Chapter 13 Pricing Decisions - s3.amazonaws.coms3.amazonaws.com/prealliance_oneclass_sample/ZRz4GVroWJ.pdfThese learning objectives (LO1 through LO8) ... products is $13 per unit,

Chapter 13: Pricing Decisions 65

Chapter 13Pricing Decisions

LEARNING OBJECTIVES

Chapter 13 addresses the following objectives:

LO1 Compare the different pricing methods and calculate prices using each method.LO2 Discuss other market-based sources of pricing information.LO3 Explain the uses and limitations of cost-based and market-based pricing.LO4 Explain price elasticity of demand and its impact on pricing.LO5 Discuss the additional factors that affect price.LO6 Compare the different pricing methods used for transferring goods and services within an

organization.LO7 Discuss the uses and limitations of different transfer pricing methods.LO8 Discuss additional factors that affect transfer prices.

These learning objectives (LO1 through LO8) are cross-referenced in the textbook to individual exercises and problems.

© 2012 John Wiley and Sons Canada, Ltd.

66 Cost Management

QUESTIONS

13.1 Factors to be considered when determining the selling price of a product include: cost, competition, and customers. Cost-based prices are determined by adding a mark-up to some calculation of the product’s cost. The cost base can be calculated in several ways such as variable costing absorption costing, or total costing. Market-based prices are determined using some measure of customer demand. Managers strive to identify what customers are willing to pay for the good or service. Market prices are affected by product differentiation and the degree of competition. The price elasticity of demand is another factor of pricing that must be considered. As prices change demand and the volume of sales will change, affecting the profit that will be realized from the price.

13.2 Cost-based pricing is performed by adding a mark-up to some measure of product cost, such as variable costs or a partially or fully allocated cost. For example, if a computer’s variable costs were $300 and the required mark-up 100%, the price would be $600 ($300 + 100%*$300).

13.3 Market based prices are determined using some measure of customer demand. Managers identify the amount that customers are willing to pay for a good or service and set the price at that amount. With historical information about prices and quantities sold, the price elasticity of demand formula can be used to determine a profit-maximizing price. Market research could be conducted and competitors’ prices could be analyzed. The Internet is also a source for pricing information.

13.4 This problem is called the death spiral because as demand falls, average costs increase because fewer units are produced. This means that price will increase because it is based on average cost. When price increases, demand usually falls, so production will also fall, and average cost will increase, causing prices to increase, causing demand to fall, and finally the company goes out of business.

13.5 Calculation of a mark-up percentage using variable costing as the cost base starts with determining the desired return on investment plus fixed costs. This amount is then divided by the variable cost per unit times the annual volume to determine the mark-up percentage. Calculation of a mark-up percentage using absorption costing as the cost base starts with the desired return on investment plus selling and administrative costs. This amount is then divided by the absorption cost per unit times the annual volume. The difference in these two formulas is that under absorption costing the fixed costs of both production, selling, and administration are all included in the absorption cost per unit and therefore are not used in the numerator value.

13.6 Not-for-profit organizations often receive donations and grants to help off-set operating costs. Therefore they do not have to set prices so that their operating costs are recovered. They have other organizational objectives, such as providing services to low-income people. Hence they may set prices using a sliding scale according to ability to pay. They may not charge for some products or services.



13.7 The componentsof a time and materials bill are a labour rate and a materials loading charge, respectively. The labour rate includes 1) direct labour salaries plus benefits, 2) selling and administrative costs and related overhead costs, and 3) a desired profit amount. The materials loading charge includes 1) all costs associated with purchasing, receiving, handling, and storing materials; and 2) a desired profit percentage.

13.8 From the overall organization’s point of view, it does not matter which branch pays for shipping. However, if each branch is held responsible for their own costs, each would prefer to have the other one pay for shipping charges because costs in the paying branch will be increased.

13.9 Advantages of decentralization for this company: Because expansion is into other countries, decision making will be timelier and probably more appropriate because local managers understand the local markets. The need to communicate detailed information up and down the organization will be reduced. The people making the decisions have the most knowledge and expertise.

Disadvantages: The decision makers may have objectives that are different from the overall company’s objectives. Decisions need to be coordinated among all of the divisions to reduce non-optimal behaviour such as duplication of products or services. Investment in new projects may not reflect the best opportunities, but instead reflect the most persuasive decision maker.

13.10 A suboptimal decision is one in which the overall organization does not receive as high a contribution as is possible. If it is cheaper to produce the product or service internally, but the transfer price is set so that the incentive is to purchase externally, more is being paid for the good or service than should be, and a suboptimal decision has been made.

13.11 Transfer prices can be set based on cost (variable, variable plus some fixed costs, or variable and a fully allocated fixed cost), or based on market price for the good or service (and there may be a variety of ways to estimate the market price). Alternatively, transfer prices can be negotiated between two divisions. The seller could receive market price and the buyer could receive variable cost under a dual-rate method. Lastly, an organization could decide not to charge for transfers.

13.12 Income tax regulations are often concerned with ensuring the adequacy of taxes paid to the local country for international transactions. The CRA in Canada requires arm’s length transfer prices (market prices). This limits the kinds of transfer prices that can be set for income tax accounting. However, companies do not necessarily use the same transfer prices for income taxes and for other purposes such as internal performance measurement.

13.13 For organizations that do business internationally, the taxable location of profit is affected by transfer price policies. To restrict firms’ ability to shift income from a high-tax to a low-tax country the Canadian government enacted legislation to regulate transfer prices.


68 Cost Management

MULTIPLE-CHOICE QUESTIONS

13.14 WWL Ltd. has a target before-tax profit of $200,000. At the planned sales volume for each of its products, the variable and fixed costs are $2,000,000 and $400,000, respectively. All fixed costs are common to all products. If the selling price of one of the products is $13 per unit, and the unit has allocated to it fixed costs of $2 per unit, what is the target variable cost (to the nearest cent) to make its average mark-up over full costs?a ) $9.00b) $9.80c) $10.00d) $10.15

Ans: C Markup on total costs. OC $200,000 + FC400,000 = CM $600,000CM $600,000 + VC $2,000,000 = Sales $2,600,000Sales/ total costs = markup; $2,600,000 / ($400,000 + $2,000,000) = 1.0833Product USP $13 = 1.08333 * (VC + FC)$13 = 1.08333 * (VC + $2.00)$13 = 1.08333VC + $2.1666$13 - $2.1666 = 1.08333VCVC = $10.8334/1.08333 = 10.0001

13.15 Clay Cookery produces ceramic cookware. Variable costs include clay and glazes for each crock andselling expenses. Fixed costs include salaries for potters and the necessary equipment to producethe cookware. There are also fixed marketing and administrative costs. Clay Cookery’s owner has$80,000 invested in the business and desires an 8% return on his investment. Clay Cookery sells3,650 crocks per year.

