ACG 2071 Lecture 13: Chapter 8 Notes Part 1
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Cost-Based Pricing
Companies use various strategies to set price. Since cost is animportant determinant of supply and is known to the producer, manycompanies base price on cost. Still other companies use atarget-costing strategy, or strategies based on the initialconditions in the market.
A cost-based pricing approach starts with product cost and thendesired profit is added. Usually, there is some cost base and amarkup. The markup is a percentage applied to base cost; itincludes desired profit and any costs not included in the basecost. Companies that bid for jobs routinely base bid price oncost.
Example: Linder Company makes and sells vitaminsupplements. The following information from last year's accountingrecords showed:
| Cost of Goods Sold | $254,000 |
| Selling and administrativeexpense | 86,360 |
| Operating income | 111,760 |
The markup percentage must include all costs that are not a partof cost of goods sold plus the desired profit. For Linder Company,the markup on COGS is found as follows:
| Markup on COGS | = (Selling and administrativeexpenses + Operating income)/COGS |
| = ($86,360 + $111,760)/$254,000 =0.78 or 78% |
Now, if Linder Company produces a new product with manufacturingcost of $2 per unit, the unit price at this markup is:
| Price = $2 + (0.78 Ã $2) = $2.00 +$1.56 = $3.56 |
A Company does not have to use Cost of Goods Sold as the basisof the markup. For example, a job-order firm might decide to usethe markup on prime costs (direct materials and direct labor) tocost jobs. Suppose that Carl's Custom Cabinetry wants to price jobsbased on prime costs plus a markup on prime cost. Last year'sincome statement revealed the following information:
| Prime costs | $134,000 |
| Overhead | 73,700 |
| Selling and administrativeexpense | 38,860 |
| Operating income | 50,920 |
| Markup on Prime Cost | = (Overhead + Selling andadministrative expenses + Operating income)/Prime cost |
| = ($73,700 + $38,860 +$50,920)/$134,000 = 1.22 or 122% |
Carl is pricing a new job with estimated direct materials of$4,300 and direct labor of $1,800. The estimated price is:
| Price = ($4,300 + $1,800) + (1.22 Ã$6,100) = $6,100 + $7,442 = $13,542 |
Neither Linder Company nor Carl's Custom Cabinets must use theprice figured according to the markup. This is just a firstapproximation. Carl, for example, may want to set a lower price inhopes of getting more business from this particular customer.Linder Company may want to charge a higher price based on marketconsiderations.
Target Costing
Another approach to pricing a product or service is targetcosting. The target cost is based on the price (target price) thatcustomers are willing to pay. The Marketing Department determineswhat characteristics and price for a product are most acceptable toconsumers. Then, it is the job of the company's engineers to designand develop the product such that cost and profit can be covered bythat price. Japanese firms have been doing this for years; Americancompanies are beginning to use target costing. So first the targetprice is set. Then the desired profit is deducted, and theremaining amount is the target cost.
| Target cost = Target price -Desired profit |
Determining the target cost is relatively easy. Actuallydesigning and manufacturing a product that will achieve the targetcost and sell for the target price is more difficult. As a result,target costing is an iterative process as the firm works to refinethe proposed product to meet the cost and price targets.
Price Discrimination
Price discrimination refers to the charging of different pricesto different customers for essentially the same product. TheRobinson-Patman Act was passed in 1936 as a means of outlawingprice discrimination by manufacturers or suppliers; services andintangibles are not included under the act.
The Robinson-Patman Act does allow price discrimination undercertain specified conditions: (1) if the competitive situationdemands it and (2) if costs (including costs of manufacture, sale,or delivery) can justify the lower price. According to the secondcondition, a lower price offered to one customer must be justifiedby identifiable cost savings and the amount of the discount must beat least equaled by the amount of cost saved.
To compute a cost differential, the company creates classes ofcustomers based on the average costs of selling to those customers.Then all customers in each group are charged a cost-justifiableprice.
