurn is 24E.
ManulhcturingoverheadcostsareaUocated to Foducts on the basisof direcl labor-hours.
 Pricng Products
andServces 765

L As$rmcthat thc companyusesthe ahsorctionapplouchto cosr-pl'spricing.

d. Computethc markuprhatthe conrpanyneedson lhejacketslo achievea 24% ROI if iLsclls
nll oi lhejrckets il crn produceu$ing21,000hoursof lahof linrc.
,. Usingdic nrarlup you hale cor)r ned.preparcr pricequolcslreetfor x sinllejacker.
c Assumcthartheconrpanyh nblc ro sellaUofthcjacketslhrl il cin prcducc.P'eparcrn in
conrestluemenrlbr rhellrst yearofactivit), andcomputerhcconrpanys ROI for ftc ycrr on
the irckcls.usingthc ROI fbnnu|r lrom Chaplcr12.
2. Alier mrrkcling thc jrckcts lbr scvcrrl yeaN.lho conrl,aDyis cxpcricncingr Julbfl tu derr nd
duer o. n c c oDomircc c c s s i o r.A l i l l rD rkcI b l k pnrchaseol j l ckcl si fi ts
l d tc rc rri l o u rl cw l l bel
is sewr ir rnd if.n.cccpl.bl€ pricocrD bc workcdoul- Wh.r is lhc minirnunracccp(able pricc

PROBLEM A-5 TheEconomists' Approachto Pricing[LOl]

'Ihc poslalscrlicc ofSr. l,uci!. an jslard i'r thc wcn IDdics.oblrins r rignificrnl
trrlion ol irs rc!c'
nncsfom salesof sp.cial soulcnir shech t(l nanrf collcckrs. Thc n)uvetri'sltccts!su.lly conlri'l
scvcfulhigh-valucSt. I-uci.rsl|mps depicting.r.on'mnt rl'eme,$reh rs the atrnivcrsrryof Prjnccss
D i l n s f unc m l.lho s o u v e ri sr h c e ts
a rcd c s i g re dx n dp r i nl crll br thcpo(dl seN i ccLryl nrl cri rl P ri nl '
i rg . r s l r np gc nc ys e rl i c ce o n rp rn )i n l h o U n i L e dKi ngdonr. Thc soul eri rshccl scosithc poshl
scf!icc lii0.60!'reh.(The.urrun0)in St. Lu.ir is rhehsl CfibbcrD dollxD 51.Lreir hrs bccnscllin8
rhcscsoulcrir shccrsfn 55.00cxch rnd o inarily s.lls 5().{XX) uDirs.Ib te( the n[rkct. thc poslrl
sclvicerecenll] pricedx ncw R)uvetrirshcc(rt $6.00rnd sdlesdn,ppodkr 40.(XX) unils.

L Doeslhc pon|l serviccol Sl. l-ucir n kc nxE mnrcy scllirr8vuvcnir shcclsli't liis.(X)crchol
li6. { X ) c ac hl
2. Estin[tc lhc priceclisticily ol d.n d lbt the snrvenr shccts.
3 B ( inr at clhc pr ol i l -n rrx i n ri z i n pgri c cj i )r s o u v c n i$t hccl s.
4. l l lnr pc r ir lP r inti n Si D c rl l s c sl h c t u o i l c h rrg csl () l hu S t. l ,l rci r posl rll cfvi cc l i r soul cni r
shccrsl() $l).70enofi,how rirlch sln kl rhc S1.Lucir po\I{llscrvieeeh|rgc irs.us(rncrs lil lbc
souvc'rirslccrs?

PRoBLEM 4.6 ThoEconomhts'Approaohto Pricing;AblorptioncostlngApproachto cost-Plus

Pricing[LOl, Lo2]
Soliway,lDc.,wnss!.ulcdby two youD8itlwlrc eD8iDccrs k, Drrkcl Adlllockcr r soliwarcapplica-
(ion they hrd wriltcn thrt blockstt(|swhcn$rling thc Inlcnrcl.Salcsol lhc s)ftwrrc h{vc bccngqxl
at 20,(XX)unitsr nronth,hLrtlhc companyh6 bccnlosingnrcncyrs shownbck^r:
trtr
Sales(20,000 unilsx $18.95 perunil)
.. . ..... .. $379,000
Vanablecost(20,000 . $5 90perLaJ . . . . 118,000
-nrls
conrributlon
margin.... 261,000
Fixed6xpens€s 264,000
Nelope'alingincome(loss) $ (3,000)

Thc cornproys only lnriabtc cost is lhc 55-90ltr il payslo urotficr comparyIo reproducclhe
soiiwarcon CDs. print nraDu.ls.and packagcthe rcsuk in nn atrrircrilebox lbr sale to consumcrs.
Monthly fixcd selling,rnd:d minisrari!ecxpetrsesare11j26,1.000.
]'he conprDy'snrarkclingmanagefhrsbeenarguinglbrsonrctimc lhattheKtlwlrl'eis priccdtoo
hi8h. Sheenilnatcsfial evcry 107.decrcrscin pricewjU yield a 207 increasein unil sales.Thc InrF
kcringmanagc.wouldlikc yourhelp ir prrparingaprcscolarion ro rlrcco'npanys owtreBconccnrinB

L To help rhe narkeling managerprcp re for hcr prerentation.she has askcdyou 1o llll in the
blanks in Ihe following lable. Thc \elling priccs in the t.ble were compuledby succcssively
decreasingthe sellnrgpriceby l0'l.. The esrimrtednnit salcswereconprlcd by successivcly
increasingthe unil salcrby 20"/..tr(trexanrple.S17.06is l0% lcssftan $ 18.95and 2,1,000
unirs
are207.,nrorethan20,000uDits
 $18,95 20,000 $379,000 $118,000 S264,000 $(3,000)
$17,06 24,000 $409,440 $141,600 $264,000 $ 3,840
$15.3528,800????
$13.8234,560????
612.44 41,472 ? ? ? ?
$11.2049,766??1?
$10.08 59,719 ? ? 't ?
$9.07 71,663 ? ? '? ?
$8,16 85,996 ? ? '1 2
$7,34 103,195 ? ? ? ?

2. Usingthedalafromthehblc,conslruct jrcomeasa funcrion

a graphtlut showsthenetoperating
of rherellingpdce.Pul resellnrg
priceondreX-uxjsandrhenetopemlinB incomeon thel-axis.
UsinSthe 8raph,estimatethe upproximale sellingpricea! whjch net operatingincomeis

3. Conputotfiepriceelasticily ofdemrndfor theAdBlockersoflware. Basedon thiscalculation,

whatis theprofit-maximizing price?
4. Theowners haveinvested $120,000 in theco'npany aDdfeellhatlheyshouldbeearningat least
2% pcr montl on thesefunds.lf tlrcabsorplion coslirrgflpprooch 1opricingwereused,what
wouldbc dretargetsellinSpricebased on thecurrenlsal€sof20.000unirs!Whatdo youthink
wouldhapp€n to thenctopemtirgincomeof th€company ifthjs pricewcrecharged?
5. If lheowne$of lheconpanyarcdi$srtisfied wi(hthenetoperdtingjncomeandrerumon investment
{t lhea€llingpricoyor co'nputedir (3) 0bove,shouldrheyincre.nse6e sellingprice?Explain.

PnOA|..Eli|A-7Ml..ln8 Drtri lrark|lp CompotrdonriRsErnon Inyostn€nqPdclngILO2I

RestEasy,Inc., hasdes'gocd d ncwpuncture-pr(}ot,
self-innatinS
sl€lpingpad thatis unlikeanyrhing
onthemarkel.Because of th€uniqucpropenies of thenewsl€epingpad.fie companyrticipates rhar
it will b€ ableto sell0ll rh€padsthatit c.n produc€.On thisbasis,thefollowingbudsered income
statement for thelirstyerrofacrivilyis nvdlablcl

56le3(--?- pad8at p€rpad)....... ........... $?

-L
Co.l ol goo& sold(_l_ pa& ar __l_ per ped) . . . . . . . 4,000,000
Gro8ama€|n,.......... ?
Selllng
andadmlnlstlaflve
exp€m$... . . ..... . ..... . .. 2,180,000
NgtoporallngIncomo $?

