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20.3 The definition of the product and the market are vital to setting a price, as a company needs to strategically
position itself to appeal to the right customer group. If the strategy is to appeal to high-income consumers,
a price noticeably lower than the competitors in that market will suggest that this product is less desirable
for one reason or another (possibly because of the image of the consumer). On the other hand, a product
that has a reputation of being of lower quality will not sell if equivalent products in that market are lower
priced.
Defining the product or market is not as simple as it sounds. A market can be defined too narrowly or too
broadly. For example, a company that produces buttons may define the product and market as buttons
and closely watch the activities of other button manufacturers as they are the relevant competitors.
However, if the button manufacturer believes it is operating in the clothing fasteners market, then
competitors will also include manufacturers of zippers, velcro fasteners and other clothing fasteners.
Selling prices and marketing strategies will differ depending on which definition of market and product is
selected.
Discussions about this issue can consider the need to understand customer value as, defining the product
and the market are necessary when identifying who the customer is and what it is about the product that
makes it attractive to customers. It is important to consider customer value when setting prices to ensure
that the price is not higher than customers perceptions of the value of the product.
20.4 The Australian furniture industry has experienced fierce competition from furniture importers. The
furniture that is imported from Asia into Australia is usually cheaper than furniture manufactured in
Australia due to much lower wages in Asian countries. Some Australian manufacturers find that they have
to reduce prices to match the competition.
20.7 The reasons often cited for the widespread use of variable costing as the cost base in cost-plus formulas are
as follows:
(a) Variable cost data do not obscure the cost behaviour pattern by unitising fixed costs and making
them appear variable.
(b) Variable cost data do not require the allocation of fixed costs to individual product lines.
(c) Variable cost data are exactly the type of information managers need when facing certain tactical
short-term pricing decisions.
The primary disadvantage of variable cost is that in the long term price must be set to cover all costs and a
normal profit margin.
20.9 The markup percentage is different depending on which product costing definition (absorption or total
variable costs) is adopted. The markup percentage is calculated as sum of the target profit and the total
annual costs not included in the cost base (denominator of the equation) divided by the total product costs
(cost base) derived from the costing method.
20.10 Under time and material pricing, the price includes a price for labour and a price for material. The labour
price is based on time and is calculated as a cost per hour plus a charge to cover some overheads and a
profit margin. The material price is based on the material costs incurred on the job plus a charge to cover
material-related overheads. By separating the time-based elements of the cost from the material costs it is
possible to use the method in industries where the material charges vary across jobs. This method assumes
that resources other than materials are consumed relatively steadily over time and can be costed to the
output on the basis of time. The need for profit to be earned steadily over time leads to adopting the
approach of marking up the hourly rate to generate the required profit. It is used in industries such as
construction, printing, repairs, legal and accounting offices.
20.11 Traditional, volume-based product-costing systems often overcost high volume and relatively simple
products while undercosting low volume and complex products. This practice can result in overpricing
high-volume and relatively simple products and underpricing low volume and complex products. Such
strategic pricing errors can have a disastrous impact on a firms competitive position and profitability.
20.12 (a) Skimming pricing: setting the initial price for a new product high in order to reap high short-term
profits. Over time, the price is reduced gradually. One example is the pricing of new technology
products such as MP4 players, Blu-ray recorders and portable video recorders.
(b) Penetration pricing: setting the initial price for a new product low in order to quickly attract a large
market share. For example, admission prices to a newly opened museum or art gallery, subscription
prices for newly launched magazines.
20.15 Predatory pricing is a temporary cut in price to broaden demand for a product with the intention of later
restricting the supply and raising the price again. Resale price maintenance occurs when a supplier dictates
the minimum price at which a product or service is to be resold to a buyer or retailer.
20.16 The Australian Competition and Consumer Commission has wide-reaching responsibilities for surveillance
and enforcement of Commonwealth anti-competitive restrictive trade practices law and consumer law. In
regulating prices, there are certain practices that are restricted. These include the use of price-fixing
contracts, price discrimination and resale price maintenance.
