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SERVICES

McGraw-Hill/Irwin Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Appendix A-2

Learning Objective 1

maximizing price of a product

or service using the price

elasticity of demands and

variable cost.

Appendix A-3

3

Elasticity of Demand

to which the unit sales of a product or service is

affected by a change in price.

Change Change

in versus in Unit

Price Sales

Appendix A-4

4

Demand for a product is inelastic if a

change in price has little effect on the

number of units sold.

Example

The demand for designer

perfumes sold at cosmetic

counters in department

stores is relatively inelastic.

Appendix A-5

5

change in price has a substantial effect

on the number of units sold.

Example

The demand for gasoline is

relatively elastic because if a

gas station raises its price,

unit sales will drop as

customers seek lower prices

elsewhere.

Appendix A-6

6

(lower) markups over cost when

demand is inelastic (elastic)

Appendix A-7

7

d =

ln(1 + % change in price)

Appendix A-8

8

Suppose the managers of Natures Garden believe that

every 10 percent increase in the selling price of its apple-

almond shampoo will result in a 15 percent decrease in

the number of bottles of shampoo sold. Lets calculate the

price elasticity of demand.

For its strawberry glycerin soap, managers of Natures

Garden believe that the company will experience a 20

percent decrease in unit sales if its price is increased by

10 percent.

Appendix A-9

9

For Natures Garden apple-almond shampoo.

ln(1 + % change in quantity sold)

d =

ln(1 + % change in price)

ln(1 + (-0.15))

d =

ln(1 + (0.10))

ln(0.85)

d = = -1.71

ln(1.10)

Appendix A-10

10

For Natures Garden strawberry glycerin soap.

ln(1 + % change in quantity sold)

d =

ln(1 + % change in price)

ln(1 + (-0.20))

d =

ln(1 + (0.10))

ln(0.80)

d = = -2.34

ln(1.10)

Appendix A-11

11

strawberry glycerin soap is larger, in absolute

value, than the apple-almond shampoo. This

indicates that the demand for strawberry

glycerin soap is more elastic than the demand

for apple-almond shampoo.

Appendix A-12

12

Under certain conditions, the profit-maximizing price

can be determined using the following formula:

Profit-maximizing -1

markup on =

1 + d

variable cost

Using the markup above is equivalent to setting the

selling price using the following formula:

-1

Profit- 1+

maximizing = 1 + d

price Variable cost per unit

Appendix A-13

13

Lets determine the profit-maximizing price for the

apple-almond shampoo sold by Natures Garden.

The shampoo has a variable cost per unit of $2.00.

Price elasticity of demand = -1.71

Profit-maximizing -1.71

markup = - 1 = 1.41 or 141%

on variable cost -1.71 +1

Appendix A-14

14

Now lets turn to the profit-maximizing price for the

strawberry glycerin soap sold by Natures Garden.

The soap has a variable cost per unit of $0.40.

Price elasticity of demand = -2.34

Profit-maximizing -2.34

markup = - 1 = 0.75 or 75%

on variable cost -2.34 +1

Appendix A-15

15

The 75 percent markup for the strawberry

glycerin soap is lower than the 141 percent

markup for the apple-almond shampoo. This

is because the demand for strawberry glycerin

soap is more elastic than the demand for

apple-almond shampoo.

Appendix A-16

This graph depicts how the profit-maximizing markup is

generally affected by how sensitive unit sales are to price.

Appendix A-17

17

of strawberry glycerin soap per year at the price

of $0.60 a bar. If the change in price has no effect

on the companys fixed costs or on other

products, lets determine the effect on contribution

margin of increasing the price by 10 percent.

Appendix A-18

18

Contribution margin will increase by $1,600.

Appendix A-19

Learning Objective 2

of a product using the

absorption costing

approach.

Appendix A-20

20

pricing, the cost base is the absorption

costing unit product cost rather than the

variable cost.