AdditionAlinformalionon lhe new sleepingpd is givenbelowl

a. Thecompanywillhheenough workcrstocommit 100,000directlabor-hoursto themanufacrure

b. A pAdiallycompletedstandardcost
cardior the new sleepingpadfollows:

Dlrcctmat€rlals S yafds $6 p€ryard $30

Dlr€ct|abor,,,,,,.,,,,,,.,,, 2 hours $? p6rho!r ?
l,lanulacturlngoveh6ad,,,,,,, ? hours $? p6rhour 2
Totalsiandafdcosl p€r
$?

c. An investmentof$3,500,000wiu be necessary
to carryinventoriesand accounlsreceivableand
to purchasesomenew equipmen!,Managementhas decidedthal the designof ihe new pad is
uniqueenoughthatlhe componyshouldseta sellingpricethal wili yield a 24% reium on invesf
menl (ROI).
 Products
Pricing andServices

d. Othcr informltion relalinSto productioD

andcostsfollows:

Varlable ovsfieadcost(pefpad). . .
manufaclurlng $7
vanaoE (pe,p"d).- -....... - -..... -
selingexpens6
Fixedmanulacludng
ovorheadcosl(otal). .. . . . . .. . . . $1,750,000
Fixedsell-gandadTinistrarivg
expensg (tola). . . . .. . . $?
Numbe. ofpadsproducsdsndso.d(pery6a1... . . . ..

e. Manulacturingoverhcrdcostsrrc rllocatedto productionoDthe basisoldirect laborhours.

l. Complelethc (andard costcardfbr a singlcpad-

2. As$me that llrc compnnyusesdrc $sorplion approrchto cosi-pluspricing.
a. Compurcrhemarlup thrtlhecompanyneedson lhe padslo rchievca 247orcturrron invcsl-
menr(ROD.
t Usingth€ nrarkupyou haveconpt|led,preparea priccquohron sheetfbr singlep d.
c. Assune, s stared,that the comp ny can scll all thc padsrhatil can prcduce.Cornple(ethc
incomeslatclnenlfor the firsl ycru ofnclivity. and lhcn cornpulcthe conrpany'rROI lor the

3. Assumclhatdircctloboris vrrisblccost.How nany unitswouklthecompAmy haveto reil thc

pricc you conrputedin (2) abovelo achievcthc 24% ROI? How m.rn) urjt$ would luve 10be
prodL'ccdaDdsold tojusr brexkevcn1,

PROBLEM A-8 TargotCostingILO3I

ChoiceCulinarySuDply,Irlc-.slls rcstaura'ir equipmenla d supplicslhroughoulmoslol rle Unilcd
Slates.Managemcntis considcringaddinga gclato rachincto ils linc oficc crcnmft ing machinos.
Mdnagcmcntwill nogotiLrlo lhc priccol lhe geldo mAchinowi(h it$ ltllim mrnulirct rcr.
Mrnrgemcnl ol ChoiccCulinlry SLrpplyb0licvesthc s0hto nachinescun be $old10ih curtom-
srs in rlrc Uniod Stntestor $3.795onch.Al (hr( pricc,rnnrualsalcsol the gcl o Innchnreshouldb(
80 units.If the gcllto m chineis addedto ChoiccCulin ry Supplys pfoducrlines.thc conrpanywill
trE
hrvc {o invest$50.000in irvenlorici u d spccialworehou$e lixlurcs.Thc lLuiablecostol Ncllingthc
gclatoN.rchincswould be $350perNrchine.

L II Choicc Culinafy Supply rcqulreso 207' returnon investmcnt(ROI), whul is lhc nrllximurrr
anrcuntdrccompanywould bc willinS lo p ylhell li n manLrliclurcr lbr lhc gel lo Drachnrcs?
2. Manag€mcnrwould like lo know how rhe purchasepriceoflhc nr chineswotrldafcct Choicc
CulinarySupplys ROl. C(nNirueta gtaphlhat showsChoiccCnlinarySuppl}'sROI as! tu c'
lior of thc putciasc pricc of lhe SclalorrrclriDc.Pul (hc purchnscpricc on LheX-axis and llrc
rcsultinsROI oD the v-axis.Plot rlE ROI tbr purchrscpricesbclween$2,400nrd 1i3.400pcr

3- Allcr muy hoursoi'icgotiudons, n lllgcmcnlhAsconcl ded thlL LhcLtrli n m nutllctlrfcfis

unwilling ro sell thegelatomachincrr a low cnoughpriccfor ChoiceCulin ry Supplylo earnils
20% rcquiredROL Apart from simply givins up on thc ider ol Mding rhc g€laromachincro
ChoiccCulinarySupply'sproducllines.wh t couldmsnagemcnt do?
Profitability
Analysis
Lritfl) | lrg LJn,ccU \ (s
Aficr sludyir(thisaDpenrlix,
yor shouldheal'lc to:
llreprofiiabty indox
LOI Corrrpule andrse t toscectfronarirong
Dossilre

lheprolitabilty
LO2 CofpuiedrrdLr:rc ifdex| \roLrnelrade.offdec
sons.
andrsc thcproliLab
LO3 Corrrputc ty rdexInothcrb|siness
decsio|s.
770 AppendixI

Introduction
erhaps more than any other information, managerswoutd like 10
know theprofitabilityof their products,cusloners.and othef busincssscgnenrs.
They want this information so thal they know what segmenrs10 drop and add
and which to enphasize.This appcodixprovklesa cohefentfi amcworkibr mea-
suring prolitability,
bringingtogclhcrrelev.rnlnaterialsffom severalchaple$.AIter
sludyingthis appendixyou shouldhavca Iirn graspof the principlesurrdcrlyingproliC
ability analysis.The first stepis 1(:)
dislinguishbel\teetlab\oLLteFoftabilh! ,\n(lreldtir(

TRIMMING
THEPRODUCT
LINE
A largepharTnaceutcalcornpany
eimnated20%of itsproducts,
despteprotestsfiomthemarkeifg
depadment.Ths resulted insaes,bLIa 60%increase I netprofts.Why?
ina 5%reduction Theprod.
uctsthatweredroppedwereabsollte,!nproftab
e. Thecompany wasbetterofi s rnpydropping
them.
Sourcel
T m Akn, 'AfeYourProducts
Profitable?' Fi,ance,Matan2A02 pp.33-37.
Strategic

I nUsoluteProfitability
,\bso|utcDrofitahilityis conccrned wiLhthoinrp ct on thcorg niz !ion'sovefallpfoli!s
ol addingof clroppingfl farlicul r segrreDtsu0h s a productor cuslornef wilhout
makinganyotherchangcs. Fof cxrmple,if Coc.r'(l)hwcfc consideriDg closiDgclowni!s
operalionsin lhe Aliicrn counLryol'ZiInbrbwe.managc$would be inreresled ir the
absoluleprolitabilityol thoscopcrntions. Measuringthc absolulopfLrlil.rbiliry of .tn ex-
istingsegmentis conccplurllyslr ighlio|\vllrd coDtpluclhc reveDues thrr would be
lost ifom droppingthc scgnienlto thecoslsfiat wouldbc rvLridcd. Whenconside|ing a
new potentilrlsegnrcnl.comparethe dditionalrevcnucs liom addiDSthe segmeu! to lhc
additionalcosts!hrr wouldbc incufred.In eachcasc.includeLrnlythe rddirionolcosts
thatwouldactuallybc avoidedor incurred. All othcrcostsitfe iffelcvaDrnd shouldbc
rgDofed.
Ir practice,
figufingout whiLcostswonlclchangeandwhalcostswouldnot chrogeif
a segmentwere droppcd(or added)can be very difficul1.Aclivily-basedcosringcan help
in identifyingsuchcosts,burall costsshouldbe carclullyanalyzed 1()derermine whether
they would rcally change.For ex.rmple,an aclivily bised {-osringstudy of Coca Cola's
Zilllbabweoperalionsmigbt inoludechargesfor stai'isupportprolided ro the Zimbabwe
operationsby Coca Cola's corporateheadquarters in Atlanla.However,ifeliminaring the
Zimbabweoperationswould bave no inpact on actualcoslsir Arlanta, then rhesecosrs
are not relevantand shouldbe excludedwhen measuringthe absoluteprofitability of the
Zimbabweoperations.
For examplesol the measurcment of absolulcproli|abiliry see'Appendix 8A: ABC
ActionA nalysis."thc sections"DecentmlizationandSegnerl Reporring"in Chaptert2 and
'Adding and DroppingProductLinesandOtherScgncnls"in Chapter13.
I