Product CostsVariable $4.50 per crockFixed $78,000 per year

Selling, Marketing and Administrative CostsVariable $3.00 per crockFixed $15,000 per year

Using the absorption approach to cost-based pricing, what are the mark-up percentage and the selling price?

Mark-up percentage Selling pricea) 5.32% $34.73b) 34.26% $34.73c) 27.48% $32.98d) 363% $34.73

Ans: B

$25.87 *(1+0.3426) = $34.73© 2012 John Wiley and Sons Canada, Ltd.

($80,000 * .08) + $15,000 + ($3.00 * 3,650) = 34.26%

$78,000 + ($4.50 * 3,650)


13.16 Based on the information in multiple choiceproblem 13.15, calculate the mark-up percentageand selling price assuming that Clay Cookery usesvariable cost-based pricing.Mark-up percentage Selling price

a) 5.32% $34.73b) 34.26% $34.73c) 27.48% $32.98d) 363% $34.73

Ans: D. ($80000 * .08) + $78000 + $15000

=3.63 = 363%($4.50 + $3.00) * 3650

$7.50 *(1+3.63) = $34.73

13.17 Road Runners is a bike sales and service shop. The service division uses a time and material billingpolicy. Based on the following costs and desiredprofits, calculate the hourly rate for labour and thematerial loading charge for Road Runners assumingthat the service technicians work 2,960 hours peryear and invoice costs total $ 64,000 per year.Round to two decimal places.

Labour MaterialsTechnicians’ salaries $74,000Office supplies $3,000 $8,000Parts $24,000Overhead on equipment $5,000Advertising costs $3,000Desired profit $7 per hour 15%

Hourly labour rate Materials loading chargea) $28.72 15%b) $28.72 50%c) $35.72 65%d) $35.72 50%

Ans: CTotal labour cost = $74,000 + $3,000 + $5,000 + $3,000 = $85,000$85,000/ 2,960 hrs = $28.72 labour cost per hour$28.72 cost per hour + $7 profit per hour = $35.72 total hourly rate for labour

[($8,000 + $24,000) / $64,000 per year]+ 15% profit= 0.5 + 0.15 = 65%


70 Cost Management

13.18 Ruce Ltd. has two manufacturing divisions, located in the same plant. Division X is evaluated as a cost centre and Division Y is evaluated as a profit centre.

Division X produces component X98 at a budgeted full cost of $108 per unit, of which $100 represents variable costs. Currently, Division X is operating at full capacity and transfers all of its output to the sales division at $108 per unit. The sales division sells component X98 to external customers for $133 per unit; it incurs variable costs of $9 per unit to sell the component.

Division Y purchases a component similar to X98 from an outside supplier for $125/unit plus a $2 per unit delivery charge. Ruce Ltd.’s production engineers have determined that component X98 could be used by Division Y with no adverse effects on the quality of the final product. Assume that no selling or delivery expenses would be incurred for internal transfers. What is the highest transfer price per unit that Division Y should be willing to accept for component X98?

a) $133b) $124c) $125d) $108e) $127

Ans: E Division Y current cost is $125 + $2 = $127 so that is the highest they would pay.



EXERCISES

13.19 Cost-Based Pricing – Designs by Breanne

A. Determine the mark-up percentage using

1. Absorption cost-based pricing

Mark-up percentage = Desired return on investment + Selling and administrative costsAbsorption cost per unit * Annual volume

($65,000 *0.12) + [$50,000 + ($45 * 3,000)] + $2,500 + ($15 * 3,000) = 58.04%$39,000 + ($125 * 3,000)

2. Variable cost-based pricing

Mark-up percentage = Desired return on investment + Fixed costsVariable cost per unit * Annual volume

($65,000 *0.12) + $50,000 + $39,000 + $2,500 =($45 + $125 + $15) * 3,000

$7,800 + $50,000 + $39,000 + $2,500

=

$99,300

= 0.1789 = 17.89%$185 * 3,000 $555,00

0

3. Total cost-based pricing

Mark-up percentage = Desired return on investmentTotal cost per unit * Annual volume

$65,000 *0.12=$50,000 + $39,000 + $2,500 + ($185 *

3,000)


$7,800= 0.0121 = 1.21%$646,50

0

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B. Determine the selling price for each mark-up percentage calculated in Part A.

Absorption cost-based pricing Selling price = Absorption costs + (Absorption costs * Mark-up %)[$125 + ($39,000 / 3,000)] *(1 + 0.5804) = $218.10

Variable cost-based pricing Selling price = Variable costs + (Variable costs * Mark-up %)$185 *(1 + 0.1789) = $218.10

Total cost-based pricingSelling price = Total costs + (Total costs * Mark-up %)[$185 + ($91,500/3,000)] *(1 + 0.0121) = $218.11

Differences in the above calculations are due to rounding

C. Discuss the other factors that Breanne must consider when setting her selling prices:

• Customers: demand, price sensitivity, expectations• Competition: existence & price

13.20 Cost-Based Pricing – Wagon Wheels

A. Determine the mark-up percentage using

1. Absorption cost-based pricing

Mark-up percentage = Desired return on investment + Selling and administrative costsAbsorption cost per unit * Annual volume

($55,000 *0.15) + [$30,000 + $4,000 + $2,400 + ($3.50 * 7,200)] =

$240,000 +$850 + [($1.50 + $45) * 7,200]

$69,850= 0.1213 = 12.13%

$575,650

2. Variable cost-based pricing

Mark-up percentage = Desired return on investment + Fixed costsVariable cost per unit * Annual volume

($55,000 *0.15) + $240,000 + $30,000 + $4,000 + $2,400 + $850=

($45 + $3.50 + $1.50) * 7,200© 2012 John Wiley and Sons Canada, Ltd.


