- 15 Marks
MA – L2 – Q50 – Pricing Strategies
Question
Nexco Industries Limited makes Product Z in department C. For the year commencing 1 January Year 7, the following budget has been formulated for department C:
| GH¢000 | |
|---|---|
| Direct costs | |
| Materials | 60 |
| Labour | 40 |
| 100 | |
| Production overheads | 100 |
| Full production cost | 200 |
| Administrative and marketing overheads | 50 |
| Full cost of sale | 250 |
| Profit | 50 |
| Revenue (see note) | 300 |
Note: This revenue is from budgeted sales of 20,000 units.
Production overheads are absorbed on the basis of 100% of direct costs. However, half of these costs are fixed, and the other half are variable. It is assumed that they vary with the cost of materials.
The administrative and marketing overheads are based on 25% of factory costs and do not vary within wide ranges of activity. A profit margin of 20% is applied to the full cost of sale. This also results in a price that appears to be fair to customers.
Halfway through the year to 31 December Year 7, it became clear that actual sales of Product Z would be 25% below budget. At about the same time that this shortfall in sales became evident, a customer asked about buying 5,000 units of a simplified version of Product Z. If Nexco Industries Limited were to produce this simplified model for the customer, the direct material and labour costs would be lower. It is estimated that materials costing GH¢12,000 and direct labour of GH¢8,000 would be required to produce the 5,000 units. As the production could take place within the firm’s existing capacity, fixed costs would not be affected.
Required:
(a) Calculate the prices that Nexco Industries Limited should quote to the customer for each unit of the simplified product, assuming that the following pricing policies are applied:
(i) Full cost plus pricing, on the current basis.
(ii) A price that would enable the company to achieve its original budgeted profit.
(b) Give your advice on the price that should be quoted to the customer.
Answer
(a) (i) Full cost pricing plus, on the current basis
| GH¢000 | |
|---|---|
| Direct materials | 12.0 |
| Direct labour | 8.0 |
| Direct cost | 20.0 |
| Production overheads (100% of direct cost) | 20.0 |
| Full production cost | 40.0 |
| Administrative and marketing overheads (25%) | 10.0 |
| Full cost of sale | 50.0 |
| Profit (20% of full cost of sale) | 10.0 |
| Selling price for order (5,000 units) | 60.0 |
Sales price per unit = GH¢60,000 / 5,000 units = GH¢12.
(ii) Price to maintain budgeted profit of GH¢50,000
If sales of Product Z are 25% below budget, the expected profit will be as follows:
| GH¢000 | |
|---|---|
| Direct costs (75% × 100,000) | 75.0 |
| Variable overheads (75% × 50,000) | 37.5 |
| Total variable costs | 112.5 |
| Fixed production overhead | 50.0 |
| Other fixed overheads | 50.0 |
| Total costs | 212.5 |
| Sales (75% × 300,000) | 225.0 |
| Profit | 12.5 |
In order to make a profit of GH¢50,000 for the year, the simplified units of Product Z must make GH¢37,500 contribution to profit. The price for the order should be as follows:
| GH¢000 | |
|---|---|
| Materials | 12.0 |
| Labour | 8.0 |
| Direct cost | 20.0 |
| Variable overhead (see note) | 10.0 |
| Variable cost | 30.0 |
| Contribution | 37.5 |
| Selling price | 67.5 |
Note: Variable overheads are assumed to vary with direct materials cost. In the original budget, variable overheads are GH¢50,000 and direct material costs are GH¢60,000. Variable overheads are therefore 50/60 × material costs. For the simplified units, variable overheads will be GH¢12,000 × 50/60 = GH¢10,000.
The selling price per unit would need to be GH¢67,500 / 5,000 units = GH¢13.50. (B)
The price of Product Z is currently GH¢15 (GH¢300,000 / 20,000 units). The price for the simplified units of Product Z must be lower than this; otherwise, the customer will not buy them.
A price of GH¢13.50 is needed to achieve the budgeted profit, but the customer may be unwilling to pay this amount. A price of GH¢12 will give a profit of 20% on full cost, using the budgeted absorption rates for overhead, but there will be some under-absorbed overheads.
Any price in excess of the minimum price of GH¢30,000 (GH¢6 per unit) will make profit higher than it will be if the simplified units are not sold to the customer.
However, the company must think of the longer term. Will the customer want to buy more units of the simplified product next year? If so, the company will want to charge a price at which it will make satisfactory profits.
The recommendation should therefore be to negotiate with the customer. If the agreed price is lower than GH¢13.50, Nexco Industries might want to warn the customer that more units of the simplified Product Z might not be available in the future, except at a higher price.
- Topic: Decision making techniques
- Uploader: Salamat Hamid