77r

KRAFTBULKSUP ANDTHENSLIMSDOWN
f2000 Kr:ftf!!as rc acquredNabrscoforSl9bhon.Thisacqustroncoupledwithnirr€oth€rs
pushedKraftsafnualsales above S32bi lon.lrdeed,
Kralthad assembed an rrpressve portfolio
ol
brandsncludng0reocooki-"s,oscarlMayer meats,Postcereas, I!4axwell
House Coilees, ard DCrorno
pizzas,
10narne a few.However, Kraft's
CEo.Roger K. Deromed, hasdecided ihatt s tme 1os im
thecompany downa bit.In2004,Kraftsod ts LifeSalersandAltords brandsto l'im !'!rg.ylr Co
forSI.5b ior in cash.Deronred soldtheselaggardbrardsto enable Kraftto "concentrate onthe
brafdsthatcar belopsin theircategores
bLockbuster worldw de."PresLrnably,Kraftconsdered Life
SavcrsandAtoidsto be relahleyunproilablecompared 10theotherbrandswihif theor8arizatron
thatwerecofirpctfgior scarcenvestrnenl
iunds.
Souc0:
NrlichaelAr
! "Why
Kraltls or a CrdslDrel,Euerr5slveek 29,2004,p.46
Noverrllnx

RelativeProfitability
I
Ii !cn whLn c \ c r ! s c g l l rrn ti s d l )k ,l u trl \ p | l ,l i trh l c.Il rrrl crs r' l r.n \!l | l rt l o In(ni $ti rh \.g-
| |r{l lls r r c nx ) s l r n( l l c L rsll)fo l i | .l b l c .l trl :rl i rc p ro l i l nhi l i t} i s co| l rcfl l ci l$ i l h l ki rrr Ir)(l
Computethcprohtabty
u cl s .er s lo|lr c f s .l|l(l (n h f| h u s i | l c s s rg rrrc n l st(r(l cl cfl l l i r)cw hl el r shoul (lbc cfrphnsi ?r(1.
ndexandusoil to selcct
wlr ! r r ( r ) ) I r r S c r\ i r)rc fc s tc (l i r)rl | rk i n g s c !rrfnl sordrl ofl ni l l i nsth(rfLrti !oIn)l i l l hi l
rl \ o l \ . ! nr c nr \ I I h r rn s $ c r l o rh i s(l c ..p rl \c l ) r n rpl . qu.sl i (nrp| 1\ i d.\ l hr kc) l o Ire| \rLl
actr0ns.
i rrr r c lnr iv c l) r 1' lirrh i l i r),.l Ic o r)l ),fc l !)| l l o frn f , scg| l rcLrliss i l so]l rcl hl rrrl orcfs )ou to
rrxk ( lr r ( le olis r Ln x )n sl l rc rn .1 l l n r(l co l l s l rc r(n fcccssrrt. l hf sol ul r)I i s si nrtl f l \cctl
r!rf! s c gnr ur lllr r r i s rh s (n u l c l ,"p fo l l rl )l f. \v h rl \ roul (l i i mc r Iunl l o l o rrrk! 11r(hol i s
rl l l o lr s lr f t , iilr hlr s c g n rc | l l sI I h c rc i s t' rrl ) o r' . r"' \w cf- .t .t,11\Itrul tt. In l hc rb\rIcr ol rl
e o n s I r inl. r lls egr rrc n tsth L rlrfc rh s o l u l rl ] p fo l i l l b l ( shoul (l hr t)ursuc(1. ()rl th! ol h(r l rl r(1,
i l x cons l i|lt i\ pf c s c l rl .l h c L rb t (l c l i Ii l i o I th c ro | l rtl rrr cuIIol ILIsrLor!uy pfr)l i l i rhl cot)
t(n l ullil\ , . ( hoic f s h r\c l (, h c m l d r. l h u s .r)c rs u ri rU fohl i \(| ]r)i i l rhi l i l \' l 1l rl c\scri sc(nrl y
$ h L ' r x c ons r r iL|ncrri s l s l h rl l i )rc c srrr(l c { )l i s .' l hi \ pol nl cl | | rrr{rr bc o!(rrIrIhi N i /e(l i c(trr
srri r ls r f c lor x linrc Iru l l (' L rn d c A | .l | | (l i LLrg rn (lI)r: rsuri rgfcIrl i vc t)rl ni l rhi l i l y.
I l( t r ' s hor L( lf cl tl l i v rp r,l i l tl b i l i l y h rn rc rs u rc ( l l l )i vi (l ccrchsog| l ro| l sl rc.rrufcol i rb\o
Irl e t ) r , lilr bjlir ! . \ r h i c h i s l h c i n c r.rl rc n l l l p r)l i l l rr)rnl Il l s.!Ircri l . h\ l hc rurul rl ()l l hc
e o | l\ r r x inr r uqt |lf ' r d h y th .s rg n rc n tl i ' rc \l l | fp l ..tr.1.r n) thc (hrtLb!l {^\ l i r r$1)ol rhe n)xn)'
\.s,r e, " s wI n||r r c o o ' p i l ])r:

SegmeniA SegmentB
proft
Incremental $100,000 $200,000
AmountolconsIanedresource
requred 100hours 400hours

Scg r i) c ntB I r : L) s c c m Ix )rr rl l rrc l i rc l h rn Sc g ' rrculA hcc.urse i l s i ncftIrcrrl rl p11)l iLs
l t$,i cc
tl s Lr f gc .bul il r c r t u i fc sl i )u f L i m c srs n ru c ho l l h c eonsl rui nc(l rcso' rfcc.l r i rct. S ognrr' l rtts
w ('l |l( l nol bc lhc he s l u s c o l th e c o | l \l fL ri n c d rc v ) urrc bccrLrsci l gc| cfrl cs orrl y :l ' 50001 i n'
crclr c Dlr lpf olil I ) L rh o u r { :l l { ){ ).0 0 { ) .1 { )0 h o u rs).$hci :rsS cgrnc| 1,\l crcrxl e\S 1.000o1
l ( ' lir p e rh (n rf($ 1 0 0 .{ X Xl: 1 0 0 h l )u r\).A nothcr $r} to l (x)k xr thi s i s ro sup-
i n .r c nr c nt . r pf
fo sc t h. r t , l00hoLr fs o 1 th c c o n n l .ti n c (lrc s o u rc cn l c l \ni l .rhl c.W (nrl dyou fi rl l rcfuserhc l xmfs
o n iiJ Ufs egnr c nlsli k e S c g n rc n A. l g c n c ftrti n gr 1 r)1rli ncrL' rD cl l l ltrol l i r (n :1j ,100.{)00.
of on
o n c s c enr eDllilc S e g n rc n tl l . $ h i c h g !n c ra tc sS1 00.000i Drucrc| rcD l rlp| ,(ni l l
In generill. lhc relLrli\c pft)litLrbililyol suglll!''rt\ \houltl l)e Irc,rsufed by rhc prolit.rhilitt
i n d c x . r sdc lir c d be l o w :
l r(tu ' m fn l rL!| roh1 l rL,i ' rl h. \' !r' r.i ' l
\rrL j !:rI L ,lL l rri rr\1 rrr r.rrr' errL,., rrL.ri t.Ll l ,t i h: r' , rr, rL
772 Appendix
B

The profitabilityindcxis computcdbelowfbf the two scgmcntsin the example:

Segment
A Segment
B
i
Incremenlal prolil(a) $100,000 $2oo,0ooi
Amounlof conslrained rcsource required (b). . . . . . . 10Ohours 400hours i
index(a) ; (b) . . . . . . . . . . . . . . . . . . . . . $1.000perhour $500perhour i
Profilability