For Qantas price fixing and cartels see: www.accc.gov.au/media-release/court-orders-qantas-to-pay-20-
million-for-price-fixing (viewed 1 February 2014).
For being guilty while ignorant of the law see: www.accc.gov.au/media-release/price-fixing-no-childs-play
(viewed 1 February 2014).
Students may need to be advised to access the ACCC web site and then put price fixing in the box in the
top right hand corner.
20.17 Short term product mix decisions involve changing the product mix temporarily, often because of some
constraint on the resources available, or because of unusual customer demands. A decision to be made in
situations where there is a resource shortage is based on using the scarce resource so that profitability is
maximised. This entails identifying the contribution per unit of scarce resource. Fluctuating customer
demands may create excess capacity for a brief period and the decision to utilise this for a one-off special
order may be based on exceeding the incremental cost of production (usually the variable cost only).
Long-term product mix decisions may entail whether new products should be adopted or existing products
discontinued. These decisions must consider costs that would have remained unchanged in the short term
product mix decisions. Fixed costs may change due to changing production requirements and there could
be an impact on market share. These issues must be considered when evaluating any investment required
to facilitate the long term change in mix.
20.18 The term contribution margin per unit of scarce resource is a products unit contribution margin divided by
the number of units of the scarce resource required to produce one unit of the product. For example, if a
products contribution margin per unit is $5 and it requires two hours of direct labour to produce one unit,
the contribution margin per direct labour hour is $2.50. In a short-term product mix decision, products are
produced in order of the highest contribution margin per unit of limited resource.
20.19 Linear programming (LP) is designed to help management to determine the optimum product mix that
would maximise the firms profit, where there are multiple limited resources. LP takes into account the
use that each product makes of each limited resource and considers the profitability of each product to
arrive at the optimum production mix.
20.20 Constraints: the limitations faced by an organisation, including limited production resources.
Decision variables: the variables about which a decision must be made.
Feasible region: the space between the axes and constraints within which lies the solution to a linear
programming problem.
Objective function: an algebraic expression of the firms goal that is used in linear programming.
These terms are used in linear programming. Linear programming is a method for identifying linear
relationships between decision variables to determine the optimal solution given a number of constraints.
Linear programming can be use to calculated the optimal product mix.
Quantity
produced and Average cost Total cost per Changes in
sold per month per unit month total cost
20 $450 $ 9 000
Dollars
40 425 17 000 } $ 8 000
Total cost } 7 600
60 410 24 600
} 9 800
80 430 34 400 } 10 100
Quantity s
Quantity Total
produced and Sales price revenue per Total cost per Profit per
sold per month per unit month month month
Total revenue
profit required to achieve target ROI + total annual costs not included in cost base
= annual volume cost base per unit used in cost - plus pricing formula
= 480 $400
= 152.08%
Thus, the Wave Darters price would be set equal to $1008.32, where $1008.32= $400 + ($400 1.5208).
2 Absorption cost:
$100 000 + total selling and administrative costs
Markup percentage = 480 $650 *
= $312 000
= 55.13% (rounded)
Thus, the Wave Darters price would be set equal to $1008.35*, where $1008.35= $650 + ($650 0.5513).
* the selling prices for parts 1 and 2 should be identical. The slight difference is due to rounding errors.
$495
Total unit cost = 1.125 = $440
Allocated fixed selling total unit all manufacturing variable selling and
=
and administrative cost cost costs administrative cost
= $44
* ($495 $275) $275 = 80%
($495 $330) $330 = 50%
b
($400 $270) $270 = 48.15% (rounded)
c
($400 $350) $350 = 14.29% (rounded)
d
($400 $230) $230 = 73.91% (rounded)
Sales commissions (60 000 $18.00 10%) 108 000 648 000
$30 000
= $3.00 per unit
10 000
Sales price required = unit variable cost + required unit
contribution margin
As an alternative approach, let X denote the price required in order to earn additional profit of $30 000 on
the special order:
West1 West2
Unit contribution margin $3.00 $12.00
Labour hours required per unit of product 0.0476 0.2857
Contribution margin per direct labour hour
West1: ($3.00 0. 0476) $62.03
West2: ($12.00 0. 2857) $ 42.00
Therefore, West1 is a more profitable product, since product West1 has the highest contribution margin per unit of
the scarce resource (direct labour hours).