Example: Raul Company manufactures specializedelastic bandages used to reinforce athletes' wrists or ankles. Raulsells to a number of individual physical therapists and athletictrainers as well as to Medallion Gym, a national chain of physicalfitness facilities. The average manufacturing cost is $169 per case(a case contains 100 plastic-wrapped elastic bandages). RaulCompany sold 350,000 cases last year to the following two classesof customer.
| Price | Quantity | |
|---|---|---|
| Medallion Gym | $235 | 175,000 |
| Individual trainers and physicaltherapists | $241 | 175,000 |
Medallion Gym requires that the bandages be individuallypackaged in boxes with the Medallion name on the label. This boxand special labelling costs $0.34 per unit. Raul also pays allshipping costs, which amounted to $1,400,000 last year.
The individual trainers and physical therapists order in smalllots that require special picking and packing in the factory; thespecial handling adds $20 to the cost of each case sold. Salescommissions to the independent jobbers who sell Raul products tothe trainers and physical therapists average 10 percent of sales.Bad debts expense amounts to 1 percent of sales.
The cost per case for each customer category can be computed asfollows:
| Medallion Gym: | |
|---|---|
| Manufacturing cost per case | $169.00 |
| Box and special labelling ($0.34 Ã100) | 34.00 |
| Shipping ($1,400,000/175,000cases) | 8.00 |
| Total cost per case | $211.00 |
| Individual Trainers and PhysicalTherapists: | |
|---|---|
| Manufacturing cost per case | $169.00 |
| Special handling | 20.00 |
| Sales commission ($241 x 0.10) | 24.10 |
| Bad debts expense ($241 x0.01) | 2.41 |
| Total cost per case | $215.51 |
Profit and profit percentages are as follows:
| Medallion Gym | Trainers and Physical Therapists | |
|---|---|---|
| Price per case | $235.00 | $241.00 |
| Less: cost per case | 211.00 | 215.51 |
| Profit per case | $24.00 | $25.49 |
| Profit percentage | 10.21% | 10.58% |
The company will need to see if the profit percentages range areclose to one another; if so, there would be a cost justificationfor the price differential. If not, the company may need toconsider potential price discrimination and change its price forthe customer group that it considers to be "out of line."
For each of the following situations, determine whether or notthere is price discrimination according to the Robinson-PatmanAct.
| 1. | Dr. Jeffrey Lowman, M.D., chargesless to patients who he feels cannot afford his usual fee.- Selectyour answer -YesNoItem 1 |
| 2. | Damian Company manufacturesspecialty jams and jellies. Damian is located in Amarillo, Texas,and sells only to stores in the Amarillo area. Sometimes Damianoffers a price break to store owners whose children attend the sameschools as Damian's children. - Select your answer -YesNoItem2 |
| 3. | A national manufacturer of hairproducts charges a significantly lower price to large chain storesthan to smaller stores. The price differential is not supported bycost differences. - Select your answer -YesNo |
In 2009, David Tucker quit his job at a large beer company to start his own brewery, Tempe Microbrewery (TM). His family supported his decision and invested in the business along with David. TM began operations on January 10, 2010 and now produces four labels of specialty beers (Saguaro pale Ale, Bisbee Bock, Ocotillo Amber Pilsner, and Sedona Stout). An explanation of the beer-making process is shown in Appendix A.
In much of the United Sates (including Arizona), beer is sold in a âthree-tierâ system. Under this system, beer is manufactured by producers, sold to distributors, who then sell to retailers (such as liquor stores, drug stores, and grocery stores). David employs two salespeople who received a fixed monthly salary, plus an 8 percent commission. All beer is sold to beer distributors (primarily in the Southwestern United States) in cases of 24 bottles. Product sales and cost information for 2013 are shown in Exhibit 1 with additional information in Exhibit 2. David rents a facility that is used to make the beer, a refrigeration area to store the beer, and a small office area. TM brewery has five machines with 9,300 total machine hours available per year to produce beer (assuming TM remains on one shift with some normal maintenance, breaks, etc.). While there is an empty space in the facility that could be used to expand the beer operations, the company would need to purchase an additional grain hopper and brew house for about $100,000 (the current water system and process control system could be expanded to handle the new machine). As discussed in Appendix A, beers are aged in a refrigeration area prior to sale. The current refrigeration unit allows for different temperatures in different areas of the unit and the unit is usually running about 80 percent full. Keeping the refrigeration unit somewhat full helps reduce refrigeration costs. Additionally, since the company is so new, sales have been growing but erratic (from 2010 to 2011, sales growth was over 45 percent; however, from 2012 to 2013, sales growth was only 12 percent). Thus keeping more beer on hand allows the company to meet the erratic demand without loss of sales.
