Pricing Decisions

Chapter 5 Pricing Decisions

Question 1 – Optimum Selling Price, Marginal Revenue and Marginal Cost
(a)     A manufacturing company is considering its pricing policy for next year. It has already carried out some market research into the expected levels of demand for one of its products at different selling prices, with the following results:

Selling price per unit	Annual demand (units)
$100	50,000
$120	45,000
$130	40,000
$150	25,000
$160	10,000
$170	5,000

This product is manufactured in batches of 100 units, and analysis has shown that the total production cost depends on the number of units as well as the number of batches produced each year. This analysis has produced the following formula for total cost:

Z = 70x + 80y + $240,000

Where Z represents the total production cost
X represents the number of units produced; and
Y represents the number of batches of production

Required:

(i)      Prepare calculations to identify which of the above six selling prices per unit will result in the highest annual profit from this product.
(7 marks)
(ii)     Explain why your chosen selling price might not result in the highest possible annual profit from this product.                                                                                      (3 marks)

(b)     Another company manufactures components for use in computers. The business operates in a highly competitive market where there are a large number of manufacturers of similar components. The company is considering its pricing strategy for the next twelve weeks for one of its components. The Managing Director seeks your advice to determine the selling price that will maximize the profit to be made during this period.

You have been given the following data:
Market demand
The current selling price of the component is $1,350 and at this price the average weekly demand over the last four weeks has been 8,000 components. An analysis of the market shows that for every $50 increase in selling price the demand reduces by 1,000 components per week. Equally, for every $50 reduction in selling price the demand increase by 1,000 components per week.

Costs
The direct material cost of each component is $270. This price is part of a fixed price contract with the material suppliers and the contract does not expire for another year.

Production labour and conversion costs, together with other overhead costs and the corresponding output volumes, have been collected for the last four weeks and they are as follows:

Week	Output volume (units)	$000
1	9,400	7,000
2	7,600	5,688
3	8,500	6,334
4	7,300	5,446

No significant changes in cost behaviour are expected over the next twelve weeks.

Required:

(i)      Calculate the optimum (profit maximizing) selling price of the component for the period.
(Note: If Price = a – bq then Marginal Revenue = a – 2bq)             (6 marks)
(ii)     Identify and explain two reasons why it may be inappropriate for the company to use this theoretical pricing model in practice.                                                                (4 marks)
(Total 20 marks)

Question 2 – Optimum Selling Price, Marginal Revenue and Marginal Cost
Alocin plc is a well-established manufacturer of high quality consumer durables. The company has recently developed a state of the art ‘travel system’ i.e. baby carriage for infant children. The travel system, named the ‘Cruiser’ is manufactured from a rare substance (CLO), which gives it superior strength to any other travel system that is currently on the market. The marketing director believes that the fact the ‘Cruiser’ weighs less than half of the weight of all currently available travel systems will give the company a considerable competitive advantage. Alocin plc also manufactures another travel system called the ‘Glider’ which is manufactured from material DMP.

The following information is available in respect of the year ending 31 December 2008:

(1)     Each Cruiser requires 2 kilograms of CLO.
(2)     Alocin plc has access to a maximum of 990 tonnes of CLO during the year. Each kilogram of CLO costs $60.
NB 1 tonne = 1,000 kilograms.
(3)     The labour cost of manufacturing a ‘Cruiser’ is estimated at $40 per unit.
(4)     Variable overheads are estimated to be $20 per unit.
(5)     Incremental fixed costs relating to the ‘Cruiser’ are estimated to be $31.5 million.
(6)     The nature of CLO means that it cannot be stored for future use. The only alternative use for any surplus CLO during the period is in the manufacture of an alternative version of the ‘Glider’.
(7)     (i)      The marketing director has estimated that at a selling price of $500 per Cruiser, an annual sales volume of 500,000 would be achieved. He has further estimated that an increase/decrease in price of $20 will cause quantity demanded to decrease/increase by 25,000 units. He has provided you with the following formulae:

Price function: Pq = P0 – bq
Total revenue (TR) function: = P0q – bq2
Marginal revenue (MR) function: = P0 – 2bq

Where P0 = Price at zero units of demand
Pq = Price at q units of demand
b = price:demand relationship
q = Units of demand.

(ii)     Where the relevant matching of total revenue and total cost functions is expressed as the quadratic equation ax2 + bx + c = 0, the break-even point(s) in units may be calculated using the formula:

N.B. This formula is independent of those formula stated in (i) above.

Required:

(a)     Calculate the profit maximising output level for sales of the ‘Cruiser’ and the profit that would arise from those sales during the period ending 31 December 2008.                        (6 marks)
(b)     Calculate the output level(s) of ‘Cruisers’ and associated selling prices at which Alocin plc will breakeven.                                                                                                                  (6 marks)

The alternative version of the ‘Glider’ is called the ‘Super Glider’. Each ‘Super Glider’ unit would require 1·5 kilograms of CLO which would be substituted for three kilograms of Material DMP, which costs $45 per kilogram.