Wc havc {llidy eoco!rrlcrcd$vcrrl cxnmplesof the profitability indcx in prcvious

chaptcrs.For cxirnrplc.anChaprcrl4 lhc projcclprofitabilityindexwasdclincdas:
Nerpre\ent\ rlue nl rhcJ'rujuct
indcx:
Proicctprolilabiliry
AD untof invest enlrcquircdby lhe pr(rieol
Thc proieclp(tit.rbilityindcxis uscrlwhena comp Dyhasmorclong'lcnnpI\)iocls wilh
posilivo nelpreseul \rrlucsrh n it cnnlirDd.In lhisc se,theiDcrcmcnlal prclil lionrthcscg-
mcn(is lhc ncl prcscnrv luc ol lhc prLriccr. ADdsincethe iDvcsrnrcnt llnds rrc lhc co|-
stririnl,lhc irnrolrntol-lhcconslrrincd rosource req iredby thc scgnrcnl is lhc iun)unlol'
inlcslnrcnt rcq{ircdby lhc p{)iccl.
As ancx nrplcol rhc0sso1thcprolilrbili(yindex,considcr thccLtso
ol QualilyKitchcn
Dcsign.a snrrllconrDny spscirliringiD desi8ning kiichcnslir upsc lc hontcs.M n gc
rucnlisconsiclcdng lhc i0shorl-Lo n prr)iccislistedin P.rncl
A o{ ExhibitB l.'lhc incfcll]c0tdl
prolitlionrcr|chpflricc(is lislc(lin lhc sccondcolumn.Forcx.rnrpl0. lhc incrcnrcnlol p(tit
lionr Pftiect A is l[9.180.This incrcnlcntLrl pl1)hlconsislsol thc rcvcnucslionr lhc pl1)jcct
lcssany coslsrh:rtwoll(l bc incu cd by thc conrpany rs a conscqucnce ol rcccptingthc
prcjecl.'[hecompirny s conslririnr is thc lcnddcsignclslimc. Pft)icctn would rcquifc
l7 hoLrsol lhc lcrd dcsigncaslin1c.ll rllol thc prliccls wcrc irccoptcd,theywould rcqIi|r
a Ohlol l(J(Jholrs.UDlinlrnflrcly.only 46 houff urc availnblc.Conscqucntly, ntnnitgcr|rcllt
will hrvc |() lo dowr s(nrrcp|r'iccrs.Thc pft)fihbility indcxwill bc Lrscdin dccidirt which
prqccls |() rcccpl ft which k' lulr] down.'l'heDiolihbiliry iodcx lin a proicctis corn|nrlcd
by dividing ilA incrcrrrc||(nlpn)lil by tho rnr(rnr ol rhc lcaddcsigncr'stinlc rcquircdlar thc
prqcct- In lhc c.rscol l'nrjccrA. lhc pr'olihbilityindcxis $5-10pcr houf.
Thepll).icclsa,c rrnkcdirroftlcrol lhcprtilabilityindcxin PaDelts ol BxhibilB I.Thc
Lrslcolurnr in lhal paflclshowsthc cunrullllivcirfi()urt ol-thcconslrrinedrcsoufcc(i.c., lcid
desiSDef's linrc)rcquirc(l lo do lhoproiccls al th l poiDlin the lisl lrDdhighcrForcx!nrdc,
lhe7 ho rs lislcd1olhcrighlol l)roiccl.l iI thccunularivo columnrcpreseDls thcsunrol lhc
4 honfsrcqnircdlin ProicclF plus lhc .l hour\ rcquircdlbr PfoieclJ.
To lindthebcstconrbinalion ol pr\)joclsu'ithinthclinils ol lhcconslraiDed rcsourtc, go
downthelisl in l'anclll 10lh0poinlwhofcull ol thc v ilablccL'Dstrrined resoufcc is uscd.
IDlhisc se,siDcc46 houNol loaddcsigncf tinrcrrc avililable,lhatwouklbe thcpoint0hovc
lhesolicllinedrawninPanol llol llxhibitU l. Proiccts Ir,J, B, l, D, md A lie abovcrh r linc
andwouldfequifca tol.llol cx clly 46 houfsol lcrd dosigner 1ime.lhe optirn0lplrn con-
sislsol acceptin! thcscsixpr(loctsandtumingdownthcotbers. ThetotalincrcmcntAl pfolit
liom accepting thescprojcclswouldbo 1;:12.910 rs shownin PanelC of ExhibitB-l- No
otherleasibleconrbinati( ol pfoicclswouldyicld highcrtotal increDrentt|l prclit.l
We shorldrcinfbrccr vcr) irDpo(anrpoi|t thatmay bc lbryotlenir the midstol thcscdc-
tails.The pfofitnbilityin(lcxis biNodor i,r.,"r,ertrl prolit.Whencomp ting the incrcnrcntl

rl n rh i s c x l n p l c .rhcr()ptni edl scxdl ydoN unN d.l l ol tl E rri l $l econ\tni ncdrc$t r r lc. Thr t wonr
alwayshlpDo. Iir cxor c. r$$nnctld only15 hoursoi lcld dcsigne. tine re ,tailablc This$nrll chrngc
complidtcsnrdrcBcusiddi't,ly.Becau*-ol th. - lumpiD.$ ol tlE prcjecrs. Lheoprnnrlphn isn r Dcclssr.-
ily rodopnrjecls F-,l.ll. l. lid D-srr)ppirSrr P()i.c(D on th.list.nd a cunulailc rquitunrenrot'29hotrN.
' Ih a t$ o u l d l e rl e 16hou^or' nu$dl cnddei i gndri mc.Thcbcsruseofl l i stnneD r yhePr ( ) jccr ( ', {hich
h.s anincre'nentrl pnnil oJ$?,0,1{r.Howe!er,olherpossibililics cxistroo.Firdingandelrlurrin! !ll ol rhc
Dostlikel]posibiliLies cur rakc! l(nol ritr)eiDd ingeluiry.Whcn rhccorsrrained re!)urcejs norcofitcrcly
cxhausred by Llt roppn)jeclsor lhc lisl,son)eriilci.s wirl rhesolutionnra] benecessary. lbr rhisrusni.
thclisrBenerared bjrtunkingbrscdon lhcpdiubiliry iidex shouldbevicwcd asa sraningpoinrfuller 1l nrs
!dctitritilc solulionw|e.lhetrriecls dr "lunuy dd rde bischunksofrhccoDstraired rc*ntrce.
 I
-;

Proitabllity
Analysis 773

EXHIBIT B_I
PanelA: Computationof the ProfitabilityIndex Rankrng
Segments Basedon
Constrained theProfitabilty
Index
lncrementalProlit Rosource
Required Profitabiliy
Index
(A) (B) (A)+ (B)
$9,180 17hours $540perhour
Pro,eclB.... $7.2OO t hours $80Operhour
$7,040 16hours $440perhour
ProjectD...- $5,680 8 hours $710perhour
ProjectE.... $5,330 13hours $410perhour
ProjeclF.... $4,280 perhour
$1,070
ProjectG.... $4,160 13hours per
$320 hour
ProjectH.... $3,720 12hours $310perhour
Po e c r l . . . . $3,650 5 hours $730perhour
ProjeclJ.... $2,940 3 hours $990perhour
100hours

Pan€lB: RanklngBasedon th€ ProtitabilltyIndex

Amountof the Cumuatve Amount
Constrained ol thoConsirained
Profitab
lityIndex Resource Required ResourceUsed
ProjectF - perhour
$1,070
ProjectJ . $980perhour 3 hours 7 holrrs
ProjoclB. $800perhour I hours 16hours
ProjectI $730perhour 5 hours 21hours
ProjectD. $710perhour I hours 29 hours
ProieclA. $540perhour l7 hours 46 hours
ProjectC. $440perhour 16hours 62 hours
ProjectE. $410perhour 13hours 75 hours
ProjectG. $320perhour 13hours 88hours
ProjeclH. $310perhour 12hours 100hourc

Pan6lCrTheOptlmalPlan
lncremenialProfit
$ 4,280
ProjectJ . . 2,940
ProjeclB. . 7,200
Projecl| . . 3,650
ProjectD. . 5,680
ProjectA. . 9,180
$3lf3o

ofprojecr.only lhe t,1(ftrlcrk,/ costsol lhc

prolil lbr.r segnrcn(suchasr prxluct. custo|rlcr,
scSnrcnrshouldbc includcd. Ihosc are lhe coslt lhal co ld bc avoidcd whctherfixcd of
v.l|iablo if lhc scgmen!is elinrinated.All olhcr costs nrc nol rclcv:l[t tud should bc
ignorcd inclLrdins ol commoncosts.
rllocirtions

Trade-Off
Volume DecisionsI
Eodicf we stutcdthirlyou haveitlrcxdyencountel'cd sevefalcx.ulplesoi lhc pfo6tabililyin_
dex in this book.One was the pr)ject prolitabililyindexir Chapter14.The olhcr examplcof
thc profitabililyindcxis inthescclionUlilizatirtlol a CoDslta inedRcsourccinChaptcr13.
'Ihrt sectioDdcalswilh situationsin wbicb r conpaDydocs Dol haveenoughcapacilylo
774 Appendix
B