$285,500= 0.7931 = 79.31%

$360,000

3. Total cost-based pricing

Mark-up percentage = Desired return on investmentTotal cost per unit * Annual volume

($55,000 *0.15)=

$8,250= 0.0129 = 1.29%$277,250 + ($50 ×

7,200)$637,350

B. Determine the selling price for each mark-up percentage calculated in Part 1.Absorption cost-based pricingSelling price = Absorption costs + (Absorption costs * Mark-up %)($45 + $1.50 + ($850/7,200) + $240,000/7,200) * (1 + 0.1213) = $79.95 * 1.1213 = $89.65

Variable cost-based pricingSelling price = Variable costs + (Variable costs * Mark-up %)($45 + $3.50 + $1.50) * (1 + 0.7031)$50 * 1.7931 = $89.66

Total cost-based pricingSelling price = Total costs + (Total costs * Mark-up %)[$50 + ($277,250/7,200)] * (1 + .0129)$88.51 * 1.0129 = $89.65

Differences in the above calculations are due to rounding

C. Discuss the other factors that Wagon Wheels must consider when setting her selling prices.

• Customers: demand, price sensitivity, expectations• Competition: existence & price

13.21 Time and Materials Pricing – Happy Homes

A. Calculate the labour rate that Happy Homes uses

Maids’ salaries $60,000Office supplies 18,000Overhead on equipment 5,000Advertising costs 3,000 Total labour costs $86,000


74 Cost Management

Labour cost / hour $86,000 / 4,000hours = $21.50Desired profit 10 .00 Labour rate $31 .50

B. Calculate the materials loading charge for Happy Homes

Office supplies $18,000Supplies 24,000Total material costs $42,000

Material costs $42,000 /$200,000 invoice costs= 0.21= 21%Profit margin 20 % Materials loading charge 41 %

C. Cathy’s bi-weekly bill

Labour 2 maids * 4 hours = 8 hours * $31.50 $252.00MaterialsFlowers $55 *1.41 77 .55

$329 .55

13.22 Activity Based Costing and Price Setting – Dundas Company

Direct materials $ 140Machine set up ($180 * 3 /60) 9Materials handling ($15 * 35) 525Milling ($50 * 6) 300Assembly ($30 * 4) 120Manufacturing cost per unit $1,094

Price to achieve gross margin of 35% the price per unit should be= $1,094/0.65 = $1,683 (rounded).



13.23 Market-Based Price (Elasticity Formula) - Lickety Split

Percent change in price = ($1.93 - $1.75)/$1.75 = +10%Percent change in demand = (1,000 – 850)/1,000 = –15%

The elasticity is ln (1 + percent change in quantity sold)/ln(1+percent change in price)= ln(1–0.15)/ln(1+0.1)= –0.16252/0.09531 = –1.705

Variable cost = $640/1,000 = $0.64

Profit-maximizing price = [–1.705/(–1.705+1)]*$0.64 = $1.55

To maximize profits, the manager needs to lower the price rather than increase it.

13.24 Market-Based Prices (Elasticity Formula) - Paulo’s Flowers

A. The elasticity is ln(1+0.35)/ln(1–0.20)= 0.30010/–0.22314 = –1.345

Mark-up = [–1.345/(–1.345+1)] – 1 = 2.899, or 2.9

Variable cost = $0.40

Price = (2.9 * $0.40) + 0.40 = $1.56OrPrice = [–1.345/(–1.345+1)] *$0.40 = $1.56

B. The elasticity is ln(1–0.12)/ln(1+0.10)= –0.12783/0.09531 = –1.341

Mark-up = [–1.341/(–1.341+1)] – 1 = 2.93

The formulas indicate that he should increase his current mark-up, to nearly 300%. However, these formulas are very sensitive to errors in the estimates of price and quantity changes, so they should be used only as guidelines. He can slowly begin increasing the mark-up until he reaches the point where contribution margin times quantity sold maximizes his profits.

13.25 Market-Based Price (Elasticity Formula), Uncertainties, Other Pricing Factors – La Cabane à Sucre

A. Elasticity = ln(1+0.20)/ln(1-0.10)= 0.18232/–0.10536 = –1.730


76 Cost Management

B. Variable cost = $2,400/1,500 = $1.60

Profit maximizing price = [–1.730/(–1.730+1)] * $1.60 = $3.79

C. She should drop the price, but in slow increments to determine the point at which the contribution margin * quantity sold maximizes profits.

D. The following factors could affect her price decision:

• Any constraints in the resources and capacity she has available• Competitor’s actions• General economic factors, if the economy is down, she may need to lower her

price• Weather affects the number of customers and she may need to run sales during

slow times to move inventory and ingredients that have a short shelf life.

13.26 Market-Based (Elasticity Formula) and Cost-Based Prices, Special Order Decision – Malpeque Bayview

[Note: This problem requires knowledge of special order decisions (Chapter 4).]

A. Elasticity = ln(1–0.15)/ln(1+0.10)= –0.16252/0.09531 = –1.705

Variable cost = $120,000/2,000 = $60

Profit maximizing price = [–1.705/(–1.705+1)]* $60 = $145 per case

B. The minimum price for a special order decision is variable cost, so it is $60 for Malpeque Bayview.

C. Linda must be sure that there are no constraints on the amount of oysters available at this time. She also needs to know whether there would be any increase in wages or fixed costs if she adds more capacity. She needs to know whether other customers might find out about this price and demand lower prices. Students may think of other relevant factors.

13.27 Transfer Prices – ED Electronics

A. The part division is operating at full capacity and the minimum transfer price that the manager would be willing to accept is the market price of $75.

B. The maximum transfer price should be $75. If the transfer price is more than $75, the manager would be better off buying the component from an external supplier. Moreover,



with a transfer price of $75 the incremental cost of each device would be $350, which is less than $425, the price offered by the wholesaler for each unit of the device.

C. No, because the part division is operating at full capacity and it can sell part X22 at the current market price of $75 and, in that case, the bit division will have to buy part X22 on the market at the same price. The company should be indifferent between the two possibilities.

