Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

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1 Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing QUESTIONS 1. The manager would estimate the quantity that could be sold at various prices. The quantities would then be multiplied by the contribution margin per unit and fixed costs would be subtracted from the total contribution margin, yielding an estimate of profit at each price. The price that yields the highest profit is the profit maximizing price. 2. The cost-plus price is based on full cost per unit. However, to determine full cost per unit, one must first estimate the quantity that can be sold. But the quantity that can be sold depends on the price! 3. The target cost depends on price, and marketing staff is needed to determine product features and price. Engineers are needed to determine efficient production methods given the product features. And cost accountants are needed to estimate costs given the production process. A cross functional team helps ensure good communication among these various parties, increasing the likelihood that a product will be put into production that can be produced for the target cost. 4. In customer profitability analysis, indirect costs are grouped into cost pools (e.g., the cost pool related to processing fax orders, the cost pool related to processing Internet orders, the cost pool related to shipping, etc.). The costs are then allocated to customers using various cost drivers (allocation bases) to determine customer profitability. 5. With activity-based pricing, customers are charged for various services. For example, there might be separate charges for delivery, for rush orders, and for returns. This way, customers that impose high costs on a supplier will pay for the services they demand.

2 8-2 Jiambalvo Managerial Accounting EXERCISES E1. While the computers may be a commodity, the business processes used by Bell to produce and sell computers are a source of competitive advantage. Assuming Bell is better at these business processes than its competitors, it may make sense to lower prices and gain market share. While Bell may be able to generate significant profit even at lower prices, the lower prices may be ruinous for competitors. E2. The marketing vice-president may, in fact, be worried that some customers really will be dropped. This will reduce sales and may have a negative effect on his bonus (which is based on sales rather than profit). However, if no customers are going to be dropped and prices to less profitable customers are not going to be changed, then there is, indeed, no point in conducting the customer profitability study. E3. At the Web site Destination CRM, there was an article by Tom Richenbacher on The Art of Customer Profitability Analysis. According to this article, to perform customer profitability analysis, marketing, and service, costs must be traced to individual customers. Unless this is done, profitable customers may be lost through overpricing, unprofitable customers won by underpricing, and unprofitable customers subsidized by profitable ones. In activity-based costing, indirect costs are allocated to products. In customer profitability analysis, indirect costs are allocated to customers.

3 Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing 8-3 E4. Variable Cost per Unit Contribution Margin per Unit Total Contribution Margin Fixed Price Quantity Costs Profit , ,000 80,000 29, , ,250 80,000 31, , ,400 80,000 30,400 A price of $5.95 yields the largest monthly profit. E5. Accepting the order will result in $110,000 of incremental profit. Incremental revenue $100 x 2,000 $ 200,000 Incremental costs: Material $25 x 2,000 $ 50,000 Labor $15 x 2,000 30,000 Variable overhead $5 x 2,000 10,000 90,000 Incremental profit $ 110,000 E6. a. Variable cost per unit $ 50 Fixed costs per unit (100,000 1,000) Markup of 20% 30 Price $ 180

4 8-4 Jiambalvo Managerial Accounting b. Variable cost per unit $ 50 Fixed costs per unit (100, ) Markup of 20% 50 Price $ 300 c. The company will not be able to sell 500 units at a price of $300. After all, the company could only sell 500 units at a price of $180. E7. a. The target cost per unit is $1,600 ($2,000.2 ($2,000)). b. If the product cannot be manufactured for $1,600, the company should consider increasing the price or modifying features so that the target cost can be achieved. E8. Sales $ 53,800 Less: Cost of good sold.9 x $53,800 $ 48,420 Order processing 200 x $5.00 1,000 Rush handling.6 x 200 x $8.50 1,020 Customer service 140 x $ ,400 Relationship management costs 2,000 53,840 Profitability of Johnson Brands account $ (40)

5 Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing 8-5 E9. a. Revenue Sales $ 53,800 Order processing fee 200 x $6 1,200 Rush order fee.6 x 200 x $10 1,200 Customer service fee 140 x $15 2,100 $ 58,300 Total revenue Less costs: Cost of good sold.9 x $53,800 $ 48,420 Order processing 200 x $5.00 1,000 Rush handling.6 x 200 x $8.50 1,020 Customer service 140 x $ ,400 Relationship management costs 2,000 53,840 Profitability of Johnson Brands account $ 4,460

