What you will learn to do: Establish a price for products and services
For most businesses, the goal in pricing a product is to select the price at which total future revenues exceed total future costs by the greatest amount, thus maximizing income.
When applying differential analysis to pricing decisions, each possible price for a given product represents an alternative course of action. The sales revenues for each alternative and the costs that differ between alternatives are the relevant amounts in these decisions. Total fixed costs often remain the same between pricing alternatives, but if producing and selling more units affects underlying fixed costs, that variable has to be taken into account as well.
Let’s review the contribution margin format for calculating operating income as a way to assess various prices:
Let’s say REVLAND’s current contribution margin break-even analysis looks like this:
| Units | $/unit | Total | |
|---|---|---|---|
| Sales | 702 | $400.00 | $ 280,800.00 |
| Variable costs | 702 | $286.00 | 200,772.00 |
| Contribution Margin | $114.00 | Single Line80,028.00 | |
| Fixed costs | 80,000.00 | ||
| Operating income | Single Line$ 28.00Double line | ||
| CM ratio | 28.50% |
REVLAND produces motorcycle helmets that consist of an outer shell made of layers of fiberglass that are hand-cut and then pressed into a mold. There is an interior shell made of polystyrene that absorbs impact in case of a crash. The outer shell is finished and painted by machine, but the decals are placed by hand. Then the helmet is covered by transparent protective paint and the inner shell and padding are added by hand. One of the things that makes these helmets unique is the embedded communications and crash detection electronics. It takes ten hours to make one helmet.
They currently plan to sell the helmets at $400 direct to the consumer via their online store, however, since they haven’t actually started selling helmets yet, they have hired a marketing firm to estimate demand at various price points.
We’ll follow the REVLAND company throughout the next readings as an example to learn more about the process of establishing a product price.
When you are done with this section, you will be able to:
- Identify pricing issues
- Establish a price to achieve a target profit
- Establish a price based on cost-plus
- Use differential analysis in decision-making
Learning Activities
The learning activities for this section include the following:
- Reading: Pricing Issues
- Self Check: Pricing Issues
- Reading: Target Pricing
- Self Check: Target Pricing
- Reading: Cost-Plus Pricing
- Self Check: Cost-Plus Pricing
- Reading: Special Pricing Issues
- Self Check: Special Pricing Issues
