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.
Jiambalvo Managerial Accounting 8-2
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.
http://www.destinationcrm.com/articles/default.asp?ArticleID=3038
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.
Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing 8-3
E4.
Price Quantity
Variable
Cost
per Unit
Contribution
Margin
per Unit
Total
Contribution
Margin
Fixed
Costs Profit
6.95 20,000 1.50 5.45 109,000 80,000 29,000
5.95 25,000 1.50 4.45 111,250 80,000 31,250
4.95 32,000 1.50 3.45 110,400 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) 100
150
Markup of 20% 30
Price $ 180
Jiambalvo Managerial Accounting 8-4
b.
Variable cost per unit $ 50
Fixed costs per unit (100,000 500) 200
250
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 $10.00 1,400
Relationship management costs 2,000 53,840
Profitability of Johnson Brands account $ (40)
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 $10.00 1,400
Relationship management costs 2,000 53,840
Profitability of Johnson Brands account $ 4,460
Jiambalvo Managerial Accounting 8-6
PROBLEMS
P1. a.
Price Quantity
Variable
Cost* CM/Unit Total CM Fixed Costs Profit
69.99 10,000 36.50 33.49 334,900 120,000 214,900
59.99 15,000 35.00 24.99 374,850 120,000 254,850
49.99 25,000 33.50 16.49 412,250 120,000 292,250
39.99 40,000 32.00 7.99 319,600 120,000 199,600
29.99 60,000 30.50 -0.51 (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.
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
4
8.99 35,000 16.99 11,000 501,540 210,000 99,000 192,540
9.99 34,500 16.99 11,300 536,642 207,000 101,700 227,942
10.99 34,000 16.99 11,500 569,045 204,000 103,500 261,545
11.99 33,000 16.99 12,000 599,550 198,000 108,000 293,550
12.99 30,000 16.99 13,000 610,570 180,000 117,000 313,570
13.99 25,000 16.99 14,000 587,610 150,000 126,000 311,610
14.99 15,000 16.99 15,000 479,700 90,000 135,000 254,700
15.99 10,000 16.99 19,000 482,710 60,000 171,000 251,710
16.99 5,000 16.99 21,000 441,740 30,000 189,000 222,740
N/A 16.99 25,000 424,750 225,000 199,750
1. 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 $12.99.
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.
Jiambalvo Managerial Accounting 8-8
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.
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.
Jiambalvo Managerial Accounting 8-10
P6. a.
Cost per change order
($175,000 700) $ 250
Cost per return
($63,750 850) $ 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.
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 (arent we paying for service
in the bid price?) and take their business elsewhere.