David has not taken a salary since the business started. While the business has been generating a small profit, David has been reinvesting the earnings in the business. He wants to grow the business to generate more profit for his family and himself. David has been considering increasing the price on Sedona Stout from $26.50 per case to $29.00 per case. He thinks that, with this price increase, unit sales will decrease from 4,184 cases to 3,750 cases per year. However, this would only reduce total annual Stout revenues to $108,750 from $110,876. Alternatively, David could drop the price of Sedona Stout to $25 per case. This is much closer to the Bock price as well as the Pilsner. Based on his market research, he thinks that this will result in Stout sales increasing to 4,700 cases per year. He is leaning toward this alternative as this will increase Stout revenues from $110,876 to $117,500 per year.
While the company has some cash on hand, neither the company nor Davidâs family have another $100,000 to invest in the business right now for a new grain hopper and brew house. Since the business is new and has been showing only small profits, David has not been able to get a loan to expand the business. Instead, David wants to fully utilize the machines they already have. In 2013, they used a little under 8,500 machine hours (as shown in Exhibit 1) and the existing five machines have a total of 9,300 machine hours available during the year (assuming normal maintenance and some repairs needed during the year). Thus, the existing machines have approximately 800 additional hours available for use. David wants to keep producing and selling all four of his product lines because many of the beer distributors like buying from breweries that offer several different beers. However, he wants to direct the salespeople to emphasize a certain product when they are out talking to the beer distributors. Given the current machine availability, David is not sure what beer product line to tell the sales people to emphasize in order to maximize his profits.
Finally, David and his family love root beer. Root beer follows a somewhat similar process to beer in that the ingredients are mixed together to form a âcultureâ that then goes through fermenting, filtering, and filling. Root beer would not need to be aged or stored in the refrigerator. There is an empty area in the current microbrewery facility that could be dedicated to making root beer. As a result, David has been talking with his family about producing and selling a line of specialty root beer. Root beer would be produced using different machinery rather than the existing five beer machines. Davidâs sister knows someone who is getting out of the soda business and would be willing to sell the used machinery needed to make the root beer for $8,000. Based on market research he has done, David thinks that he could charge $16.50 per case of root beer. Based on the same market research, there is a lot of uncertainty in how many cases of root beer the company could sell. David is less familiar with the root beer market and there is a wide range in sales of specialty root beer in the local groceries. Based on his understanding of the market, he thinks he could sell between 3,000 and 12,000 cases of root beer per year with likely sales of about 6,000 cases.
Root beer could be sold to some of his current distributors. However, soda does not need to be sold through the three-tier system that is required for alcohol sales. Therefore, much of the root beer sales would be directly to upscale groceries such as La Grande Orange Grocery and Pizzeria in Phoenix and Whole Foods and AJâs Fine Foods with locations throughout Arizona. David could produce the root beer in-house or out-source the production. David has talked with another company who could produce the root beer for TM using Davidâs recipe and TM could sell it as their brand (this option is referred to as âprivate labelâ). It could be purchased from this other company for $13.05 per case. TM would still need to incur some variable handling costs and some minor fixed costs. Alternatively TM could produce the root beer in house. See Exhibit 3 for estimated cost information.
You have been hired as a consultant to help David with the business. Please address the following questions in preparation for your discussions with him.
1. Ignore any current plans. Using last yearâs actual data and sales mix, how many total cases would David need to sell in order to earn $80,000 before tax? How many cases of each of the four labels would TM need to produce?
2. In Question 1, you identified the total number of cases the company needs to sell to earn $80,000 before tax. Assume you did the calculations in Question 1 correctly. However, before discussing your solution with the owner, identify and explain at least three issues related to you analysis and the assumptions employed in your analysis in Question 1 (discuss each concern; what it is and why it is a concern; do not just question general facts of the case such as why TM is charging a certain price for one product or how TM can reduce direct material cost.
3. Ignore the desire to earn $80,000 before tax and refer to the original data. David has a few options regarding Sedona Stout pricing: (a) keep the sales price the same (no change), (b) increase the sales price, or (c) decrease the sales price. What would you recommend he do and why? Provide both quantitative and qualitative analysis.