D. If the part division is not operating at full capacity, it would be beneficial for the company to transfer at full cost. If the transfer is not taking place, then the part division would not be able to sell the 500 units on the market and the bit division would have to buy them from an external supplier at $75 per unit, which is greater than the full cost of $50 and even greater than the variable costs, which are the only relevant costs in this case.

13.28 Transfer Prices – Wood Inc.

A. For the company as a whole:

Contribution margin from selling 10,000 logs to external customers:[$75 – ($40.50 + $9.50)] × 10,000 = $250,000

Contribution margin from selling 10,000 units of Pole-S:[$122.00 – ($40.50 + $9.50) – ($35.00 + $4.50 + $2.50)] × 10,000 = $300,000

The contribution margin is $50,000 higher if logs are transferred from the Harvesting Division to theSawing Division. Wood Inc. would be better off transferring the logs.

B. The transfer of logs at $61.50 will have the effect of transferring profits from the Harvesting Divisionto the Sawing Division. As the two divisions are evaluated as profit centres, the manager of theHarvesting Division will be penalized while the manager of the Sawing Division will benefit.

C. The minimum transfer price is equal to the variable costs of the Harvesting Division, which is equal to$50. The maximum transfer price is equal to the market price of $75 per log. The market price of $75is the appropriate transfer price because the Harvesting division is operating at full capacity


78 Cost Management

13.29 ROI, Transfer Prices, Taxes, Employee Motivation – Fowler Electronics

A. ROI if the screens are transferred at variable cost:

Windsor DetroitRevenue (10,000 x $2,500) $25,000,000Variable production costs:

(10,000 x $350) $(3,500,000)(10,000 x $110) (1,100,000)

Fixed production costs (2,000,000) (4,000,000)Transfer price (10,000 x $350) 3,500,000 (3,500,000)

Pre-tax income (loss) (2,000,000) 16,400,000Income taxes (a) 0 (7,380,000)

Net income (loss) $(2,000,000) $ 9,020,000

Total assets $20,000,000 $30,000,000

ROI (Net income / Investment) (10)% 30%

(a) Income tax calculations:The Windsor plant has a loss. The problem provides no information about whether Canadian tax law allows companies to carry losses back against prior income or forward against future income. However, if the Windsor plant does not sell to outside customers, then it might always incur a loss if variable cost is used as the transfer price. Therefore, the income tax effect is estimated as zero.

Tax for Detroit plant = $16,400,000 x 45% = $7,380,000

B. ROI if the screens are transferred at market price:

Windsor DetroitRevenue (10,000 x $2,500) $25,000,000Variable production costs:

(10,000 x $350) $(3,500,000)(10,000 x $110) (1,100,000)

Fixed production costs (2,000,000) (4,000,000)Transfer price (10,000 x $750) 7,500,000 (7,500,000)

Pre-tax income (loss) 2,000,000 12,400,000Income taxes (a) (600,000) (5,580,000)

Net income (loss) $ 1,400,000 $ 6,820,000

Total assets $20,000,000 $30,000,000

ROI (Net income / Investment) 7% 23%



(a) Income tax calculations:Tax for Windsor plant: $2,000,000 x 30% = $600,000Tax for Detroit plant = $12,400,000 x 45% = $5,580,000

C. The firm will prefer the market transfer price because it maximizes company income. Total income is increased through tax rate differences between Canada and the United States. In addition, if variable costs are used, then there is a tax loss in Canada for which no tax benefit is received. The net tax advantage of using market value for the transfer price is:

Taxes if transfer price is the variable cost:Windsor $ 0Detroit 7,380,000

Total $7,380,000Taxes if transfer price is the market value:

Windsor $ 600,000Detroit 5,580,000

Total 6,180,000Difference $1,200,000

D. The Windsor plant manager will prefer to transfer at the market price, and the Detroit plant manager will prefer variable cost because these transfer prices make their operations look best.

E. Use of either the dual rate or the negotiation method would give managers the information they need to make the best decisions for the overall corporation. A problem with the dual rate method is that both plants appear to be more profitable than they really are. A problem with negotiating is that manager time can be tied up on activities that do not necessarily add value to the overall firm.

13.30 Choice of Transfer Price – Hand Held

A. The contribution margin is $8 for the Cell Phone Division, so they will only be willing to pay what they pay now ($12) plus up to $8 more for $20, although they may not want to assemble the cell phones at break even.

B. The transfer price that would be best for the company as a whole is $24, the market price. If market price is used for the transfer price, units will always be sold externally instead of internally.

C. If the Chip Division has plenty of excess capacity, the transfer price should be the variable cost because the Chip Division could not sell the chips otherwise.


80 Cost Management

13.31 Minimum Transfer Price, Capacity, Contribution Margins – Nexa’s

A. At capacity, Division A will only sell at the market price of $200

B. If there is excess capacity, Division A has no demand for the units so the minimum transfer price would be Division A’s variable cost of $100

C. If there is excess capacity and Division B buys externally, the firm makes $80,000 less:1,000 units × ($100 Division A variable cost – $180 for outside supplier) = $(80,000)

D. If Division A is forced to sell to B when there is no excess capacity, the contribution margin is:

1,000 units × ($600 Division B selling price – $200 Division B variable cost – $100 Division A variable cost) = $300,000

E. If Division A is at capacity, Division A sells 1,000 units on the external market, and Division B purchases from an outside supplier, the contribution margin is:

Division A contribution margin [($200-$100) × 1,000 units] $100,000Division B contribution margin [($600-$200-$180) × 1,000 units] 220,000

Total contribution margin $320,000

F. The more profitable course of action depends on whether Division A is operating at capacity selling to outside customers. As calculated in Part C, the company is better off by $80,000 if Division A sells to Division B when there is excess capacity. If there is no excess capacity, the calculations in Parts D and E show that company is better off by $320,000 – $300,000 = $20,000 if Division A sells to outside customers and Division B purchases from an outside supplier.

G. If there is no outside supplier for Division B, the best course of action depends on the companywide contribution margin per unit under each option:

If units are sold by Division A: ($200 – $100) = $100 per unit

If units are sold by Division B: ($600–$200–$100) = $300 per unit

Because the companywide contribution margin per unit would be higher for units sold by Division B, the company would be better off for Division A to sell internally.

