Chapter+8+Notes - Chapter Eight Costs and Pricing Decisions...

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Chapter Eight Costs and Pricing Decisions
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Objectives 1. Discuss price elasticity and the profit maximizing price for a product or service. 2. Explain the cost-plus approach to pricing and discuss its limitations. 3. Use incremental analysis to price a special order. 4. Explain the target costing process for a new product. 5. Analyze customer profitability and explain the activity-based pricing approach.
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What is the best price? Common sense suggests that in general the higher the price, the lower the quantity customers will buy . Price Elasticity refers to the effect of price changes on the quantity demanded. If demand is inelastic then raising the price produces more revenue because quantity doesn’t change much. If demand is elastic then dropping the price produces more revenue because the effect of quantity is stronger.
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Should we drop or raise the price? However, managers need to consider the effect on costs as well. Example : Suppose the price today is $20 per unit with volume of 4000 units per month and we believe that if the price is decreased by 10%, the number of units sold will increase by 20% (because demand is elastic) However, the variable producing and selling costs are $12 per unit. True dropping the price from $20 to $18 will increase volume by 20% of 4000 units or 800 units. Compare 4800 units @ $18 to 4000 units @ $20. Dropping the price will increase revenues from $80,000 to $86,400, a $6,400 increase.
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However, it will cost an extra 800 x$12= $9600 to produce the extra 800 units. Incremental revenues are $6,400 but incremental costs are $9,600 So your bottom line is $3,200 worse off! What if we increase the price instead? Increasing the price here from $20 to $22 would cause revenues to decrease to $70,400 (22 x (4000-800)), a change of -$9,600 But costs will also decrease by $9,600 (800 x $12). In this case maybe we could leave the price at $20 or raise it to $22 without affecting our bottom line. To make a decision we compared
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This note was uploaded on 05/01/2008 for the course ACCT 1301 taught by Professor Milbrath during the Summer '07 term at University of Houston.

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Chapter+8+Notes - Chapter Eight Costs and Pricing Decisions...

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