4. Next, ignoring the Sedona Stout information, consider Davidâs question regarding what product line the sales people should emphasize. David wants their sales efforts to maximize profits and utilize the companyâs current capacity. What would you tell him? Explain your rationale.
5. Analyzing the sales forecast for root beer, what preliminary course of action do you recommend (in-house or out-source production) and why? Support your recommendations with numbers.
| Exhibit 1 | |||||
| 2013 Cost and Sales Information |
| ||||
| Panel A: Per Case Information | |||||
| Saguaro Pale Ale | Bisbee Bock | Ocotillo Amber Pilsner | Sedona Stout | Total | |
| Sales price | $21.00 | $24.50 | $23.50 | $26.50 | |
| Direct materials | 2.75 | 2.90 | 3.15 | 4.00 | |
| Direct labor | 3.75 | 3.75 | 3.00 | 5.25 | |
| Variable overhead | 5.90 | 6.18 | 6.10 | 6.34 | |
| Total variable cost | 12.40 | 12.83 | 12.25 | 15.59 | |
| Contribution margin | $8.60 | $11.67 | $11.25 | $10.91 | |
| Cases sold last year | 12,593 | 7,126 | 6,827 | 4,184 | 30,730 |
| Direct labor hours per case | 0.25 | 0.25 | 0.20 | 0.35 | |
| Total direct labor hours last year | 3,148.25 | 1,781.50 | 1,365.40 | 1,464.40 | 7,759.55 |
| Machine hours per case | 0.20 | 0.40 | 0.30 | 0.25 | |
| Total machine hours last year | 2,518.60 | 2,850.40 | 2,048.10 | 1,046.00 | 8,463.10 |
| Panel B: Contribution Margin Income Statement | |||||
| Sales | 264,453.00 | $174,587.00 | $160,434.50 | $110,876.00 | $710,350.50 |
| Variable costs | 156,153.20 | 91,426.58 | 83,630.75 | 65,228.56 | 396,439.09 |
| Contribution margin | 108,299.80 | 83,160.42 | 76,803.75 | 45,647.44 | 313,911.41 |
| Direct fixed costs | 10,329.62 | 8,392.91 | 6,017.39 | 9,893.92 | 34,633.84 |
| Segment margin | $97,970.18 | $74,767.51 | $70,786.36 | $35,753.52 | 279,277.57 |
| Common fixed costs | 245,389.44 | ||||
| Operating income | 33,888.13 | ||||
| Taxes (35%) | 11,860.85 | ||||
| Net income | $22,027.28 | ||||
| Exhibit 2 | |
| Additional Cost Information | |
| Panel A: Details of Total Variable Costs | |
| Direct materials | $ 93,537.20 |
| Direct labor | 116,393.25 |
| Production supplies | 26,064.41 |
| Variable portion of maintenance | 40,892.55 |
| Variable portion of utilities | 27,610.57 |
| Variable office supplies | 3,493.88 |
| Shipping costs | 31,619.19 |
| 8% sales commission | 56,828.04 |
| Total variable costs | $396,439.09 |
| Panel B: Details of Total Fixed Costs (Direct and Indirect) | |
| Brew master/quality control manager | $ 60,293.15 |
| Receiving and shipping department expenses | 22,511.32 |
| Depreciation | 11,712.10 |
| Facility costs (rent, taxes, insurance, etc.) | 78,938.15 |
| Advertising and marketing costs | 22,994.91 |
| Fixed portion of maintenance | 9,992.98 |
| Fixed portion of utilities (including refrigeration) | 10,390.37 |
| Fixed portion of office supplies | 4,305.66 |
| Fixed salary of salespeople | 32,221.81 |
| Administrative staff to assist owner | 26,662.83 |
| Total fixed costs | $280,023.28 |
| Exhibit 3 | |
| Root Beer Cost Information | |
| Panel A: Alternative 1 â produce in-house | |
| Direct materials per case | $1.75 |
| Direct labor per case | 2.25 |
| Variable overhead per case | 3.50 |
| Total variable costs per case | $7.50 |
| Additional fixed costs per year â not including the initial purchase cost of the machine | $37,640.00 |
| Panel B: Alternative 2 â out-source production | |
| Purchase price per case | $13.05 |
| Variable overhead per case | 0.25 |
| Total variable costs per case | $13.30 |
| Additional fixed costs per year | $6,000.00 |
Appendix A
Beer-Making Process
Beer is the overall generic term for fermented malt beverages. There are only two kinds of beer: ale and lager. Within those two broad categories there are many styles. Major ale styles are pale ale, India Pale Ale (IPA), porter, stout, and barleywine. Among the major lager styles are pilsner, Märzen, bock, and dunkles (dark lager). TM makes two ales (Saguaro Pale Ale and Sedona Stout) and two lagers (Ocotillo Amber Pilsner and Bisbee Bock).