13.32 Transfer Price, Sale to Outside Versus Inside Customer – Carlyle Corporation

There are several ways to solve this problem. Here is one approach:

First, consider the per-unit differences in cost and revenue for the two options. Ajax’s variable cost per unit is $900,000 / 20,000 units = $45 VC per unit. If Ajax sells to



outsiders at $75 per unit, the contribution margin is $30 to Ajax, so its gross margin improves by $600,000 ($30 x 20,000 units).

If Bradley replaces Ajax’s units with $85 units from an outside supplier, the total cost per unit to the company is $55 ($85 cost from outside vendor less the $30 contribution margin from Ajax’s outside customer). The variable cost of these units is $45 each, so Carlyle’s gross margin is maximized only by transferring the units internally at a savings of $10 per unit.

Here is another approach:

Notice that none of Ajax division’s costs will change if it accepts the new opportunity; the division will continue to operate at full capacity. The only change in its gross margin will be the difference in revenue:

Revenue from new customer (20,000 x $75) $1,500,000Current revenue from Bradley division 900,000

Increase in revenue $ 600,000

Based on the preceding calculation, the Ajax division will be better off if it accepts the new order.

However, the company as a whole will not be better off. The company will receive outside revenue of $75 per unit and it will pay an outside supplier $85 per unit, for a net decrease in gross margin of $10 per unit.

PROBLEMS

13.33 Cost-Based and Market-Based Pricing, Elasticity, Uncertainties, Economy Effects - Heritage Jewellery Store

A. John is probably influenced by traditional pricing methods in this industry. The mark-ups may be published in industry trade journals and John knows that his competitors are using similar methods and so feels comfortable using this method.

B. Elasticity is the sensitivity of demand to changes in price. The demand for some products is greatly affected by any change in price. For example, commodities prices are published daily. Demand for these products is considered very elastic (very responsive to price changes). For other products, changes in price lead to little change in demand. For example, demand for expensive cars such as a Rolls Royce or Lotus is inelastic; it is not very responsive to small changes in price.

C. When prices increase, consumers will not buy products for which demand is very elastic. For example, if frost has damaged this year’s asparagus crop and the price increases, consumers will substitute other vegetables for asparagus and demand will decrease.


82 Cost Management

However, if the weather is perfect for asparagus and the crop is large, prices decrease and demand increases because consumers buy asparagus instead of other vegetables that are similarly priced.

D. If John has not tracked sales and prices over the years, he does not have accurate data with which to use in the elasticity formulas. Therefore he cannot be certain about the accuracy of his estimates. These formulas are very sensitive to error, and if they are based on inaccurate estimates, he may set a price that is profit-minimizing instead of maximizing. In addition, response to changes in his prices may depend on whether his competitors match his new prices, and John cannot know for certain whether their prices will change.

E. Elasticity of demand depends on the availability of substitutes. As more substitutes are developed, demand becomes more elastic. In addition, as competitors enter a market, prices may drop to levels at which demand is satisfied, and small decreases in prices will not affect demand. As new markets open through globalization, prices may increase because demand is greater than supply for a period of time. Students may think of other possibilities.

F. Changes in the economy cause a shift in the demand function. If economic times are good, people may be more willing to buy higher priced goods and services. Alternatively if there is a downturn, people may forego some types of purchases. For example, during a recession (2001 to 2003) people continued to indulge in low-priced luxury products such as specialty coffee drinks, but cut back on large expenditures such as luxury cars or boats. These changes in consumer preferences affect the elasticity of demand for these products.

13.34 Cost-Based Pricing, Death Spiral, Uncertainties, Customer Reaction - Haywood Ceramics

A. Under cost-based pricing, decreases in volumes result in increases in prices. Because demand is sensitive to price, as prices increase, volumes are likely to decrease. Over time the product is discontinued because sales do not cover costs. This is called the death spiral.

B. There are a number of different reasons that customers would continue to shop at Haywood or choose to shop elsewhere. If there are other ceramics studios nearby, price-sensitive customers will find another studio with better prices. Some customers may decide to change hobbies if they believe the price increases are unwarranted. Some customers may value their relationship with the studio and would not be willing to change, even if prices increase.

C. Pros: Customers may enjoy their relationship with the owner and be willing to accept price increases to continue the relationship because they understand the reason for the price increase.



Cons: Customers may not care about why prices increase, but they would be more concerned about their ability to pay higher prices. These customers could be annoyed by letters explaining the price increase and feel resentful that they cannot afford to buy at Haywood, or cannot participate in their hobby as often.

D. Following is the recommendation of Roberta Maynard in “Taking the Guesswork Out of Pricing” (Nation’s Business, December, 1997). She recommends that small businesses fail to consider the many interrelated factors that should affect pricing decisions. She suggests that pricing decisions should consider the company’s costs, the expected costs of product updates and new equipment, objectives for each product, and competitors’ products. She quotes a business consultant from Arthur Andersen who says that business owners typically price products arbitrarily, or they base prices only on cost or on competitors’ prices. In addition, customer perceptions, involvement of distributors and suppliers, government regulations, ethical considerations, and economic conditions play roles. Maynard gives the example of the role that communication played for a coffee wholesaler and its customers. When the cost of green coffee rose dramatically, the small business owner sent a six-page letter to customers explaining how coffee prices were changing, what his firm was doing to control costs, suggested things customers could do to reduce their costs, and informed them of the new price and when the change would be made. He allowed customers to place orders at current prices. He believed that his approach gave him credibility. He didn’t lose a single customer. Students may have made a similar recommendation.

13.35 Market-Based Pricing, Relevant Information - Java Alive

A. Java Alive can develop information about prices and demand and use the profit-maximizing formula to guide their pricing decisions.

B. Other information needed includes the size of the local coffee shop market, Java Alive’s market share, competitors’ drinks and prices, economic predictions for the local and regional area, any seasonal variation in sales and differences in elasticity due to seasonal variation.

13.36 Market-Based Pricing, Customer Preferences - Transrapid

A. Here are examples of information that could be gathered before recommending a pricing policy; students may think of others.

• Information about prices, number of train departures, and volumes from train systems in other similar sized cities because this would give an indication about price and volume relationships.

• Information about competing transportation systems, for example information about prices, frequency, and volume of riders for buses in the area, or in similar locations.