LEARNING
OBJECTIVE
2
satisfydemandfor all of its producrs.Therefore,the companymusl producelessthan the
Conpute andusethe marketdemandsof someproducts.This is calleda volumetrade-offdecisionbecausethe
profrtability
indexinvolume d€cision,at the m{rgin, consistsof tading off units of one productfor units of another
tradeolfdecisions. Fixedcostsare typicallyunaftectedby suchdecisions---capaciry will be fully utilized,it is
just a questionof how h will be utilized.In volumetrade-offdecisionswherefixed coslsare
irrelevanl,the profitabilityindextakesthe specialform:
Profitabilityindcxfbr a _ Unitcontribution
Inrrgin
volumetradc-olldecision- Amountol theconstrained
resourccrcquircdby one unit
This prolitabilityindex is identicalto the "contibulion marginper unit of the conslrained
resource' thatwas usedin Chapler13 to decidewhich productsshouldbe emphasized. An
exampleof a volumetrnde-olldecisionis prescntcdin Exhibit B-2. In this example,the
companymakesthrecproduclslhatus€theconstraincd rcsource-a machinelhat is available
2.200minutesper weck.As shownin PanelB of Exhibit B-2. producingall threeproducts
up lodemandwouldrcquire2.7(X)minutcsper week-500 moreminutesthanareavailable.
Cons€quently, the companycannotfully sltisfy dcmandlbr theserhreeproductsand some
productor productsmuslbe cut back.
The prolitabilily index for this decisionis computedin PanelC of Exhibil B 2. For
exrmple,the prolilabilhyindexfor prodrct RX200is $3 pcr nrinutc.The compamblcligure
for pmduclVB30 is $5 Perminutoand for productSQ500is $4 pcr mint(c. Conscquently,
thecorrectrankingol the productsis VB30 followedby SQ500,rhenfollowcdby RX200.
The optimalprodoctionplan is laid out in PanclD ol Exhibit B-2. The mosl prolitable
products,VB30 andSQsfi), areproducedup to dcmandand the remaininglime on thc con-
straintis usedlo makc2 ) u'ritsofRX200(l,U)0 availableminures+ 5 minutesDcrunil).
Thc totalconributionmarginfrom tollowingthisplan iscomputedin PanclEofExhibil
B-2. Thc lolnl contributionmillgin of $8,600is higher rhm the contributionmargin thal
coold bc rcalizedliom lbllowing rny othcr fbasibleplm. Assumingthat lixcd costsare nol
irffecledby thc decisionol which productsto cmphasize.this pln will also yicld a highef
tohl prolit lhananyotherfeasibleplan.

Managerial
lmplications
LEARI{INGOBJECTIVE
3 In addi(ionto rhe add-or-dropand volumctrade-offdecisionsdiscusscdabove,the profit-
Compute and{isethe ability indcxcanbe usedin odrcrways.Forexample,which productswould you ratherhave
profrtability your salcspersonscmphasize-dmscwilh a low prclitabilhyindexorlhosc with a high prof-
indexinolher
business decisions. itahility indcx?Theansweris, ofcoursc,ftal salcspersonsshouldbe crcouraged(o empha-
sizesalcsol theproductswith thehighcstprolitabilityindexes.However,il salespersons
are
paid commissionsbasedon sales,what productswill rheylrf 10scll?The sellingpricesof
productsRX200,V830, andSQ500appe.rrbelow:

productr
RX200 VB30 SQ500
Un lls e llh g p ric € . . . . . . . $ 4 0 $30 $35

Il salespersonsare paid a commissionbasedon grosssales,they will preferto sell product

RX200.which har the higbeslselli|l8price.But rhatis the /sart prolilobleproductgiventhe
currenlconstrlint.It hasa prcfilabililyifldexofonly $3 per minulecomparedto $5 per min-
ute forVB30 and$4 per rninutefor SQ500.
ThissuggeststhatsalespersoDs shouldbepaidcommissions basedoDtlteprofitabilityindex
andlbe amountof constraint timesoldratherthanon salesrevenue, This wouldencourage them
to sellthe,nostprofitableproducls.ratherthanrheprcductswilh thehighestsellingprices. How
wouldsucha compensalioD systemwod? Prior lo naking a salescall, a salespersonwould
-;:-

Aiays s
Proitabilty 775

EXH'BIT B_2
LJsng theProfitabilty
Indexin a VoumeTradeOffDecson
Panel A: Prodlct Data

RX2OO VB3O sQ500

Unitcontrlbutionmargin $15perunlt $ 1 0p e ru n il $16perunil
Demandper week 300units 400unils 100uniis
Amountof theconstrained
resource requtre0 perunil 2 m nulesperunt
5 minutes 4 minulesperunit

PanelB: TotalDemandon the Constrained

Besource

RX2OO VB30 SQ500 Total

Demand perweek(a) 30Ounits 400unils 100unils
Amountof theconstrained
resource requir€d (b) perunit 2 minut€s
5 minutes perunit 4 minulesperunit
Totalamountol lhe consirainl
requitedpetweekto meel
demand(a) x (b) . . . . . . . . . . . . . . . . . 1,500nrinutes 800minutes 400minutes 2,700minules

Panelc: Computationofthe ProlitabilityIndex

Products
RX2OO VB3O s0500
U nitco n tr i bu tinargin
on (a)........... $15perunit $10perunii $16perunlt
Amountof theconslrained resource
req u ir e( db ) ........... perunit 2 minulesperunit 4 minutes
5 mlnules perunlt
Profitabilityindex(contribut on margin
perunitof theconstrained
reso u r ce ) (=a)(b)................ $3perm nule $5perminute $4perminule

Panel D: Thg Optlmal Plan

AmoLnlo'constrai.redresoJrce
availab'e. .. 2,200minules
Less:Constrainedresourcerequhedfor Droduction oi 400 unitsof VB30 . . . . . . . . 800minutes
Remainingconstrainedresourceavailable 1,400minutes
Less:Consirainedresourcerequiredlor produclionof 100 un ts ol SQ500 . . . . . . . 400minutes
Rema'nr4gconslrarn€dresoure availabre 1,000minutes
Less:Conslralnedresourcerequiredfor oroduclionof 200 unitsol 8X200". , , , , . , 1,000minutes
Bema'ni1oconsrained esourceavailabe 0 minules

'1,000 minutesavailable= 5 minuiesper unitof RX200= 200 unilsof RX200.

Panel E: The Total Contribution Margin underthe Optimal Plan

Producls
RX200 VB30 SQ500 Tolal
margin(a) ........
Unitcontribution $lSperunit $l0perunit $16perunit
Optimalproduclionplan(b) . -...... 200units 400units 100units
Contributionmargin(a) x (b). . . . . . . $3,000 $4,900 $1,600 $8,600

rcceivean up-to-dutercpo( indicatinghow nn|chof the constuinedresourlreis cufl€nlly

vailableandr lislirgol all produclsshowiugthcamountof tbcconstmi e.rh requires|nd thc
prulitabiliiyindex.SuchI rcponwouldapperrrs folkrwsi
 xB
Append

MarketingDala Repoft

RX2OO V83O sQ500

Unilsellingprice. $40 $30
Unitvariablecost 25 20 19
lJnitcontrib uma t o nrg in
(a ) . . . . . . . . . . . . . $15 !t! $16
Amountof theconstrained resource
perunil(b)
required 5 minules 2 manutes4 manutes
x )+ (b ). . . . . . . . . . . . . .
P rofitabilinitdye (a 55 per $4 per
minute minule
Totalavailable
limeontheconstra
nedresource:
100m nutes

'lhc kcy hereis to rrali/clhllllhcs lespersonis rc.Lllyscllingtimeon iheconstrairt. A srlcs'

pcrson who is pxidb sc(loI lhc prolitrbility
indcxwill prclcrk) sellproduct Vlll0 sinccthe
sirlespcrson wouldgctcrcditlin salcsof5500ilall l0(l rrrirlt|lr\rrcuscdon pft)ftrctVBl0
{\i Irf rrrifulcx l(X)r)rinutcs). whcrcrslhc cl1rditwork! bc only t3(X)tbr pfo(hrcl l{Xl{)(}
or 54(X)Ibr prnlucr SQ50{).1
'lhc li)r pdcirrfne$,|rcducls.
trolilabililyiDdcJ(nisoh.rsinrdicrtnnrs Supposc thll lhe
conrp ny h.rsdcsigncda rrcwpR)rhrcl, W]t6000.whoscvlri blc cosris li30 pcf unil rnd th|l
fcrtuircs 6 nrinulcsoi lhceonstflrincdrcsoufcc|cf unil.Sinccthcconrj ny is cu|Tcnlly usinS
11olits clp.Lcity,
thc ncwt)foduclwouldncccssurily disfl cc Irxluclionol cxistinSpR)d-
ucrs.Onrscqucnlly. lhc pficcol lhc ncwp(xlucrshoullcovcrnotonly ils vurirblccosl,hut
it shorld.Llso covcfthcopFnlunitycostol displtlcing cxislingpr1)ducts. Wh l trodrctwould
bc disphccdlPrlxlucti(noll{X2(X)should bccul lil1\rbcc.rusc it is lhc lc st pRtit bI cxisG
in! pr( ucr.And how nrrch is r nrinrlc ol lhc conslffircd rcsourccwo h il it world othcF
wisc bc uscdk) nukc p()ducl l.lX2(X)lA nrinrlc ol thc corstrnincdrcsorr.'cis wonh \ I t)cl
|l)Ill[e, lhc prnilLrbililyirrdcxol froduclRX2{)l).lhcrcli)c. lhc sclliD8pfiecol lhc ncw
pfoducrshoukl r lclsrcovcfrhccosrsLridourbclow:r