EXERCISE 20.30 (20 minutes) (appendix) Linear programming; formulate and solve
graphically: manufacturer
Zanide Kreolite
Price $ 36 $ 42
Maximise 8X + 14Y
Subject to: 2X + 2Y 24
1X + 3Y 24
X, Y 0
25
20
15
Machine I constraint
10
Optimal solution (X = 6, Y = 6)
Objective function
Machine II constraint
5
Feasible region
X
5 10 15 20 25
X=0 Y=0 $ 0
X = 12 Y=0 96
The maximum objective function value is achieved when X = 6 and Y = 6. Thus, the company should
produce six drums of Zanide per day and six drums of Kreolite per day.
3 The objective function value at the optimal solution is a $132 total contribution margin as shown in
requirement 2.
$13 300
2 The price which Razzle could charge is $13 300, given that the Dry Master represents increased economic
value to the customer. Whether the firm will charge this price depends on the attitude of the customers
when comparing the new machine to the present market leader. It may be more appropriate to price the
Dry Master closer to the DryWell initially in order to prove itself under operating conditions and thereby
gain market acceptance.
The laundry owners are unlikely to buy the new machine unless the annual cost to own and operate it at
least equals that of the existing machine, even if it has one more year of useful life. The annual cost to own
and operate both machines can be shown below, with the figures for the Dry Master built up from the
bottom line of the DryWell.
12 200 15 525
This suggests that the laundry owner could pay a maximum price of $13 300 and still be as well off, given
the added functionality and the longer life of the proposed new machine.
3 The demand for these machines is derived; that is, the user is the real customer, not the owner of the coin-
operated laundry. The laundry owner may not care about softer, fluffier clothes, but may have to respond to
this requirement if enough of their customers raise it as an issue. The laundry owners may be more likely
to value the speed of the wash. Razzle should undertake further research to see how the laundry owner
values each of these two featuresalthough the laundry owner may not care about soft, fluffy clothes, the
faster speed may benefit the business through added capacity. More information about the operating costs
such as relative electricity usage may be useful.
Department I Department II
Variable overhead
budgeted overhead
budgeted direct labour hours
Predetermined overhead rate =
$1 125 000
= 75 000
2 Velvet Leather
3 Department I Department II
Manufacturing overhead:
Department I:
Velvet: 2 $18 36
Department II:
Velvet: 8 $12 96
Leather: 2 $12 24
5 Velvet Leather
6 The management of Stevenson Furniture should use departmental overhead rates. The overhead cost
structures in the two production departments are quite different, and departmental rates more accurately
assign overhead costs to products. When the company used a plantwide overhead rate, the Velvet model
were overcosted and the Leather model were undercosted. This in turn resulted in the Velvet model being
overpriced and the Leather model being underpriced. The cost and price distortion resulted from the
following facts: (1) the Velvet model spends most of its production time in Department II, which is the
least costly of the two departments; and (2) the Leather model spends most of its production time in
Department I, which is more costly than Department II.
Material cost material cost annual materia l handling and storage costs
incurred on job incurred on job annual cost of materials used
$62 500
1
= Material cost incurred on the job x $625 000
2 Price quotation
3 Price of job without markup on material costs (from requirement 2) $ 194 000
= 500 DLH
Traceable out-of-pocket costs:
Direct labour ($24.00 500) $ 12 000
$20 000
2 As in requirement 1 500 direct labour hours are required for the job.
$34 500
1 000 000 doses
=
= $0.0345 per dose
3 If the price calculated by Halifax Pharmaceuticals is greater than $0.03, some factors that Halifaxs
management should consider before deciding whether or not to submit a bid at the maximum allowable
price of $0.03 include:
whether Halifax Pharmaceuticals has spare capacity
whether there are other more profitable jobs that might use the spare capacity
whether the maximum bid of $0.03 contributes toward covering fixed costs (in this particular case
the contribution margin per dose would be $(0.03 0.02), which gives a total contribution margin
of $10 000)
the possible impact on existing customers who may be charged a higher selling price
budgeted overhead
* Variable overhead rate =
budgeted direct labour hours
$1 944 000
=
(12x15 000) DLHrs
* Based on an analysis of the year just ended, variable overhead is 30 per cent of direct labour ($1125 $3750).