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• Information on expected economic conditions, in particular gas and parking prices because automobiles would be a competing form of transportation so as costs to drive a car increase, ridership on trains may increase.

B. Before making a recommendation to Transrapid, it would be wise to conduct market research. Transrapid did this before building the system. As reported by the consultants who worked with Transrapid:

“The engineers were thinking of a system to accommodate trains departing every 10 minutes. Research indicated, however, that the value-to-customer increased significantly when planned departure frequency went from every hour to every half-hour to every 20 minutes. The value was only slightly increased if the departure interval was further decreased to the planned 10 minutes. At the same time, costs increased dramatically due to more complex electronics in the track, more train units, more personnel, and so forth. The result: Transrapid has now been re-engineered for scheduled departures every 20 minutes. The resulting design simplifications and scheduling of fewer trains per hour result in savings of hundreds of millions of dollars.”1

Considering its pricing policies, Transrapid could set the initial price to be competitive with other land-based transportation, such as buses and other trains. As information is logged into its information system, a price based on product elasticity could be developed.

C. Customer preferences may be different for this type of product than others because the product potentially reduces the amount of time that customers travel. It is difficult to know the value that people set on extra time. In addition, it is difficult to know whether increasing the scheduled departure times would affect the price people are willing to pay. Because these factors are uncertain, gathering information about their preferences could be an important part of the pricing process. If prices are set too high, people will not try the train service, even though they may benefit from having more time for other activities. If prices are set too low, and need to be increased later, people may complain and look for other modes of transportation at that point.

13.37 Market-Based Price (Elasticity Formula), Uncertainties - Hanson & Daughters

A. Elasticity = ln (1 + percent change in quantity sold)/ln(1+percent change in price)= ln(1 – 0.10)/ln(1 + 0.10)= –0.10536/0.09531 = –1.105

1 Hermann Simon and Ulf Munack, “Setting the Right Price, at Internet Speed,” Brandweek, August 21, 2000, pages 22-27.© 2012 John Wiley and Sons Canada, Ltd.


B. Variable cost (VC) = $50,000/100,000 = $0.50

Profit maximizing price = [elasticity/(elasticity + 1)] * VC= (–1.105/(–1.105+1)] * $0.50= 10.52 * $0.50= $5.26

This solution assumes that Hanson has enough capacity to fill increasing volumes of demand. The profit-maximizing price is that point where contribution margin is largest overall, so as contribution margin decreases, volume of sales has to increase to more than make up for the decrease in margin. If an organization cannot increase volumes to this point, it may be better off with a higher contribution margin and sales within its relevant range of operations.

C. Customers may find substitutes for the product such as a cheaper brand or another type of juice.

D. Quality is good, the price was perceived as being reasonable, in light of quality, customer loyalty.

E. The assumptions are that the variable cost remains constant, that elasticity is greater than 1 and constant, and that changes in the price of juice do not affect product costs or sales of other products. In addition, the calculations are very sensitive to error, so any measurement error could affect the price. These are strong assumptions. If they are not met, the calculated price may not maximize profits.

F. Here is a sample recommendation. Student responses will vary, but should include the following points.

My best estimate is that a price of $5.26 will maximize your profits. However, you should reduce your price slowly and monitor demand and profits. Keep reducing the price slowly until profit plateaus, and then keep the price steady at that point. You want to identify the point at which lower prices and higher volumes maximize profits.

13.38 Cost Reduction and Market-Based Prices at a University - Trudeau University

A. This problem is open ended because there are a variety of solutions to the university’s problem. These solutions could involve not increasing tuition but cutting costs, increasing tuition and not cutting costs, or a combination of tuition increases and cost cutting. In addition, the amount that tuition could be increased is an open-ended problem that does not have a single correct answer. The same is true of potential cost cuts, and the combination of tuition increases and cost cuts. There are likely a number of different optimal solutions to this problem.

B. Some class members may want to analyze competitors’ programs and tuition and financial aid policies. Some class members could gather information to determine the


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elasticity of demand for the MBA degree. Some class members may gather information about costs, and may choose to use activity-based-costing and activity-based management or target and kaizen costing to reduced costs. Alternatively, value-chain analysis could be performed to provide information about costs and value-added and non-value added activities.

C. They would need to gather information about past volumes and tuition levels, and current information using surveys of current and prospective students’ price preferences. In addition, they would need information about the direct costs of the program, number of courses offered, and number of students enrolled in different courses. Further, information about revenues from all possible sources would need to be gathered, including all educational offerings such as executive education, CPE courses, donations, grants, and government support.

D. Student responses will vary. At a minimum, students should consider multiple sources of information, and they should describe some trade-offs in making the decision. Here is a sample response.

When deciding upon an appropriate level of tuition, I would evaluate the results of marketing research, the ability of students or other providers to pay tuition, alternative sources of funds, and the ability of the university to reduce costs. For example, if market research suggests that students are price sensitive, then the rate of tuition charged by competitor universities and the extent of available financial support from employers or governmental agencies might weigh heavily in the decision. I would also consider the university’s values and priorities. For example, some universities establish a relatively high tuition rate, but then give scholarships to students meeting certain criteria, such as low income, race, gender, scholastic aptitude, and so on.

13.39 Cost-Based Pricing in a Not-for-Profit Organization - Mountain County Legal Services

A. Avoidable costs would be any variable costs. Supplies appear to be the only variable costs, so the average cost of supplies of $1.20 ($6,000/5,000) would be the minimum fee.

B. Avoidable costs for the whole department would be the cost of lawyers, secretary, supplies, and paralegal and the avoidable administrative cost, plus the $8,000 savings in rent, or $38.00 [($90,000 +12,000 +6,000 + 70,000 + $4,000+$8,000)/5,000]. These costs would be dropped if the program were dropped.

C. The minimum fee for all avoidable and allocated costs is $44.40 ($222,000/5,000).

D. This fee may be higher than many of the clients can afford and so volumes would drop. Then the fee would have to be increased, and volumes would likely drop again.

E. This price would be considered arbitrary because the cost allocations are considered arbitrary. The current allocation bases are salary for administrative costs and space



occupied for rent. The use of other allocation bases would result in different amounts of allocations, and a different pricing structure.