/ O|l)(nlunjly A x)untolrhc \
(,1
Srl l i n g l fi cc ol , V rri rbl c cosl oi ,
lcostl)efu|'ir ! c,n'slftrincdfcnn'|1\,I
u c w p | rx h rct thc ncw prl xl ucl c(nrsrf'rinr(l rc(trirc(lby ,)f/
lrhr 'r ",rir
\ rc"n'reO llrcncwpfo(lLrcl /
ln thcc scol lhencwproduct
Wl{60{X).
thccrlcul.rli(nrs
woukltrc:
Scllin*pricell - Lr$ltlcrII
-
u iiiOorr
'$.r" ITc I,rrrrrrr||.\|:{1{\-l rLlrr $lx

WRrr{)o0shonldsell 1in r lcrsl S4l3or the conrprny$orLldbc bcller ol'l c(nrliuuinglo Lrsc
rhclvriiLrblc
cap city 10t)rr LLcc
IlX200.r

I I lluiv ilc nL inc c n r i l c sw ( N L dh c | ( ) v i ! L c d h y c o n r n r i \ so n \ b n \ c d . n l ( x r l c o n r r i b u t l o rn r n fg i D .l l r l l

l( J { )r v ! ihbl. m inltc s r . c r s c d l , ' n r r \ . ! ( ) d u c r V ! - 1 0 . 5 0 u n i l \ e o u l d b . t . o d u c c d ( 1 0 0 !r i n !r u \ r
lDr inr r e\ p. r unill- L r s . h i . h l h c l o r ! l c o D t r i h u r n D n u r g i n $ 1 N l d b e 5 5 {) 0 ( 5 l l ) p c r t r n i t t 5 0 u !i t!) .
l- ilc s i* . r le k nr l c o n l r i h u l n n rn t r r l i n l i ) r t . o d u c r R X l l ) 0 $ o n U n e S l 0 0 . , n d r h c lo u l c.i r i b u -
lion Dhr gir t uould b c S . l 0 {)t u r t u l r c l S Q 5 0 0i f r l l r u i h b l c t r i D r l e \ $ e r e u s e d l o m r L c i r sl l h o sc

' In irldilioi, rhe selliirs fi'icc oi n ics p,odu.L sl|rld co!c. riy itr)idrtrle nxed c('sh ol rlie linxlucl
' lhis s c r sic r s ! i. l I h r n d o f u , h o w c ! r , s n c c r c h i e ! i n g L t r i s s o r lr v o l v c s c ( i m r r i i g h o w n 'r r yi i r i l sw i l l h c
s'll whidr iD ftrn deperds(r lirc scl iDBprice.
' ll t(xlL.Iior ofwR6o0l)evenLrrl]y eo pletelt dispfuce\ n({luclnlr olRX200, thc oppo rnily cosl
w(rkl chrnge. ft lvould i.crers0 r(' 54 pcr n'inule. the p()lihbiliLy iidcx of dre rxt p()d(ct in line ro bc
I

Prolitabilty
Anaysrs 777

DEALING CUSTOMERS
WITHUNPROFITABLE
0ne retaer d scoveredthatmanyof thebiggestspendrngcusio[relsn thei "loyaiy" prograrn
were
unprolrtable
because theyboughtory salelemsandreturned lotsof terns.Thecompany stopped
sendrngthes€cl.rstorners
notLces ' prvate"saes
of upcomrrrg
thrs SnkYour
Customer
Source:LdfySdderandGeoirreyCoun,'Wl Slockifoflun€,
Septerrber
30,20C2,
DD.121132

Summary
,\ n n ! r ! ( linir . r i, n s h rk l l )c n ,rd cb !6 \e e trrb !)l !rr pr(ti l rbi l i l r"rnd rehl i re Iml i htri l i l y.,^sc8.
i n .n 1is er nr s i( l. R(p(l n i l rb l ei n rr rb !' l u l c s c i \c i l d rn t)ti rrg i t w oul (lfcnrl ti r l ow croveml ltrol i h
r\b s, lut et r ) r r lr bilir yi i n re i :u rc db ) l h c s c e i t.i r\ i rc knrcntxlU ol i r. sni ch i s l hc di l l cr!tcc be.
l w.rn r hcr c v enuclr \ o rr th c \c g ,,rn l rt(l rh . e o s l sl l n l cou!dbc rvoi (Lcd hy dr,t)pi rr8l hc scgr' rcr)1.
A Nhr i! c pr olitl b i l i t)| | rc rs rtrti s rs c (lro rrn l s .rnrcnrs. srch rrnki nS srrc necc$rrtonl y i l r
e o r\r f uir rin, ec sr hco ,!ri i T rl i ( 1 ()n l i c Ifu d r o l l s 0 n oD 8\cgnrc!l \' l b rt)tn,P i !l cl yi ncrr{ r. tel r'
l i vc p r olil! hili( yr,hc c l h i n A srrs l b c k ro !v r.I i rs l .l h ceorrsl rri lnrust l he i derl i l i c(1. S ccon(1, rl rci n
e rc,, ieor pnnirrl is { ) c i n rc (l \!i rhc r.h s c tD tn l n ro \lb ce o D l l n,l c(l l hi
. nl .l h.rrxu)l ol l h..on\l ri j terl
re vn, r ! r r c qLr iLrhy { i cr.h s c Srtrc inrlro ( h c (l c rc rn i n e(1. l tcl ul i vc1)!r' i i rrbi l i li ys (Lcl ofl ni ri cd
by thc
t),o l it r hilir ylr dex , wh i .h i s l h c i n c rc n rc n l rl p r(i l i li r!r 1(| | e \egdrcdr di !i l cd b) thf xtrurl ,)l l he
co ,N lt ulic di. ! { t r ! e R l u i ((l h ! l l rcs c S n re rli h e tr{ )i i l i rbi l i l iyr(l cxern bc uw l i tr r !rri cryoLsi l u
rri (rr s .lt r . Lor lir s . lc e l i (rso l p (,l e c l s{ n d v t' l u i rcl l r(l el )l l dcei snr\

Glossary
r\b sohr t rpr olilnhilit y l h c i rn p i L c{ !r l l l rc,tErri l /n l i ( s r)vcnLlIr)l i l s t)l rd(l i rrg{ r (l R )l )l )i i rs 1)rf
r ic uhrs . gnr . nls u c hr\ r tr(rl !L ctnr c !s to n i .r rv i rh(rrnrxl i rg rn) i )rhcI.hr,rg.s.1p.?70)
l 'rti l a bilit t ir dc \ f h .i c rn ,ru r)l t.!rl i !.t)l o l i l rh i l i l y.N hi .hi sc,nri N l e(l bydl !i di rtA l hci ncrtnrcnl xl
I ir ( iI rlnnr ! s c g rrN nbty rh cn N n n I o l th ..o n s r' x u rc(l N !\Irc l eqri ttl b! rh. \.gn' .nt.(t. 771)
Ite t{ li} r pr ot ilabilit ! A ,rn k i n so l tR !]u .rs .e u (o n rer' ,n . r)1hef hL,si N ss.!N ori l sl of turposcs ol '
n ir l( ir glnr lc , ills ri u rA \c A n rc n rs .' l hirs
s n c c c s sryw l i cnI er) oxi sl s(P .77l l
' suri nr

Questions
l ]'l W nr r is nr r nl h y rr\rri l . tru l i l rh i l l r!)
ll2 W hr r Lsnic r n (h ) r? /.rn ?p r()l l L a b i L i ry l
B'-l A slcccsJitl ,trrncr ,t ! ur,rllbu\i,rcs!\!r(cd "W. hrverhc bcsllcchrrol,)gy. llrebe\l Pnducls.
ud r hchc s rt co p l c i n th ew o L L d .w c h rvnc o .o nsl ni nl s:l )oyourgr.e1
8-.1 \\rhir inliiflnrrior is nec(lcd&' dt.r{rfc rhcdr!a1?r/rftolilabilirr' ol ! \e!Dt,l l
8 ^5 \ \ l[ l ir lir nr l]o n i \ n e c { l e1d0n rc r\u f.1 h cry ' dri trpr)i i l rhi l i l yol P r)dncl l
It-(, IkN sh,rklthc €hrl!e fn)ritrhillr) olp(trlucrr bc dele nincriii a \olune l.rl. orl dc.isionl
l i -7 whr l c os ls\ ho rL dl ,c .o v .a c dh ) rl rcs .l l i rg t)riccol r rcw l ]r1)duel ?