It is the yeast that is the significant difference between the ale and the lager. Ale yeasts coagulate loosely at the top of the fermentation tank. Given the type of yeast, ales ferment best between 64 to 70 degrees Fahrenheit. Lager yeasts are more successful at colder temperatures, typically 50 to 55 degrees Fahrenheit and coagulate closer to the bottom of the fermentation tank. Lager yeasts also tend to ferment more aggressively, leaving behind less residual sweetness and flavor than ales.
Direct Materials â Beer primarily consists of four ingredients: water, barley, hops, and yeast. A clarifying agent is also used in the beer-making process. The different types of beer require different proportions of these ingredients and even slightly different ingredients (e.g., pale ale uses a pale malted barley while stout is made using a darker roasted barley).
Brewing Process â Work in the brewery is typically divided into eight steps: mashing, lautering, boiling, fermenting and conditioning, filtering, filling, and aging.
Mashing â Mashing is the first process in brewing. The barley grains are mixed with water in a large vessel. This mixture is heated with periodic breaks, or rests, at certain temperatures to allow enzymes in the malted grains to break down the starch in the grain into sugars.
Lautering â Lautering is when the mash is separated into a liquid and the residual grain. There are two stages to lautering. In the first stage, called Wort Run-Off, a liquid (or extract) is separated in an undiluted form from the used grains. The second stage is called sparging. During sparging, the extract that remains with the grains is rinsed off with hot water. The results of these two stages are combined and the result is a dark, sugary liquid called Wort. This is returned to the original mashing vessel.
Boiling â Boiling the Wort in the vessel ensures that the mixture is sterile and prevents infection. During the boiling step, hops are added to the Wort. The hops contribute bitterness, aroma, and flavor compounds to the beer. The boiling must be continuous and intense (rolling boil) and typically lasts between 60 and 120 minutes, depending on its intensity, when the hops are added and the amount of Wort expected to evaporate. The Wort is then cooled before the fermentation stage.
Fermenting and conditioning â The cooled Wort is put into a fermentation tank and yeast is added, which starts the fermentation process. This is also the point at which the product is first called beer. It is during this stage that fermentable sugars are metabolized into alcohol and carbon dioxide (the bubbles in beer). As noted above, fermentation temperatures are very different for ales versus lagers.
Fermentation takes about a week. When the sugars in the fermenting beer have been almost completely digested, the fermentation slows down and the yeast cells will naturally start to die off and begin to settle to the bottom of the tank. At TM, the fermentation tanks are equipped with cooling jackets. Therefore, conditioning can take place in the same tank as fermentation. Conditioning (also called âmaturationâ) is when beer is cooled in the tanks to allow the yeast to settle to the bottom of the tank. Conditioning allows the flavor of the beer to become smoother and is a natural filtration process (removing cloudy material from the beer).
Filtering â The beer that comes out of the fermentation tank must be filtered prior to bottling. Filtering the beer stabilizes flavor and gives beer its gloss or âshine.â Filtering removes much of the yeast and any solids (e.g., hops and other grain particles) that remain in the beer.
Filling â The filling process (also called âpackagingâ) is putting the beer into bottles in which it will leave the brewery. At this point, carbon dioxide is added to the bottling process to increase the carbon dioxide in the beer. Cases of beer (consisting of 24 bottles) are then put into aging.
Aging â Beer is stored (aged or âlageredâ) in the refrigerator unit and the temperature and length of the aging will vary based on the type of beer. Ales are usually aged no more than a few weeks. The aging process is generally done at 40 to 55 degrees Fahrenheit. Lagers are similarly aged but at much lower temperatures, 32 to 45 degrees Fahrenheit, and for a much longer time (typically months). Lagering creates a cleaner, clearer beer. The refrigeration unit allows for different temperatures in different areas of the unit.