F. The county executive may rely on those closer to the clients to determine how to best carry out instructions. Alternatively, the executive may not have analyzed the information and realize that there are a number of different ways to interpret the edict.

13.40 Profit Effect of Price Change - French Perfumery

A. BreezyOriginal Data New Price and Demand

Sales volume 200,000 160,000Price $6.00 $6.60

Revenue $1,200,000 $1,056,000Variable costs 800,000 640,000Contribution margin $ 400,000 $ 416,000

Variable costs per unit = $800,000 / 200,000 = $4.00New volume = 200,000 * (1-20%) = 200,000 * .8 = 160,000 unitsNew total variable costs = 160,000 * $4.00 = $640,000

B. The uncertainty depends on several factors. The problem does not indicate how accountants estimated these amounts. If software was used to track changes in prices and volumes, the estimates might be relatively accurate. However, the profit-maximizing formula is sensitive to small changes in estimates. Measurement error could reduce the ability to anticipate how changes in price will affect demand. Other factors that could affect demand are competitors’ prices, the availability of close substitutes, and economic downturns.

13.41 Transfer Price, Company Versus Division Profit, Idle Capacity –International Woodworking

A. No because at a price of $60, the variable cost to the furniture division under the current transfer price policy is $70 and the Furniture Division would lose $10 per chair.

B. If the Furniture Division buys from Portneuf, the contribution margin is as follows

Price $150Variable Costs

Transfer (40)Manufacturing (75)Selling (10)

Contribution margin $ 25

The total contribution margin is 800 x $25 = $20,000


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C. If Portneuf always has excess capacity, the transfer price should be variable cost because Portneuf has no other opportunities to sell the lumber. This transfer price policy would motivate the Furniture Division to purchase internally. The mill would want to keep its workers busy and be satisfied to transfer at variable cost because there are no other alternative outlets for the lumber.

D. If there is no idle capacity, Portneuf Mill would forego revenue from outside sales when units were transferred internally. Therefore they would not transfer except at the market price.

13.42 Transfer Price, Incentives for Internal Services – Avra Valley Services

A.Computer Services Management Advisory Company

External revenues $400,000 $700,000 $1,100,000Internal transfer:

$50 x 3,000 hours 150,000 (150,000) 0$60 x 1,200 hours (72,000) 72,000 0

Total costs (220,000) (480,000) 700,000Operating Income $258,000 $142,000 400,000

B. Net income for the company currently = $400,000 ($258,000 + $142,000). The new income would be $340,000 [$400,000 – ($50 x 1,200)].

C. Avra Valley could use an opportunity cost for the transfer price. This could be the variable costs for services. Although labour is guaranteed a wage, the hourly labour rate and cost of any supplies used in these services would approximate an opportunity cost. This way, the department that provides services receives credit for its work, but the department purchasing services is not charged as much as outsourcing would cost.

D. Qualitative factors would include quality of service or level of technical expertise. Managers need to determine whether better quality of service or expertise would be provided inside the organization or by outsourcing. Another potential qualitative factor is the possible effect on employee morale if the outsourcing option is taken and the firm lays employees off.

MINI-CASES

13.43.1 Cost-Based Pricing, Cost Allocation, Specialty Market – Jackson Jets

A.



Alternative A. Under this alternative, unavoidable costs are allocated to the three contracts equally ($3,600 / 3 = $1,200 each). Then a mark-up of 50% is added to total costs as follows:

Potential Customer

(In thousands) Rock Star CEOSports Figure Total

Total avoidable costs $1,100 $2,200 $1,500 $ 4,800

Allocated unavoidable costs 1,200 1,200 1,200 3,600

Total cost $2,300 $3,400 $2,700 $ 8,400

Price (150% of total cost) $3,450 $5,100 $4,050 $12,600

Alternative B.Under this alternative, unavoidable costs are allocated to each contract based on its proportion of avoidable costs. For example, a rock star’s allocated cost is ($1,100 / $4,800) * $3,600 = $825. A mark-up of 50% is then added to total costs to arrive at the price as follows:

Potential Customer

(In thousands) Rock Star CEOSports Figure Total

Total avoidable costs $1,100 $2,200 $1,500 $ 4,800

Allocated unavoidable costs 825 1,650 1,125 3,600

Total cost $1,925 $3,850 $2,625 $ 8,400

Price (150% of total cost) $2,887 $5,775 $3,938 $12,600

B. As illustrated by these two price alternatives, determining product cost is not straightforward and different alternatives generated differed cost bases and consequently different prices. Decision makers always face uncertainty in determining an appropriate cost base. Additional information including market price of each jet or any cost relationship, if any, to unavoidable costs may help in determining the appropriate allocation base for the allocation of unavoidable costs.

D. To avoid this problem, some companies use only avoidable costs in their price calculations. However, they also face uncertainty in determining an appropriate mark-up percentage.

E. High quality and brand name for a company such as Jackson Jets are likely to be as important as, if not more important, than price. Accordingly, a cost-based pricing scheme might not maximize profits and as such the mark-up may not be as relevant for price determination as Jackson Jet’s practice suggests. As the company’s managers make pricing decisions, they need to understand competitors’ prices; however, they should also consider each buyer’s ability and willingness to pay for the product. To maximize profits,


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Jackson Jets should charge the highest price possible but not such a high price that the customer buys from a competitor or decides not to buy a jet.

13.44 For-Profit Versus Not-for-Profit Pricing, Setting a Market Price – Province of Alberta

A. Not-for-profit organizations usually have other sources of funds than revenues from their products and services. This allows them to set prices based on different objectives than just contribution margin. Some not-for-profits charge based on customer ability to pay, and they may provide services for free to low-income customers. For-profit organizations usually set one price for all customers, and the price includes a profit margin.

B. Fees for caves in parks, such as Canmore Caverns in Alberta, are between $99 and $129 for youths and $109 and $139 for adults. Horne Lake Caves in British Columbia range from $54 to $159. A Canyon Ice trek in the Canadian Rocky Mountains costs $75 for a half day tour and $140 for a full day tour.

C. Information about other attractions in the local area could be gathered, for example prices for mine tours, entrance fees for any other types of similar tourist activities that could substitute for the cave tours. Surveys of tourists at nearby natural attractions, such as the Banff National Park would provide information about pricing. Focus groups could be held with local residents touring the facility and then providing information about acceptable prices.

