Chapter 9 Pricing Policies and Profitability Analysis

1.      Objectives

1.1       Explain the factors that influence the price of a product.
1.2       Establish the price/demand relationship of a product.
1.3       Establish the optimum price/output level when considering profit maximization and maximization of revenue.
1.4       Calculate prices using full cost and marginal cost as the pricing base.
1.5       Discuss the advantages and disadvantages of these pricing bases.
1.6       Discuss the pricing policy in the context of price skimming, penetration pricing, complementary product pricing and price discrimination.
1.7       Appreciate the importance of profitability analysis in decision making.

2.      Factors Influencing the Price of a Product

2.1       Several factors underlie all pricing decisions and effective decisions will be based on a careful consideration of the following.

Influence	Explanation/Example
Price sensitivity	Sensitivity to price levels will vary amongst purchasers. Those that can pass on the cost of purchases will be the least sensitive and will therefore respond more to other elements of perceived value. For example, a business traveller will be more concerned about the level of service in looking for an hotel than price, provided that it fits the corporate budget. In contrast, a family on holiday are likely to be very price sensitive when choosing an overnight stay.
Price perception	Price perception is the way customers react to prices. For example, customers may react to a price increase by buying more. This could be because they expect further price increases to follow (they are 'stocking up').
Quality	This is an aspect of price perception. In the absence of other information, customers tend to judge quality by price. Thus a price rise may indicate improvements in quality, a price reduction may signal reduced quality.
Intermediaries	If an organisation distributes products or services to the market through independent intermediaries, such intermediaries are likely to deal with a range of suppliers and their aims concern their own profits rather than those of suppliers.
Competitors	In some industries (such as petrol retailing) pricing moves in unison; in others, price changes by one supplier may initiate a price war. Competition is discussed in more detail below.
Suppliers	If an organisation's suppliers notice a price rise for the organisation's products, they may seek a rise in the price for their supplies to the organisation.
Inflation	In periods of inflation the organisation may need to change prices to reflect increases in the prices of supplies, labour, rent and so on.
Newness	When a new product is introduced for the first time there are no existing reference points such as customer or competitor behaviour; pricing decisions are most difficult to make in such circumstances. It may be possible to seek alternative reference points, such as the price in another market where the new product has already been launched, or the price set by a competitor.
Incomes	If incomes are rising, price may be a less important marketing variable than product quality and convenience of access (distribution). When income levels are falling and/or unemployment levels rising, price will be more important.
Product range	Products are often interrelated, being complements to each other or substitutes for one another. The management of the pricing function is likely to focus on the profit from the whole range rather than the profit on each single product. For example, a very low price is charged for a loss leader to make consumers buy additional products in the range which carry higher profit margins (eg selling razors at very low prices whilst selling the blades for them at a higher profit margin).
Product life cycle	During the life of an individual product, several stages are apparent: introduction, growth, maturity and decline. The duration of each stage of the life cycle varies according to the type of product, but the concept is nevertheless important as each stage is likely to influence the firm’s pricing policy.

3.       Markets

3.1       The price that an organization can charge for its products will be determined to a greater or lesser degree by the market in which it operates.
3.2       Perfect competition (完全競爭) – many buyers and many sellers all dealing in an identical product. Neither producer nor user has any market power and both must accept the prevailing market price.
3.3       Monopoly (壟斷) – one seller who dominates many buyers. The monopolist can use his market power to set a profit-maximising price.
3.4       Monopolistic competition (壟斷競爭) – a large number of suppliers offer similar, but not identical, products. The similarities ensure elastic demand whereas the slight differences give some monopolistic power to the supplier.
3.5       Oligopoly (寡頭壟斷) – where relatively few competitive companies dominate the market. Whilst each large firm has the ability to influence market prices, the unpredictable reaction from the other giants makes the final industry price indeterminate. Cartels are often formed.
4.      Price and Demand Relationship

4.1       You know from your personal experience as a consumer that the theory of demand is essentially true, the higher the price of a good, the less will be demanded.
4.2       If you think about how you decide which goods to buy, you will realize that there are many factors entering into the decision.

Influence	Explanation/Example
Price	This is probably the most significant factor. For each of the goods, the higher the price, the less likely people are to buy it.
Income	In general, the more people earn, the more they will buy. The demand for most goods increases as income rises, and these goods are known as normal goods. This does not apply to inferior goods, such as low quality foodstuffs. These are cheap goods which people might buy when on a low income, but as their incomes rises, they switch to more attractive alternatives.
Price of substitute goods	Two or more goods are defined as substitutes if they are interchangeable in giving consumers utility. For example, Coke and Pepsi are substitutes, a rise in the price of Coke will cause a rise in demand for the Pepsi, and vice versa.
Price of complementary	Complements are goods which must be used together. For example, a compact disc player is no good without compact discs. If the price of a complement rises, then demand for another complementary good will fall.
Taste	Taste is influenced by many different things. Advertising may make something popular or unpopular.
Market size	The size of total demand depends on the number of people who are aware of the good’s existence. Market size can be altered by changes in the size and structures of the population. If the birth rate falls in the area, this will have a long-term effect on the total population size and will have a more immediate effect in reducing the number of babies, hence influencing the demand for prams (嬰兒車), equipment and clothing designed for babies.
Advertising	In general, it is not only the volume and quality of advertising that can influence demand for a product but also the amount of advertising in comparison with that for competing products.

5.      Price Elasticity of Demand

5.1       Concept of price elasticity of demand

5.1.1	Price elasticity of demand
	(a)       The price elasticity of demand (PED) is a measure of the extent of change in demand for a good in response to a change in its price. It is measured as: The % change in quantity demanded The % change in price (b)       Demand is referred to as inelastic if the absolute value is less than 1 and elastic if the absolute value is greater than 1.

5.1.2

Example 1

The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research indicates that an increase in price of 10 cents per unit will result in a fall in annual demand of 75,000 units. What is the price elasticity of demand? Solution: % change in demand = (75,000 / 800,000) x 100% = 9.375% % change in price = (0.1 / 1.20) x 100% = 8.333% Price elasticity of demand = (–9.375/8.333) = –1.125 Ignoring the minus sign, price elasticity is 1.125 The demand for this good, at a price of $1.20 per unit, would be referred to as elastic because the price elasticity of demand is greater than 1.

5.2       Special values of price elasticity

5.2.1    There two special values of price elasticity of demand.
(a)        Perfectly inelastic (PED = 0). There is no change in quantity demanded, regardless of the change in price. The demand curve is a vertical straight line.

(b)       Perfectly elastic (PED = ∞). Consumers will want to buy an infinite amount, but only up to a particular price level. Any price increase above this will reduce demand to zero. The demand curve is a horizontal straight line.

5.3       PED and revenue

5.3.1	PED and revenue
	(a)       When demand is elastic, total revenue rises as price falls and vice versa. This is because the quantity demanded in very responsive to price changes. (b)       When demand is inelastic, total revenue falls as price falls because a fall in price causes a less than proportionate rise in quantity demanded.

5.3.2    It would be very useful to a producer to know whether he is at an elastic or inelastic part of his demand curve. This will enable him to predict the effect on revenue of raising or lowering his price.

6.      Profit Maximization

6.1	Profit maximization
	Profits are maximized using marginalist theory when marginal cost (MC) = marginal revenue (MR). The optimal selling price can be determined using equations. The optimum selling price can also be determined using tabulation.

6.2       In economics, profit maximisation is the process by which a firm determines the price and output level that returns the greatest profit. There are two common approaches to this problem.
(a)        The Total revenue (TR) – Total cost (TC) method is based on the fact that profit equals revenue minus cost.
(b)        The Marginal revenue (MR) – Marginal cost (MC) method is based on the fact that total profit in a perfect market reaches its maximum point where marginal revenue equals marginal cost.

6.3       From the graph above it is evident that the difference between total costs and total revenue is greatest at point Q. This is the profit maximising output quantity.

6.4

Example 2

AB has used market research to determine that if a price of $250 is charged for product G, demand will be 12,000 units. It has also been established that demand will rise or fall by 5 units for every $1 fall/rise in the selling price. The marginal cost of product G is $80. Required: If marginal revenue (MR) = a – 2bQ when the selling price (P) = a – bQ, calculate the profit-maximising selling price for product G. Solution: b = change in price / change in quantity = $1 / 5 = 0.2 a = $250 + 12,000 x 0.2 = $2,650 MR = 2,650 – (2 x 0.2)Q = 2,650 – 0.4Q Profit are maximized when MR = MC, i.e. 80 = 2,650 – 0.4Q Q = 6,425 Now, substitute the values into the demand curve equation to find the profit-maximising selling price P = a – bQ P = 2,650 – 0.2 x 6,425 = $1,365

6.5       The optimum selling price can also be determined using tabulation. To determine the profit-maximising selling price:
(a)        Work out the demand curve and hence the price and the total revenue (P x Q) at various levels of demand.
(b)        Calculate total cost and hence marginal cost at each level of demand.
(c)        Finally calculate profit at each level of demand, thereby determining the price and level of demand at which profits are maximized.

6.6

Exercise 1

An organisation operates in a market where there is imperfect competition, so that to sell more units of output, it must reduce the sales price of all the units it sells. The following data is available for prices and costs. Total output Units Sales price per unit (AR) $ Average cost of output (AC) $ per unit 0 - - 1 504 720 2 471 402 3 439 288 4 407 231 5 377 201 6 346 189 7 317 182 8 288 180 9 259 186 10 232 198 The total cost of zero output is $600. Required: Complete the table below to determine the output level and price at which the organisation would maximise its profits, assuming that fractions of units cannot be made. Units Price Total revenue Marginal revenue Total cost Marginal cost Profit   $ $ $ $ $ $ 0             1             2             3             4             5             6             7             8             9             10

7.       Pricing Strategies

7.1       Cost-plus pricing

7.1.1	Cost-plus pricing
	Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark-up for profit.

7.1.2    In practice cost is one of the most important influences on price. Many firms base price on simple cost-plus rules (costs are estimated and then a profit margin is added in order to set the price).
7.1.3    The 'full cost' may be a fully absorbed production cost only, or it may include some absorbed administration, selling and distribution overhead.
7.1.4    A business might have an idea of the percentage profit margin it would like to earn, and so might decide on an average profit mark-up as a general guideline for pricing decisions.
7.1.5    Advantages of full cost-plus pricing
(a)        It is a quick, simple and cheap method of pricing which can be delegated to junior managers.
(b)        Since the size of the profit margin can be varied, a decision based on a price in excess of full cost should ensure that a company working at normal capacity will cover all of its fixed costs and make a profit.
7.1.6    Disadvantages of full cost-plus pricing
(a)        It fails to recognise that since demand may be determining price, there will be a profit-maximising combination of price and demand.
(b)        There may be a need to adjust prices to market and demand conditions.
(c)        Budgeted output volume needs to be established. Output volume is a key factor in the overhead absorption rate.
(d)        A suitable basis for overhead absorption must be selected, especially where a business produces more than one product.

7.1.7

Example 3

A company budgets to make 20,000 units which have a variable cost of production of $4 per unit. Fixed production costs are $60,000 per annum. If the selling price is to be 40% higher than full cost, what is the selling price of the product using the full cost-plus method? Solution: Full cost per unit = variable cost + fixed cost Variable cost = $4 per unit Fixed cost = $60,000/20,000 = $3 per unit Full cost per unit = $4 + $3 = $7 Selling price using full cost-plus pricing method = $7 x 140% = $9.80

7.2       Marginal cost-plus pricing

7.2.1	Marginal cost-plus pricing
	Marginal cost-plus pricing/mark-up pricing involves adding a profit margin to the marginal cost of production/sales.

7.2.2    Whereas a full cost-plus approach to pricing draws attention to net profit and the net profit margin, a variable cost-plus approach to pricing draws attention to gross profit and the gross profit margin, or contribution.

7.2.3

Example 4

A product has the following costs.   $ Direct materials 5 Direct labour 3 Variable overheads 7 Fixed overheads are $10,000 per month. Budgeted sales per month are 400 units to allow the product to breakeven. Required: Determine the profit margin which needs to be added to marginal cost to allow the product to break even. Solution: Breakeven point is when total contribution equals fixed costs. At breakeven point, $10,000 = 400 (price – $15) $25 = price – $15 Price = $40 Profit margin = (40 – 15)/15 x 100% = 166.67%

7.2.4    Advantages of marginal cost-plus pricing
(a)        It is a simple and easy method to use.
(b)        The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect demand conditions.
(c)        It draws management attention to contribution, and the effects of higher or lower sales volumes on profit. For example, if a product costs $10 per unit and a mark-up of 150% ($15) is added to reach a price of $25 per unit, management should be clearly aware that every additional $1 of sales revenue would add 60 cents to contribution and profit ($15 ÷ $25 = $0.60).
7.2.5    Disadvantages of marginal cost-plus pricing
(a)        Although the size of the mark-up can be varied in accordance with demand conditions, it does not ensure that sufficient attention is paid to demand conditions, competitors' prices and profit maximisation.
(b)        It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high to ensure that a profit is made after covering fixed costs.

7.3       Market skimming pricing

7.3.1

Market skimming pricing

Price skimming involves charging high prices when a product is first launched in order to maximize short-term profitability. Initially there is heavy spending on advertising and sales promotion to obtain sales. As the product moves into the later stages of its life cycle (growth, maturity and decline) progressively lower prices are charged. The profitable 'cream' is thus skimmed off in stages until sales can only be sustained at lower prices.

7.3.2    The aim of market skimming is to gain high unit profits early in the product's life. High unit prices make it more likely that competitors will enter the market than if lower prices were to be charged.
7.3.3    Such a policy may be appropriate in the cases below.
(a)        The product is new and different, so that customers are prepared to pay high prices so as to be one up on other people who do not own it.
(b)        The strength of demand and the sensitivity of demand to price are unknown. It is better from the point of view of marketing to start by charging high prices and then reduce them if the demand for the product turns out to be price elastic than to start by charging low prices and then attempt to raise them substantially if demand appears to be insensitive to higher prices.
(c)        High prices in the early stages of a product's life might generate high initial cash flows. A firm with liquidity problems may prefer market-skimming for this reason.
(d)        The firm can identify different market segments for the product, each prepared to pay progressively lower prices. It may therefore be possible to continue to sell at higher prices to some market segments when lower prices are charged in others.
(e)        Products may have a short life cycle, and so need to recover their development costs and make a profit relatively quickly.
7.3.4    Products to which the policy has been applied include mobile phone, computers, video recorders, etc.

7.4       Market penetration pricing

7.4.1	Market penetration pricing
	Penetration pricing is a policy of low prices when a product is first launched in order to obtain sufficient penetration into the market.

7.4.2    A penetration policy may be appropriate in the cases below.
(a)        The firm wishes to discourage new entrants into the market.
(b)        The firm wishes to shorten the initial period of the product's life cycle in order to enter the growth and maturity stages as quickly as possible.
(c)        There are significant economies of scale to be achieved from a high volume of output.
(d)        Demand is highly elastic and so would respond well to low prices.

7.5       Complementary product pricing

7.5.1	Complementary product pricing
	(a)       Complementary products are goods that tend to be bought and used together. (b)       Complementary products are sold separately but are connected and dependant on each other for sales, for example, an electric toothbrush and replacement toothbrush heads. The electric toothbrush may be priced competitively to attract demand but the replacement heads can be relatively expensive.

7.5.2    A loss leader (犧牲品定價) is when a company sets a very low price for one product intending to make consumers buy other products in the range which carry higher profit margins. Another example is selling razors at very low prices whilst selling the blades for them at a higher profit margin. People will buy many of the high profit items but only one of the low profit items – yet they are 'locked in' to the former by the latter. This can also be described as captive product pricing (附屬產品定價法).

7.6       Price discrimination (價格歧視)

7.6.1	Price discrimination
	The use of price discrimination means that the same product can be sold at different prices to different customers. This can be very difficult to implement in practice because it relies for success upon the continued existence of certain market conditions.

7.6.2    There are a number of bases on which such discriminating prices can be set.
(a)        By market segment. A cross-channel ferry company would market its services at different prices in England and France, for example. Services such as cinemas and hairdressers are often available at lower prices to old age pensioners and/or juveniles.
(b)        By product version. Many car models have 'add on' extras which enable one brand to appeal to a wider cross-section of customers. The final price need not reflect the cost price of the add on extras directly: usually the top of the range model would carry a price much in excess of the cost of provision of the extras, as a prestige appeal.
(c)        By place. Theatre seats are usually sold according to their location so that patrons pay different prices for the same performance according to the seat type they occupy.
(d)        By time. This is perhaps the most popular type of price discrimination. Off-peak travel bargains, hotel prices and telephone charges are all attempts to increase sales revenue by covering variable but not necessarily average cost of provision. Railway companies are successful price discriminators, charging more to rush hour rail commuters whose demand is inelastic at certain times of the day.

8.       Profitability Analysis

8.1       In running a business, management has to know the profitability of their products, customers and other business segments as they want to know what segment they should focus on. To achieve such purpose, they should be able to distinguish between absolute profitability and relative profitability.
8.2       Absolute profitability is measured by the segment’s incremental profit, which represents the difference between the revenues from the segment and the costs that could be avoided by dropping the segment. In other words, it measures the effect of adding or dropping a segment on the company’s profits.

8.3       Product and supplier profitability analysis

8.3.1    Product and supplier profitability analysis allow the management to identify the true costs associated with their products and supplies.
8.3.2    Normally, it takes into account those initial costs (such as purchase, transport, receiving and reject cost), on going costs (such as storage and overheads), finance and customer return costs for different product or product groups.

8.3.3

Example 5

In general, it can be elaborated as follows (assuming two products groups);   Product A Product B Total   $ $ $ Sales 150,000 (37.5%) 250,000 (62.5%) 400,000 (100%) Expenses       Variable costs       Materials & supplies (% of revenue) 15,000 (10%) 22,000 (8.8%) 37,000 (9.25%) Labour (% of revenue) 2,000 (1.33%) 3,500 (1.4%) 5,500 (1.38%) Distribution (% of revenue) 3,000 (2%) 5,000 (2%) 8,000 (2%) Marketing (% of revenue) 12,000 (8%) 10,000 (4%) 22,000 (5.5%) Other (% of revenue) - 5,000 (2%) 5,000 (1.25%) Total variable costs 32,000 (21.3%) 45,500 (18.2%) 77,500 (19.4%)         Fixed costs       Location (% of revenue) 10,000 (6.67%) 10,000 (4%) 20,000 (5%) Administration (% of revenue) 5,000 (3.33%) 6,000 (2.4%) 11,000 (2.75%) Labour (% of revenue) 3,000 (2%) 3,000 (1.2%) 6,000 (1.5%) Others (% of revenue) 2,000 (1.33%) 3,000 (1.2%) 5,000 (1.25%) Total fixed costs 20,000 (13.3%) 22,000 (8.8%) 42,000 (10.5%) Operating profit 98,000 182,500 280,500 Operating surplus (%) 65% 73% 70.1% Profit contribution (%) 34.9% 65.1% 100% When management considers the resource allocation and strategy formulation, it can determine whether the company should put more emphasis on a particular product or whether they would allocate the costs differently to get a better margin for the product group.