For Holistics Pizzas order: Direct labour cost 0.30 = $28 000 0.30 = $8 400.
2 Yes. Although this amount is below the $82 500 full-cost price, the order is still profitable. Harmon can
afford to pick up some additional business, because the company is operating at 75 per cent of practical
capacity.
Note that the fixed manufacturing overhead and fixed corporate administration costs are not relevant in this
decision, because these amounts will remain the same regardless of whether the order proceeds.
DATA INPUT
['000s]
Costs:
(a) If the bid price is accepted, this order would boost Harmons net income by $14 016:
Net loss per machine hour if component B18 is purchased = $6.00/3 machine hours = $2.00 per machine
hour
B12 B18
2
$ $
Purchase price quoted 22.50 27.00
Direct material 4.50 7.50
Direct labour 8.00 9.00
Variable overhead 4.00 4.50
Total variable cost 16.50 21.00
Net benefit per unit of making component 6.00 6.00
Machine hours required per unit 2.5 3
Net benefit per machine hour of making component 2.40 2.00
Conclusion: purchase 4000 units of component B18 and manufacture the remaining bearings. The answer
to requirement 2 is d.
Department
Product 1 2 3 4
Department
Product 1 2 3 4
The monthly sales demand cannot be met for all three products as a result of the labour shortage in
Department 3.
Product
Variable costs
Direct labour 66 38 51
Variable overhead 27 20 25
Variable selling 3 2 4
Contribution
Contribution Department 3 margin
Product margin DLH per DLH
B19 70 2 35
Department 3
DLH
Units required Balance (DLH)
M07 250 Produce as much as the constraint allows (750 3 DLH per
unit). Reduced production is based on its lower contribution
margin per direct-labour hour.
3 To supply the additional quantities of M07 that are required, EFM should consider:
subcontracting the additional units
operating on an overtime basis
acquiring labour from outside the community.
2 The sales volume of the Economy model must increase by at least 1 920 000 units in order to offset the
cost of increased advertising, as shown in the following calculations:
Breakeven sales = $320 000 [($6 $3 $2) $6] = $320 000 .166666667 = 1 920 000 units.
3 Mammoth should advertise the more profitable model or the Economy model to maximise its profitability.
The most profitable product is the one that yields the highest contribution margin per unit of the scarce
resource, machine hours. The Economy model gives higher contribution margin per machine hour, as
shown below:
Classic Economy
Unit contribution margin $2.00 $1.00
Machine hours required per unit of product 0.75 0.2
(Fixed manufacturing cost/$2 per machine hour)
Contribution margin per machine hour
Classic: ($2.00 0.75) $2.66667
Economy: ($1.00 0.2) $5.00
The estimated increase in total contribution margin if all production were dedicated to producing the
Economy model instead of Classic model would be $266 667 (rounded), as shown below.
Increase in contribution margin = $5 100 000 machine hours $2.66667 100 000 machine hours
= $500 000 $266 667
= $233 333 (rounded)
Mammoth should advertise the more profitable model or the Economy model to maximise its profitability. The
most profitable product is the one that yields the highest contribution margin per unit of the scarce resource,
which is the machine hour. The economy model gives a higher contribution margin per machine hour.
4 The calculations in above requirements do not provide sufficient information to make an informed
decision. Additional information could include the following:
customer demand for both products
impact on customer demand if no classic pens are produced
customer preferences in the new private sector school market
the effectiveness of different forms of marketing
the market share of each product.
2 The number of batches of each bar that should be produced to maximise contribution can be determined by
graphing the linear program, as shown below. The optimal solution is to produce 200 batches of Moon bars
and 150 batches of Star bars.