Appendix A-21

21

Here is information provided by the management of

Ritter Company.

units of the new product, and that Ritter typically

uses a 50% markup percentage, lets determine

the unit product cost.

Appendix A-22

22

The first step in the absorption costing approach to

cost-plus pricing is to compute the unit product cost.

by 50%. Lets calculate the target selling price.

Appendix A-23

23

The second step is to calculate the target selling

price ($30) by assigning the appropriate markup

($10) to the unit product cost ($20).

Appendix A-24

24

A markup percentage can be based on an industry rule

of thumb, company tradition, or it can be explicitly

calculated.

The equation for calculating the markup percentage on

absorption cost is shown below.

Markup %

(Required ROI Investment) + S & A expenses

on absorption = Unit sales Unit product cost

cost

expenses and to provide an adequate return on

investment.

Appendix A-25

25

Lets

Lets assume

assume that

that Ritter

Ritter must

must invest

invest $100,000

$100,000 in

in the

the

product

product and

and market

market 10,000

10,000 units

units of

of product

product each

each

year.

year. The

The company

company requires

requires aa 20

20 percent

percent ROI

ROI on

on all

all

investments.

investments. Lets

Lets determine

determine Ritters

Ritters markup

markup

percentage

percentage onon absorption

absorption cost.

cost.

Appendix A-26

26

Markup %

on absorption = (20% $100,000) + ($2 10,000 + $60,000)

cost 10,000 $20

Variable SG&A per unit Total fixed SG&A

Markup %

($20,000 + $80,000)

on absorption = $200,000 = 50%

cost

Appendix A-27

27

Approach

The absorption costing approach assumes that

customers need the forecasted unit sales and will

pay whatever price the company decides to

charge. This is flawed logic simply because

customers have a choice.

Appendix A-28

28

Approach

Lets assume that Ritter sells only 7,000 units at

$30 per unit, instead of the forecasted 10,000

units. Here is the income statement.

Appendix A-29

29

Approach

Lets assume that Ritter sells only 7,000 units at

$30 per unit, instead of the forecasted 10,000

units. Here is the income statement.

Absorption

Absorption costing

costing approach

approach to

to pricing

pricing is

is aa safe

safe

approach

approach only

only ifif customers

customers choose

choose toto buy

buy atat

least

least as

as many

many units

units asas managers

managers forecasted

forecasted

they

they would

would buy.

buy.

Appendix A-30

Learning Objective 3

cost for a new product

or service.

Appendix A-31

31

Target Costing

Target costing is 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

Target cost

cost == Anticipated

Anticipated selling

selling price

price Desired

Desired profit

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.

Appendix A-32

32

1. The market (i.e., supply and demand)

determines price.

2. Most of the cost of a product is determined

in the design stage.

Appendix A-33

33

Target

Target costing

costing was

was developed

developed in

in recognition

recognition

of

of the

the two

two characteristics

characteristics summarized

summarized onon

the

the previous

previous screen.

screen.

Target

Target costing

costing begins

begins the

the product

product development

development

process

process by

by recognizing

recognizing and

and responding

responding to

to

existing

existing market

market prices.

prices. Other

Other approaches

approaches

allow

allow engineers

engineers to

to design

design products

products without

without

considering

considering market

market prices.

prices.

Appendix A-34

34

Target costing focuses a companys cost reduction

efforts in the product design stage of production.

Other approaches attempt to squeeze costs out of

the manufacturing process after they come to

the realization that the cost of a manufactured

product does not bear a profitable relationship to

the existing market price.

Appendix A-35

35

Target Costing

Handy Appliance feels there is a niche for a

hand mixer with certain features. The

Marketing Department believes that a price of

$30 would be about right and that about

40,000 mixers could be sold. An investment of

$2,000,000 is required to gear up for

production. The company requires a 15

percent ROI on invested funds.

Let see how we determine the target cost.

Appendix A-36

36

Target Costing

would be responsible for keeping its actual costs

within the target established for that area.

Appendix A-37

37

End of Appendix A

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