Exercises
EXERCISE 8-1 RankingProjedsaasedon the Pfontability lndexILOr]
Al l !n LirA nr ! ! . nr em si s j n l h cti 1 )c c sosl !e !i e w i i i gp (,p osrl sl i )rncs d(l csdl i Lsthcnreprrksi r' ci l i c\
scrte r c dr hnr ughourht c ;\rl m(i cc ()n (.T h c .o n p x i y : onl ] .xpcr cncedsri tl ) entnrccrtnr\l cde
f!l l ! r \ ' lc N phns Nr d n D i l o r c o n \l .u .l i o no r c rc h rnd cl cty | rcj ecL-l l ri s.orrsri ri nrnrrkc\ i t
774 AppendixB

impossible to build all of the new rides this year.The ner prePnt values and the amoun( of safety en-
gineertime requiredfor tne proposedridesarelisredbelow:

Rids1...,,.... s 741,400 220

Ride2. . ... . ... 382,500 150
Fid€3......... 850,500 350
Rid64......... 450,500 170
Rld€5......... 620,400 220
Rld€6......... 1,004,400 310
Rld€7. ... . ... . 953,800 380
81d68,........ 332,500 190
F|de9,,,...... 385.500 150
Ride10,....... 680,400 270
Tolal.......... $6,401,900 2,4t0

l. Thesnletyengineer is nvaihbl€to workon newrid€sfor 1,220hoursduringtheyear.Whichof

lhe propos€dridesshouldthecompanybuild rhisyear'l(Nore:The incremenralprofir of a long-
lermprojeclsuchasconstructing a newrideis irsnetpresenrvolue.)
2. Whatwouldbcthetotllret presenl valueoflhe ridesbuilrunderyourplanl

EXERCISE 8.2Volumo Trad€.Otl

D6cl.lon[LO2]
BateauxduBois,Lld.,makes rcproductions
olclassicwooden boats.Theborleneckin lheproducton
preessis littinSwooden
plnnksto buildup th€curvedsections
ot rhchull.Thisprocessrequir€sthe
an€ndonof theshop'smostexpcricncedcrnfisman.
A totalof1.800hoursarcavailable
peryearin rhis
bo(leneck opemtion.Dataconccmingthecoopany'sfourproducls rppearbelowi

Unllconlbr{ionmdlg|n. . , . . . . . . . . , . . 8444 $4{'4 $312 S482

Annualdomand (unll6)............... 80 80 70 1m
HouEroqulred ln th6bottleneck
opefqllonp€run||,,,,,,,.,,,.,,,,. I

No fixed costscould be avoid€dby modifying how mrny unils are produc€dof any producr or even by
dropping any one of the producrs.

l. Is thercsr,r
fficientcapacilyin the boltl€neckoperationto satisfydemandfor allproductsl
2. Whal is the opiimalproduotionplan for theyear?
3. Whatwouldbe thetotnlconlributionmarginfor theoptimalproductionplan yon havep.oposed?

EXERCISE B-3 Pdclng a .f, Product [LO3l

JavaStopownsandoperates a chainof popularcoffeeshDdsthat serveover30 diffe'enrcoflee-based
bevemges.The constraint at the coffee standsis the Amountof time requn.edro fiU an order. wlich can
be considerobte fbr the ore conpiex bevemgcs.SAlesare ofteDlosLbecausecuslomersieavealter
seeingr long waitingtine to placean order.Careiulanalysisofthe conpany'sexislingproduclshas
revealedthat theoppomrnirycostof order-fillingrimeis $3.40per minure.
The company is considering intoducing a new pmduct, amffetro cappuccino, 10 be made pith
dmod extract ond double-fine sugar The va.riablccost of ahesrrndrd size amare(o cappuccino
woutd be $0.46 and tbe time required 10filI an order for the beveragewould be 45 seconds.

What is the minimumacceptable

sellinsplice ior the new anarettocappuccinoproduct?
 ProitabilU
Aiayss 779

Problems
I
PROBLEI, 8"4 RankhgAltern.tivesrnd Managingwltha CorcVaint[101,LO3]
Teni's Baking Companyhas developeda rcpntatiotrfor producingsuperb.one of-a'kind weddirg
cakcsin addiLionto iLsnomalfuc ofbreadsandpasrries.
moneymaker,
While tbc weddinscakebu$iness is a maio.
it createssonrcprobleN id the bakery'sowner,Tcrri Chavez-parlicularlyin JuDe.
The companyt rcputationfor weddinscales is larg€lybasedon the skills of MesanEast€rli'is.who
decoratesall of the cakes.UnfortunrELy.last year thc conrprnyaccepEdloo manycakeordersfor
som€Junewcekends.with thc resulltha!Meganwas lvorkedto a fmzzleand dnosl quj!. To prelenl
utr
a rec nence.TcrrihaspromiscdM€gantharshewillhrve to work no morethAn33hoursin any week
to preparcthe weddingcakestor lhe upcomingweekend.(McganalNohasolherduticsa( tlreb*ery.
so evcnwilh the 33-hourlimil.|tion,shewouldbe workingrnor€thrn full finc in June.)
A numberof rcs€ryations for wcddi"g c keslbr lhe lirst weekendin Junehad alreadybcenre-
ceilcd rroln custonrcnby c dy May. When0 custonefmakcra rescNalion,Ms. Chrvezgeh cnorglr
iDfonnationconcenringthe si/-€oflh€ weddingpany andthedesircsof thecusiomerto detenninethc
cakc'spricc,lhe cost to m.ke it, rnd he arnountof lime that MeBanwill nccdio spcnddecoratingil.
Thc reseNrlionstbrlhe iirst weekcndin Junearelistedbelow:

$ 14O
B oyer,,,,.,,,,., 124 4
comfort.,,,,.,,, 160 5
Dona9h6,,,,.,,,,
Due.,,,,.,,,,,, 190 5
Dupuy.. ..... ... 288
E bb€r|s
. ... -. ... 93
|mm,,,,,,,,,,,, 136
2U 6
P a u l d i n g ......... 204 6
Total
-. .. . .. . .. .. $1,665 48

Forexample,thc AudetcNkewould rcquire4 houls of Mesans lime and would Sereraten profil {)1'
$140 ibr the bakery.Folbwnrg indtrsrryp|"clice,pricingfor thc cakesis basedon thek sizeand san-
durdlbrmulosdtrddocsDotrcfleclhow muchdecotAtinswould be teouired.

l. Ms. Chavezteelstha( shemusic celenoughcakercservations to rcduceMcgan s workloadto

the prcDised lelel. S[e knows that curtoDerswhosercserlalionshale bcerrcancelcdwill be
disappointe.l,buashc intendsto rcfcr allofthose customeNto an excellentbakeryacrosstown.
lf the sole obieclive is to mdximiz€thc conrpany\ tolal lrolit, which reservationssfiouldbe

2. in pan (t) abovcis lollow€d?

What would bc the tolal profil ifyour rccomnrcndalion
3. Assumethat lbr competitivercasonsit would not be practicll for T0 i's Baking ConrpanyLo
changcrhe pricingofi(s weddnrgcakes. Wharfccommcndations wouldyou makero Ms. Chavcz
concerningtakingrescNationsin the lirlure?
4. Arrume thal Teri\ Buking Comlany could changethe way il pricesils wcddingc kes.Whul
recommendations would you makelo Ms. Chavezconc€minghow sheshouldsetthe pricesof
weddingcakcsin the iirture'/
5. Whal Ms. Chavezbe ableto do to keepboLhMcganandhercuslomers happywhilei.creas-
'nigh!
ing her pofitsl Becrcative.(Hint:Reviewthesectionon man{gingconstmintsin Chrpter13.)