D. Because tourists can substitute among activities, the price for tours is likely to affect volume. Because park entrance fees range from $54 to $159, prices set similarly would probably attract the highest volume of tourists, but this may not be the profit-maximizing price. It is possible that prices up to $150 would result in lower volumes, but a larger contribution. If capacity limits are a problem, prices could be increased during times when demand exceeds capacity and lowered when demand is low.

E. There is no one answer to this part. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

13.45 Cost-Based and Market-Based Pricing, Collusion - Burton Turner and Short Whittum

A. The following pricing policies are available: cost-based pricing and market-based pricing.

B. This is an open-ended problem and has no single, “correct” solution. There are many different cost-based prices that could be developed, depending on the cost definition used. Because the cost of wholesale gasoline varies widely, retail prices also vary



widely. Information for setting market-based pricing could be competitors’ prices, or could be developed from the relationship between price and demand.

C.1. Turner and Whittum may see nothing wrong with their desire to collude in setting

prices. They may feel that they each have loyal customers who will continue to use their services even if small price differences arise.

2. Regular customers may not care whether the prices are collusively set because they value their relationships with the owner more than responding to changes in prices. However, over time prices could become higher than in nearby communities and local and out of town customers might feel resentful at having to pay more in this town.

3. Government officials would see Turner and Whittum’s behaviour as collusion in setting prices. Even if gas and service prices are similar to prices in nearby small towns, government officials believe that prices should be set independently by competitors to guarantee free market economies.

D. Legally, Turner and Whittum are prohibited from colluding on prices. From an ethical point of view, price collusion is detrimental to the local business environment and should not occur. Therefore, both viewpoints would condemn collusion because it restricts free trade. Legal consequences are more stringent than ethical consequences.

E. Because the town is so small, local residents cannot know whether both owners are monitoring each other’s prices and pricing competitively or colluding on prices. However, if prices are set competitively, they would increase relatively slowly, and are likely to be affected only by increases in underlying costs. Business publications occasionally carry reports of large companies in the fast food or airlines industries that raise prices expecting others to follow suite, and finally reduce their prices because no one else increased prices. If prices are set collusively, they would increase because both parties agree to the increase, so it is likely that they would be higher under collusion than under competition. If prices are higher for services in this small town, local residents are paying more than they should. This could mean unnecessary hardship for some people on limited incomes. Because of these possibilities, price collusion is unethical.

F. Price changes can be monitored but it would be very difficult to determine that collusion was taking place without actually recording a conversation in which prices were set collusively, or the practice of collusive pricing was mentioned.


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13.46 Choice of Transfer Price, Fairness to Managers – Prem International

A. Fixed costs are not relevant because it is unlikely that they would change under the two options. Following is a calculation of the contribution margin under each option

Contribution margin for each kilogram of gasoline:Selling price $ 0.16Crude oil (0.06)Variable production costs (0 .02 )

Net $ 0 .08

Contribution margin for each kilogram of polystyrene:Selling price $ 0.30Chemical variable production costs (0.03)Crude oil (0.06)Oil variable production costs for Benzene (0 .04 )

Net $ 0 .17

Additional contribution margin for each kilogram of polystyrene $0.09

Times expected quantity of polystyrene sold 50 million kg

Expected increase in pre-tax profit from selling polystyrene $4.5 million

B. Using the usual quantitative rules for short term decisions, the maximum transfer price Chemical would be willing to pay is the price at which Chemical’s contribution margin for Benzene would be zero, calculated as follows:

Per KgSelling price $ 0.30Chemical variable production costs (0 .03 )

Contribution margin before cost of Benzene $ 0 .27

Chemical’s managers would be willing to pay up to $0.27 per kg for the Benzene.

C. At a price of $0.27, the subsidiary would earn zero contribution margin, and it would report a net loss equal to its fixed costs. Assuming that the fixed cost of $0.05 per kilogram was based on 50 million kilograms of production, this means that Chemical would report an operating loss on Benzene of $2.5 million. At the same time, Oil would report a sizeable profit on the Benzene:

Per KilogramTransfer price $ 0.27Crude oil (0.06)Oil variable production costs (0 .04 )

Additional contribution margin $ 0 .17

In Part A above, the contribution margin of selling gasoline was calculated to be $0.08 per kilogram. Thus, Oil would report an incremental contribution margin of $0.09 ($0.17



- $0.08) per kilogram of Benzene produced. In other words, Oil would receive all of the company-wide benefit of selling Benzene.

Chemical’s managers would be unhappy with this arrangement, because they would be responsible for selling the product but would receive none of the company-wide incremental profit.

D. Using the usual quantitative rules for short term decisions, the minimum transfer price Oil would be willing to receive is the price equal to the contribution margin that Oil gives up ($0.08 per kilogram) plus the additional variable cost that Oil will incur if it produces Benzene (incremental variable production cost of $0.02 per kg), or $0.10 per kg.

E. Oil’s managers probably would not be willing to accept the transfer price of $0.10 per kg, because in this case Chemical would receive all of the company-wide incremental profit. Because Oil can sell all of the gasoline it produces, its managers have no incentive to produce a product for which they receive no incremental profit.

F. The most fair transfer price would be somewhere between $0.10 and $0.27 per kg (i.e., between the prices calculated in Part B and Part D above). In negotiations, however, the managers of Oil could have the upper hand. Because Oil is operating at full capacity and can sell all of its production elsewhere, its managers might be able to require a transfer price of $0.27. In this case, Chemical’s managers may have no option but to accept a transfer price of $0.27 (and to report operating losses every year because of its fixed costs).

Sometimes companies establish transfer prices that reflect the degree of risk assumed by each responsibility centre. In the Prem International problem, this might mean that Chemical would receive most of the benefit, because it is assuming the risk of selling polystyrene to outside customers. Oil might be given a transfer price sufficient to ensure that it does not report an operating loss from the sale of Benzene ($0.10 plus fixed costs of $0.09 per kg).


Documents

Chapter 13 Pricing Decisions - s3.amazonaws.coms3.amazonaws.com/prealliance_oneclass_sample/ZRz4GVroWJ.pdfThese learning objectives (LO1 through LO8) ... products is $13 per unit,