6 8-6 Jiambalvo Managerial Accounting PROBLEMS P1. a. Price Quantity Variable Cost* CM/Unit Total CM Fixed Costs Profit , , , , , , , , , , , , , , , , , (30,600) 120,000 (150,600) * Equals 15% of price + $20 + $6 b. The profit maximizing price is $49.99, which yields a profit of $292,250. P2. This approach does not seem unethical. Consumers in certain zip codes are apparently willing to pay higher prices and the company is simply identifying them. Consumers who are in the same zip code but unwilling to pay the 3% higher prices are not forced to make purchases.

7 Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing 8-7 P3. a. Price of Rover Quantity of Rover Price of Royal Quantity of Royal Total Revenue 1 Cost of Rover 2 Cost of Royal 3 Profit , , , ,000 99, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,700 90, , , , , ,710 60, , , , , ,740 30, , ,740 N/A , , , , Revenue equals price of Rover times quantity of Rover plus price of Royal times quantity of Royal. 2. Cost of Rover equals $6 times quantity of Rover. 3. Cost of Royal equals $9 times quantity of Royal. 4. Profit equals total revenue minus cost of Rover minus cost of Royal. The profit maximizing price of RoverPlus is $ b. At the profit maximizing price, profit is $313,570. Without the RoverPlus brand, profit was $199,750. Thus, profit is $113,820 higher with RoverPlus.

8 8-8 Jiambalvo Managerial Accounting P4. a. Variable cost per unit $ 2,000 Fixed cost per unit ($10,000,000 5,000) 2,000 Total 4,000 Markup of 30% 1,200 Price $ 5,200 b. Price influences the quantity demanded, but the estimated quantity demanded is being used to determine the price! c. Variable cost per unit $ 2,000 Fixed cost per unit ($10,000,000 4,000) 2,500 Total 4,500 Markup of 30% 1,350 Price $ 5,850 d. The number of units sold will not equal 4,000 at a price of $5,850 since only 4,000 units were sold at a lower price of $5,200. e. To mark-up full cost, a manufacturing firm must first estimate the quantity that will be sold so that it can determine the fixed manufacturing cost per unit. But price influences the quantity that can be sold, so the process is inherently circular.

9 Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing 8-9 P5. a. Price $ 3,500 Desired profit of 25% 875 Target cost $ 2,625 b. $2,000 + ($1,500,000 x) = $2,625 x = 2,400 c. Price $ 3,000 Desired profit of 25% 750 Target cost $ 2,250 Variable cost per unit $ 1,400 Fixed cost per unit ($1,500,000 2,500) 600 Total 2,000 The revised target cost will be $2,250 and, after dropping the steam feature, the cost per unit will only be $2,000 (with sales of 2,500 units). Therefore, the company will be able to produce the item at less than the new target cost.

10 8-10 Jiambalvo Managerial Accounting P6. a. Cost per change order ($175, ) $ 250 Cost per return ($63, ) $ 75 Cost per design meeting hour ($60,000 1,200) $ 50 Indirect cost related to Orvieto job Change orders 20 x $250 $ 5,000 Returns 25 x $75 1,875 Design hours 30 x $50 1,500 Total $ 8,375 b. Lauden should consider adopting activity-based pricing and charging companies like Orvieto for the indirect costs it imposes.

11 Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing 8-11 P7. a. Mark-up of product cost and installer salary $208,000 Charges for indirect services Change orders 20 x $300 6,000 Charge for returns 25 x $100 2,500 Charge for design time 30 x $75 2,250 Total revenue and charges 218,750 Less costs Product costs 140,000 Installer salaries 20,000 Change orders 20 x $250 5,000 Returns 25 x $75 1,875 Design time 30 x $50 1,500 Total costs 168,375 Profit $ 50,375 b. Use of activity-based pricing will discourage customers from imposing indirect costs on the company. On the other hand, some customers may find the pay for service plan to be offensive (aren t we paying for service in the bid price?) and take their business elsewhere.