3 The total contribution margin, then, is $110 000 [(200 $250) + (150 $400)].
Graph of linear program:
Haute Cuisine
70
60 Preparation constraint
Objective function
50
40
30
20
Feasible
region
10
Cooking
constraint
Premier
Cuisine
0 10 20 30 40 50 60
Haute Cuisine
70
Objective function
60
50
Cooking
constraint
40
Freezing
constraint
30
20
Optimal solution
Feasible (P = 45, H = 10)
region
10
Premier
Cuisine
0 10 20 30 40 50 60
(a) Contribution analysis for separate pricing (estimated hotel registrations = 60% 2 000 = 1 200)
Estimated
Function Attendance Revenue Expense Contribution
Registration 100% 2 000 = 2 000 $1 000 000 $0 $1 000 000
Reception 100% 2 000 = 2 000 0 300 000 (300 000)
Plenary address* 100% 2 000 = 2 000 0 0* 0
Keynote luncheon 90% 2 000 = 1 800 144 000 108 000 36 000
Six concurrent sessions* 70% 2 000 = 1 400 112 000 0* 112 000
Plenary session* 70% 2 000 = 1 400 84 000 0* 84 000
Six workshops 50% 2 000 = 1 000 100 000 0* 100 000
Banquet 90% 2 000 = 1 800 $270 000 $216 000 $54 000
* Meeting rooms and halls are free when 1000 members register at the hotel.
Reflects 20% discount: ($160 3 days) .80 = $384
1 The lowest price Swift would bid for a one-time special order of 25 000 kg (25 batches) would be $51 325,
which is equal to the incremental costs of producing the order, calculated as follows.
Direct materials:
On a one-time-only special order, chemicals used in manufacturing the firms main product have a
relevant cost of their expected future cost, represented by the current market price per kilogram.
Chemicals not used in current production, which have no other use, have a relevant cost that is their
salvage value to the firm.
CW-3: (400 kg per batch) (25 batches) = 10 000 kg.
Substitute CN-5 on a one-for-one basis to its total of 5500 kg.
The relevant cost is the salvage value. $1 000
The remaining 4500 kg would be CW-3 at a relevant cost of
$.90 per kgits expected future cost. 4 050
JX-6:(300 kg per batch) (25 batches) = 7500 kg at $0.60 per kg 4 500
MZ-8(200 kg per batch) (25 batches) = 5000 kg at $1.60 per kg 8 000
BE-7: (100 kg per batch) (25 batches) = 2500 kg.
The relevant cost per kg is $0.65 $0.20 (handling charge) = $0.45
the amount Swift could realise by selling BE-7. 1 125
Total direct materials cost $18 675
Direct labour:
(60 DLH per batch) (25 batches) = 1500 direct labour hours.
Because only 800 hours can be scheduled during regular time this month, overtime would have to
be used for the remaining 700 hours; therefore, overtime is a relevant cost of this order.
(1500 DLH) ($14.00 per DLH) $21 000
(700 DLH) ($7.00 per DLH) 4 900
Total direct labour cost $25 900
Overhead:
This special order will not increase fixed overhead costs. Therefore, fixed overhead is not relevant,
and the relevant overhead charge is the variable overhead rate, as follows:
(1500 DLH) ($4.50 per DLH)= 6 750
Total cost of special order $51 325
3 The owner of Taylor Nursery is not acting ethically in this situation. It is inappropriate to allow Swift to
revise its bid on the basis of sharing confidential information from the Dalton Industries bid. All firms
competing for the Taylor Nursery contract should be given the same product specifications, information,
and time frame with which to prepare a bid.
Purchased Manufactured
Less:
Tackle boxes:
Skateboards:
In calculating the contribution margin, $6.00 of fixed overhead cost per unit for distribution
must be deducted from the selling and administrative cost.
The optimal use of Sportway Corporations scarce resource (direct labour) is to manufacture skateboards,
up to the number of skateboards that the company can sell (17 500). With its remaining labour time,
Sportway can produce 1000 tackle boxes.
Less: