Unit 8 Flashcards
Price elasticity of demand
a measure of how the volume of sales is affected by a change in price.
can be used to calculate the profit-maximizing price for a company
Profit-maximizing price
affected by how sensitive unit sales are to price.
Under certain conditions, it can be determined by marking up variable cost
The Profit-maximizing Price graph
The higher the % change in sales compared to a 10% change in price means that the product is more elastic
The more elastic the product the lower the optimal mark up on variable cost will be
Other Issues of the Price Maximizing Formula
- The assumptions underlying the formulas are probably not completely true
- The estimate of the percentage change in unit sales that would result from a given percentage change in price is likely to be inexact.
- The optimal selling price should depend on two factors – the variable cost per unit and how sensitive unit sales are to changes in price.
Elastic (1) vs inelastic (2)
(1) Demand is elastic if affected by price
(2) Demand is inelastic if unaffected by price
Cost-plus pricing
Selling price = Cost + (mark-up % x Cost)
Mark-up = difference between selling price and cost
Absorption costing approach
- The first step in absorption costing is to compute the unit product cost.
- The mark-up must be large enough to cover SG&A expenses and provide an adequate return on investment (ROI).
- The ROI will be attained only if the forecasted unit sales volume is attained.
Problem with absorption costing
Managers think approach is ‘safe’
Target costing
- the process of determining a new product’s maximum cost and developing a prototype that can be profitably made for that figure
- recognizes that many companies have less control over price than they would like to think
- The anticipated market price is taken as a given in target costing
Target costing explanation
- Target costing is not just a pricing model.
- It is also a cost management model.
- Target costing involves designing to cost and quality targets set by competitive conditions.
- It takes a longer-term perspective by considering the life-cycle of a product.
- Examines all ideas for cost reduction:
– from product planning stage,
– to development stage
Using Target Costing
- Instead of starting with a product and determining costs and prices, target pricing starts with the price and then determine allowable costs.
- Most of the cost is determined at the design stage of the
product.
Common approaches
- Allow managers to negotiate their own transfer price.
- Set transfer price at cost, using variable or absorption cost.
- Set transfer price at the market price.
The objective should be to set prices in the best interests of the overall company.
Negotiated transfer prices
- a transfer price that is agreed between the selling and purchasing divisions.
- It preserves the autonomy of the divisions and is consistent with the spirit of decentralization.
- The managers of the divisions are likely to have much better information about the potential costs and benefits of the transfer.
selling VS purchasing divisions
- The selling division would like a high transfer price and agree to the transfer only if its profits increase as a result of the transfer.
- The purchasing division would like a low transfer price and will agree to the transfer only if its profits also increase as a result of the transfer.
- The actual transfer price agreed to by the two division managers can fall anywhere between those two limits – the range of acceptable transfer prices
Transfers at The Cost to the Selling Division
- Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division.
- This approach has some major defects.
- The use of cost – particularly full cost – as a transfer price can lead to bad decisions and thus sub-optimization.
- If cost is used as the transfer price, the selling division will
never show a profit on any internal transfer.
No incentives to control costs.