PAOAIEMB-5 Interpreting Conmon Practico EOrl

In practice,rnanyorgnnizAtions easurethe relativeprolitabililyof their segmenrs
segmcnls'maqins by their'rcvenues.
by dividing rhe
Tlr€ seglnenlmdgin fbr this puDoseis the segment'srcvenne
less ils fully allocatcdcosts-including allcations of fix€dcomrnoncosts.For example,r hospihl
mightconrputefte reLative profitabilityof its major segmenBasfollowsl
trtr
 Appendix
B

Em€rgency
Room Surg€ry AcuteCqr6
$8,650 $14,870 912,120 $35,640
8,360 14,490 11,760 34, 610
li,4argin $ 290 $ 380 s 360 $ 1,030
(l,{argii+ Rev6nu€)
PrctltabllV 3.4% 2.6% 3.O% 2.9%

Th€ hospital'snetoperatingincomcforthis periodwas$l,030.000.

L E!|)lualcthe useofthe margiD,asdelinedabove,in the numeralorofrheprofirabililymeasure.

2. Evalualetheuseofrflenue i re denominabroffie prolitabililymeasure.

PROBLEM B.SVolumoTrads-oflDscl6lon;Managlnstho Constralnt[1O2,LO3]

EnumchwBrick,Inc.. munufnctrres bricksusingclay deposksonrhecompany'sproperty.Raw clays
areblcnd€dandthenextrudedinto moldsto form unfifedbri.ks. The unnredbricksffe thenslacked
onlo movablemetalplaltormsand mlled inlo lhe kiln wherclhey are fi.ed until dry. The dried brioks
arc ftcn packa8edand shippcd to rehil oudets and conrraclors.The bonleneck in rhe producrion pro-
cessis rhckiln, whichis availabletbr 2,000hoursper year.Dnlaconcemingthecompa'ry'stburmain
p.oduclsuppe below.Produclslre sold by the pallel.

Grcssrcvenue p€rpall€l $789 s1,264 S569 $836

Conlhllionmargin p3rpall€l..... -.... $€70 $4S7 S328 $39O
Annualdemand (pallets)... 't20 80 180 70
Hou|sr6qulr6din lh€ kllnpsr pdllsl . . . . . . . 5 74

No fixedcostscouldbe avoidedby modifyinghow nuch is producedofany prcduct.

t. Is theresullicien!capacityin thc kiln to satislydemandfbr0ll products?

2. Whal is the productionplan iof the y€arthatworld maxin ze the company\ proiil?
3. WharwoLrldbe the lotal contributionmaryinfor $c productionplan you havepropo$ed?
4. The kiln could b€ operat€dfbr morc than2,000 hours per yearby runnin8 it afier ormalworking
lloun. Up ro how muchperhourrhouldthecompanybe willing to pay ir ovenimewages,energy
cosls,md olh€rirErementalcoststo operetethekilnaddilionalhours?
5. Tllc complnyis considering inuoducinga new producl,glazedVenelianbricks,tharwould h.ve
av iablecosLofii530 per pdlet md would r€quir€II houN in the kiln. Wh r is the minnnun
&ccptablesellingpdcefor this newproduct?
6. Salcspersons a.e cuncndy pAida cormission of 5'l ol grossrevenues. Will rhis morivatethc
salcspc$ons to makeftc right choic€sconce.ningwhich produclsto sell mosl aggfessively?

trtr PROALEfl&7 CustomerPofitabllftt and ttlamgffial DeclslonsEOr, LO3l

Firstl-inePha.naceuticals,
andhospildl"based
Inc., is a wholesaledistributorof prescripriondrugsro jndependenr
pharmacies. Management believesthatlop-no|chcusromerrepreseniatives
key factorin delerminingwhether re companywill be successful
livesseNeas(heconpany'sliaisonwith customers-helpingpharmacies
eringdrugswhencustomerstocksrun low, andprovidhg up-to-date
diffcrentcompanies.Customerrepresentatives
retail
arethe
tu lhe future.Custome!rcpresenta-
moDitor'theirslocks,deliv-
informationon drugslron nmy
must be ullrn-r€liableand are highly lrained.Cood
custom€rrcpresentativesare hard to come by md are not easily replaced.
Customerrepr€sentativesroutin€ly rccord lhe amountof time they spendserving eachpharrnacy.
This time includes lravel time to and from the @mpany s central warehouseas well as rime sp€nl re
plenishingstocks,dealingwith complaints,answeringqucslionsaboutdrugs.infonning pharmacisrs
of the htest developments and newesrproducts,reviewingbills, explainingprocedures,and so on.
Somephrrmaciesreqlire nore hand-holdirsand atter(ionthanotherr and consequendy they con-
sumemoreof thereDresenlatives' time.
 ProftablityAnalysis 78L

Reccnlly.customerrepresentative hayeinoreasinglycomplainedthat it is impossibleto do theh

jobs wirhoutworkingwell beyondtromal workng hoxrs.This hasled to d alamins increasein the
number of custome. rcprcsenhtives qui(ing forjobs in other orgdizations. As a consequence,man-
agemenlis consideringdropling somecustomeru to reducetheworkloadon customerrepresenhdves.
Dataconcerninga represenlutive sampleof the company'scustomers appedsbelow:

Tolalr€v€nues s344,880 $1,995,200 $1,414,170 S154,800

$263,340 $1,446,520 $1,047,660 $120,960
C ls t om €rs er v ic sc o s ts... ........ . $12,240 $62,6{0 $39,900 $4.500
C us t om €r r epr e s € n l a l i v € l i m e ........ lao 1.160 570 90

Cuslomerservicecoslsincludeall ofthe cosls{ther thanthe costsofthe drugstle'nse]lcs-

rhdr could b€ avoided by drupping the cllstolner. Thesecos(sincludc lhe hourly wl8es of the customer
represenhtives, their saLescommissions,th€ mileage-felted cosrsof rhe ouslomerfepresentalives'
company-provjded vehicles,and so on.

l. Rankthe fouf c0stomersin termsoitheir profitability.

2. Cuslomefrepresrnldivesar€ curcntly pardli25 per hour plus I commissionol' I % ol salesrcvcnues.
lf lh€s€four plunnacies are indeedrcprcsenladveof ft€ compdny'scuslonloni.could the comBny
afford to pay its customerrepEsentatvesmore in oder to altracland reraincustomefreprEsenlatives?

Cases
CASE8.8 RsdircctlngEffo.t 11021
Pr€vala Corpomtion recentlysufferedfromits tounhstraightdeclinein quarledyearnings--iespil€
modeslincreflses in sales.Unlortunately, Prevro'sindustryis highlycompetitive, sothecompany is
reluclanl1o increase i$ prices.However, managemenl bclievesthatprofitswouldiDrprove if theelTotu
of its salesforcc werer€direct€dbward the moreprofilableproduclsin its offerings.
Several yearsagoPrevaladecided thrt itscorecompetencies werestrategy,design, andmarkeling
andrhatpmducrion shouldbeoutsourced. Consequerlly, Prevalasubconracb all ofils production,
Prevalo's salespersons arcpaidsalarics andcommissiorN. All ofthecompany's salespersons scll
thecompAny's ftrll lineofproducts. Thesomnissions are6%ol tie rcvenue gcnemted by a salesper-
sonandavdageaborr?09,ofr salesper'son\ totalcompensolion. Therehacbcensomediscussion ol'
increasingthesizeof lhe salcsforce,but manag€ncnlprefersfor thc presenl10rcdirecllhe effbnsof
snlespersons towards th€morcpmfitable products. Whilemanagement is reluctant to tinkerwilhthe
salescompcnsAtion scheme, rev€nuelIlrgelsfor thevariousproducls willbe setfortheregional $ales
munagers based onlheproducls thalmanagemenl wanlrlopushmo$laggressjvely. Thcregional sules
managers will bepaida bonusif thes esta8etsaremet.
Thecompany computes producrmafgins forall ofits produclsusingthetollowingformula;

Ssllingprlcs
L€ss:Salgscommisslons
L€ssrCosl ot salos
L6ss:Opolallng 6xpenses

The cosl of salesin the product margin formub is the amou Prevalapays lo ils production subcon-
rnctors. Thc opqratingexp€nscsrepresentfixedcosrs.Eachpmductis charyeda fair shareof thos€
cosrs,calculaoed lhh yearas3?.2E ofrheproduot'ssellingprice.
Manag€ment is convinced that the best way to improle overall profits is to r€direcl the effons of
fte company's salespersons.There are no plans lo add or drop any products.

How would you measuretherelativeprofilabilityof tle company'sproductsnr $is situatioD?Assume

lhal it is not feasible to changcthe way salespersonsare compensated.Also assumethat the only dala
you have availableare the selling price. the salescommlssions,lhe cost of sales,the operAting
<),pen.e5. and Ine produc murernforcuchproJucr