8.4       Customer profitability analysis (CPA)

8.4.1    CPA is very important to decision making of management, as best customers implies customers who contributes the highest sales. Thus, we need to understand what products and services customers buy and the associated product and services costs when designing business strategies.

 

 

 

8.4.2

Example 6

A simple CPA can be conducted as follow:   Customer A Customer B Total   $ $ $ Sales 150,000 (37.5%) 250,000 (62.5%) 400,000 (100%) Cost of sales       Ongoing service & support 17,000 25,500 42,500 Other direct customer costs 15,000 20,000 35,000 Total cost of sales 11,800 (78.7%) 204,500 (81.8%) 322,500 (80.6%) Other costs       Customer acquisition 10,000 10,000 20,000 Customer marketing 5,000 6,000 11,000 Customer termination 5,000 6,000 11,000 Total other customer costs 20,000 22,000 42,000         Profit by customer groups 98,000 (34.9%) 182,500 (65.1%) 280,500 (100%)

 

Examination Style Questions

Question 1 – Pricing with ABC
Brick by Brick (BBB) is a building business that provides a range of building services to the public. Recently they have been asked to quote for garage conversions (GC) and extensions to properties (EX) and have found that they are winning fewer GC contracts than expected.

BBB has a policy to price all jobs at budgeted total cost plus 50%. Overheads are currently absorbed on a labour hour basis. BBB thinks that a switch to activity based costing (ABC) to absorb overheads would reduce the cost associated to GC and hence make them more competitive.

You are provided with the following data:

Overhead category	Annual overheads ($)	Activity driver	Total number of activities per year
Supervisors	90,000	Site visits	500
Planners	70,000	Planning documents	250
Property related	240,000	Labour hours	40,000
	400,000

A typical GC costs $3,500 in materials and takes 300 labour hours to complete. A GC requires only one site visit by a supervisor and needs only one planning document to be raised. The typical EX costs $8,000 in materials and takes 500 hours to complete. An EX requires six site visits and fi ve planning documents. In all cases labour is paid $15 per hour.

Required:

(a)     Calculate the cost and quoted price of a GC and of an EX using labour hours to absorb the overheads.                                                                                                                               (5 marks)
(b)     Calculate the cost and the quoted price of a GC and of an EX using ABC to absorb the overheads.                                                                                                                               (5 marks)
(c)     Assuming that the cost of a GC falls by nearly 7% and the price of an EX rises by about 2% as a result of the change to ABC, suggest possible pricing strategies for the two products that BBB sells and suggest two reasons other than high prices for the current poor sales of the GC.             (6 marks)
(d)     One BBB manager has suggested that only marginal cost should be included in budget cost calculations as this would avoid the need for arbitrary overhead allocations to products. Briefly discuss this point of view and comment on the implication for the amount of mark-up that would be applied to budget costs when producing quotes for jobs.                                                                           (4 marks)
(20 marks)
(ACCA F5 Performance Management June 2010 Q1)

Question 2 – Marginal cost plus pricing and special order
RSG Ltd is the business of canning peaches for sale to food distributors. The normal pricing policy is adding a mark-up of 66.67% on absorption cost. All costs are classified as either manufacturing or marketing. RSG prepares monthly budgets. The January 2004 budgeted absorption costing income statement is as follows:

	$
Revenues (1,000 crates x $1,000 per crate)	1,000,000
Cost of goods sold	600,000
Gross profit	400,000
Marketing costs	300,000
Operating profit	100,000

Monthly costs are classified as fixed or variable (with respect to the number of crates produced for manufacturing costs and with respect to the number of crates sold for marketing costs):

	Fixed	Variable
Manufacturing	$200,000	$400,000
Marketing	$160,000	$140,000

RSG has the capacity to can 1,500 crates per month. The relevant range in which monthly fixed manufacturing costs will be “fixed” is from 500 to 1,500 crates per month.

