Pricing Products and Services,Appendix A,Learning Objective 1,Compute the profit-maximizing price of a product or service using the price elasticity of demands and variable cost.,The Economists Approach to Pricing,Elasticity of Demand,The price elasticity of demand measures the degree to which the unit sales of a product or service is affected by a change in price.,Price Elasticity of Demand,Demand for a product is inelastic if a change in price has little effect on the number of units sold.,Example The demand for designer perfumes sold at cosmetic counters in department stores is relatively inelastic.,Price Elasticity of Demand,Demand for a product is elastic if a change in price has a substantial effect on the number of units sold.,Example The demand for gasoline is relatively elastic because if a gas station raises its price, unit sales will drop as customers seek lower prices elsewhere.,Price Elasticity of Demand,As a manager, you should set higher (lower) markups over cost when demand is inelastic (elastic),Price Elasticity of Demand,Natural log function,Price elasticity of demand,Price Elasticity of Demand,Suppose the managers of Natures Garden believe that every 10 percent increase in the selling price of its apple-almond shampoo will result in a 15 percent decrease in the number of bottles of shampoo sold. Lets calculate the price elasticity of demand. For its strawberry glycerin soap, managers of Natures Garden believe that the company will experience a 20 percent decrease in unit sales if its price is increased by 10 percent.,Price Elasticity of Demand,For Natures Garden apple-almond shampoo.,Price Elasticity of Demand,For Natures Garden strawberry glycerin soap.,Price Elasticity of Demand,The price elasticity of demand for the strawberry glycerin soap is larger, in absolute value, than the apple-almond shampoo. This indicates that the demand for strawberry glycerin soap is more elastic than the demand for apple-almond shampoo.,The Profit-Maximizing Price,Under certain conditions, the profit-maximizing price can be determined using the following formula:,The Profit-Maximizing Price,Lets determine the profit-maximizing price for the apple-almond shampoo sold by Natures Garden. The shampoo has a variable cost per unit of $2.00.,Price elasticity of demand = -1.71,The Profit-Maximizing Price,Now lets turn to the profit-maximizing price for the strawberry glycerin soap sold by Natures Garden. The soap has a variable cost per unit of $0.40.,Price elasticity of demand = -2.34,The Profit-Maximizing Price,The 75 percent markup for the strawberry glycerin soap is lower than the 141 percent markup for the apple-almond shampoo. This is because the demand for strawberry glycerin soap is more elastic than the demand for apple-almond shampoo.,The Profit-Maximizing Price,This graph depicts how the profit-maximizing markup is generally affected by how sensitive unit sales are to price.,The Profit-Maximizing Price,Natures Garden is currently selling 200,000 bars of strawberry glycerin soap per year at the price of $0.60 a bar. If the change in price has no effect on the companys fixed costs or on other products, lets determine the effect on contribution margin of increasing the price by 10 percent.,The Profit-Maximizing Price,Contribution margin will increase by $1,600.,Learning Objective 2,Compute the selling price of a product using the absorption costing approach.,The Absorption Costing Approach,Under the absorption approach to cost-plus pricing, the cost base is the absorption costing unit product cost rather than the variable cost.,Setting a Target Selling Price,Here is information provided by the management of Ritter Company.,Assuming Ritter will produce and sell 10,000 units of the new product, and that Ritter typically uses a 50 percent markup percentage, lets determine the unit product cost.,Setting a Target Selling Price,Ritter has a policy of marking up unit product costs by 50 percent. Lets calculate the target selling price.,Setting a Target Selling Price,Ritter would establish a target selling price to cover selling, general, and administrative expenses and contribute to profit $30 per unit.,Determining the Markup Percentage,The markup percentage can be based on an industry “rule of thumb,” company tradition, or it can be explicitly calculated. The equation to calculate the markup percentage is:,Determining the Markup Percentage,Lets assume that Ritter must invest $100,000 in the product and market 10,000 units of product each year. The company requires a 20 percent ROI on all investments. Lets determine Ritters markup percentage on absorption cost.,Determining the Markup Percentage,Markup % on absorption cost,(20% $100,000) + ($2 10,000 + $60,000) 10,000 $20,=,Problems with the Absorption Costing Approach,The absorption costing approach assumes that customers need the forecasted unit sales and will pay whatever price the company decides to charge. This is flawed logic simply because customers have a choice.,