Three models of the ‘Super Glider’ could be manufactured. These are the ‘Gold’, ‘Silver’ and ‘Bronze’ models. The marketing director is confident that all units manufactured would be sold during the year.

Revenue and quantity information relating to the ‘Super Glider’ is as follows:

Model	Incremental revenue per unit ($’s)	% of total sales units
Gold	50	20
Silver	40	50
Bronze	30	30

Each ‘Super Glider’ unit has labour and variable overhead costs of $30 and $18 respectively.

Required:
(c)     Calculate the incremental contribution arising from the sale of the ‘Super Glider’.  (4 marks)
(d)     Explain why the board of directors of Alocin plc may choose not to use the profit maximising model (per (a)) in order to derive a selling price for the ‘Cruiser’. You should include reference to demand being a function of a range of endogenous and exogenous variables as part of your answer.
(9 marks)
(Total 25 marks)

Question 3 – Full Cost, Marginal Cost Pricing and Pricing Strategies
A small company is engaged in the production of plastic tools for the garden.

Subtotals on the spreadsheet of budgeted overheads for a year reveal the following.

For the purposes of reallocation of general factory overhead it is agreed that the variable overheads accrue in line with the machine hours worked in each department. General factory fixed overhead is to be reallocated on the basis of the practical machine hour capacity of the two departments.

It has been a long-standing company practice to establish selling prices by applying a mark-up on full manufacturing cost of between 25% and 35%.

A possible price is sought for one new product which is in a final development stage. The total market for this product is estimated at 200,000 units per annum. Market research indicates that the company could expect to obtain and hold about 10% of the market. It is hoped the product will offer some improvement over competitors' products, which are currently marketed at between $90 and $100 each.

The product development department have determined that the direct material content is $9 per unit. Each unit of the product will take two labour hours (four machine hours) in the moulding department and three labour hours (three machine hours) in finishing. Hourly labour rates are $5.00 and $5.50 respectively.

Management estimate that the annual fixed costs which would be specifically incurred in relation to the product are supervision $20,000, depreciation of a recently acquired machine $120,000 and advertising $27,000. It may be assumed that these costs are included in the budget given above. Given the state of development of this new product, management do not consider it necessary to make revisions to the budgeted activity levels given above for any possible extra machine hours involved in its manufacture.

Required:

(a)     Prepare full cost and marginal cost information which may help with the pricing decision. (10 marks)
(b)     Comment on the cost information and suggest a price range which should be considered.  (5 marks)
(c)     Briefly explain the role of costs in pricing.                                              (5 marks)
(Total 20 marks)

Question 4
The QQ organization is a large, worldwide respected manufacturer of consumer electrical and electronic goods. Q constantly develops new products that are in high demand as they represent the latest technology and are “must haves” for those consumers that want to own the latest consumer gadgets. Recently QQ has developed a new handheld digital DVD recorder and seeks your advice as to the price it should charge for such a technologically advanced product.

Required:

Prepare a report, addressed to the Board of Directors, that discusses the alternative pricing strategies available to QQ.                                                                                                               (10 marks)

Question 5
Hammer is a large garden equipment supplier with retail stores throughout Toolland. Many of the products it sells are bought in from outside suppliers but some are currently manufactured by Hammer’s own manufacturing division ‘Nail’.

The prices (a transfer price) that Nail charges to the retail stores are set by head office and have been the subject of some discussion. The current policy is for Nail to calculate the total variable cost of production and delivery and add 30% for profit. Nail argues that all costs should be taken into consideration, offering to reduce the mark-up on costs to 10% in this case. The retail stores are unhappy with the current pricing policy arguing that it results in prices that are often higher than comparable products available on the market.

Nail has provided the following information to enable a price comparison to be made of the two possible pricing policies for one of its products.

Garden shears
Steel: the shears have 0.4kg of high quality steel in the final product. The manufacturing process loses 5% of all steel put in. Steel costs $4,000 per tonne (1 tonne = 1,000kg)

Other materials: Other materials are bought in and have a list price of $3 per kg although Hammer secures a 10% volume discount on all purchases. The shears require 0.1kg of these materials.

The labour time to produce shears is 0.25 hours per unit and labour costs $10 per hour.

Variable overheads are absorbed at the rate of 150% of labour rates and fixed overheads are 80% of the variable overheads.

Delivery is made by an outsourced distributor that charges Nail $0.50 per garden shear for delivery.

Required:

(a)     Calculate the price that Nail would charge for the garden shears under the existing policy of variable cost plus 30%.                                                                                                  (6 marks)
(b)     Calculate the increase or decrease in price if the pricing policy switched to total cost plus 10%.    (4 marks)
(c)     Discuss whether or not including fi xed costs in a transfer price is a sensible policy.           (4 marks)
(d)     Discuss whether the retail stores should be allowed to buy in from outside suppliers if the prices are cheaper than those charged by Nail.                                                         (6 marks)
(Total 20 marks)
(ACCA F5 Performance Management June 2010 Q4)