Required:

(a)     Briefly describe the THREE major factors affecting pricing decisions.               (6 marks)
(b)     Prepare a marginal-costing (variable-costing) income statement and calculate the mark-up percentage based on total variable costs.                                                                                 (5 marks)
(c)     Assume that a new customer approaches RSG wishing to buy 200 crates at $500 per crate for cash. The customer does not require any additional marketing effort. Additional manufacturing costs of $20,000 (for special packaging) will be required. RSG believes that this is a one-time-only special order because the customer is discontinuing business in six weeks’ time. RSG is reluctant to accept this 200-crate special order because the $550 per crate price is below the $600 per crate absorption cost. Do you agree with this reasoning? Explain.                                                                                               (5 marks)
(d)     Assume that the new customer decides to remain in business. How would this longevity affect your willingness to accept the $550 per crate offer? Explain.                                      (4 marks)
(20 marks)
(HKIAAT PBE II Management Accounting December 2003 Q6)

Question 3 – Cost plus pricing, target pricing and balanced scorecard
A company is exploring the construction of a new hotel in a resort area in Wuhan city in mainland china. The Financial Planning Department estimates that land and building costs are RMB 80 and RMB 150 per square foot. A hotel room has an average of 800 sq. ft. Besides these costs, the company needs to pay interest, tax and general overheads which are expected to be 35% of land and construction costs. Initial per-room expenditure for bedroom furnishings and decorations is RMB 15,000, for room supplies is RMB 2,000 and for marketing, it is RMB 5,000/

To safeguard the estimation error, 10% estimation errors are added to the calculated costs. The construction period is 2 years. The room rate is set at RMB 1 of RMB 1,000 of the total cost, i.e. 1/1,000 of the total cost. Upon completion, comparable facilities are expected to charge RMB 420 per day as reflected by the prevailing room rate in the market.

Required:

(a)     Calculate the total cost of a hotel room.                                                                (6 marks)
(b)     What is the planned hotel room rate? Compared with the market rate, is the planned hotel rate a competitive one?                                                                                                   (4 marks)
(c)     Distinguish between cost plus pricing and target pricing.                                    (3 marks)
(d)     Besides costs, what suggestions would you make to the management team in order to make the new hotel more attractive based on the balanced scorecard framework? Illustrate them with measurable examples.                                                                                                                               (7 marks)
(Total 20 marks)
(HKIAAT PBE II Management Accounting and Finance December 2010 Q6)

 

Question 4 – Customer profitability analysis
Success Production Ltd sells machine parts to industrial equipment manufacturers at an average price of $30 per part. There are two types of customers: those who place small, frequent orders and those who place larger, less frequent orders. Each time an order is placed and processed, a set-up is required. Scheduling is also needed to coordinate the many different orders that come in and place demands on the plant’s manufacturing resources. The company also inspects a sample of the products each time a batch is produced to ensure that the customer’s specifications have been met. Inspection takes essentially the same time regardless of the type of part being produced. The management accounting department has provided the following budgeted data for customer-related activities and costs expected for the coming year:

	Frequently Ordering Customers	Less Frequently Ordering Customers
Sales orders	8,000	800
Average order size	200	2,000
Number of set-ups	5,000	1,000
Scheduling hours	7,000	1,000
Inspections	5,000	1,000
Average unit cost*	$20	$20

* This cost does not include the cost of the “customer-related” activities listed below.

Customer-related activity costs:	$
Processing sales orders	4,400,000
Scheduling production	2,400,000
Setting up equipment	7,200,000
Inspecting batches	9,600,000
Total	23,600,000

Required:

(a)        Determine the profitability of each customer type using the traditional approach of assigning customer-related activity costs in proportion to the sales revenue earned by each customer type. Discuss the problems of this measure of customer profitability.
(5 marks)
(b)        By using the activity rates to assign customer-related activity costs to each customer type, re-calculate the profitability of each customer category. Discuss how you, as a manager, would use this information.                                                                                                                         (11 marks)
(c)        Describe briefly the nature of value-added and non-value-added activities and give an example of each type of activity.                                                                                                  (4 marks)
(Total 20 marks)
(HKIAAT PBE II Management Accounting December 2007 Q3)