Costs (Chapter 2)

FACT: ONLY TWO KINDS OF COSTS ARE RELEVANT

FOR PRICING.

1. INCREMENTAL: Costs associated with changes in

sales. Includes variable costs and some fixed costs.

2. AVOIDABLE: Costs that have not yet been

incurred or that can be reversed. Excludes cost of
sunk assets.

WHY? Generally speaking, the above costs are the only

ones subject to change as a result of the pricing decision
-- hence their relevance.
 Symphony Orchestra Illustration
Two Saturday evening performances (each a new one) every month

Ticket price = $10.00

Sell-out attendance = 1,100
Actual attendance = 900
Fixed overhead costs $1,500
Rehearsal costs 4,500
Performance costs 2,000
Variable costs $1/per patron

Sell-out Actual
attendance attendance
Revenue $11,000 $ 9,000
Fixed costs 8,000 8,000
Variable costs 1,100 900
Profit $1,900 $100
Avg. $8.27 $9.89
Cost/ticket
 Effect of Incremental Costs
Exhibit 2.1 Analysis of three proposals for the symphony orchestra
I II III
Student Sunday New
Pricing Options rush matinee Series
Price $ 4 $ 6 $ 10
x unit sales 200 700 800
= Revenue $ 800 $4,200 $8,000
- other sales foregone (0) ($1,500) ($1,000)

Incremental rehearsal cost 0 0 $4,500

Incremental performance cost 0 $2,000 2,000
Variable costs $ 200 550 700
Incremental Costs $ 200 $2,550 $7,200
Net Profit Contribution $ 600 $ 150 ($ 200)
Average Cost Per Ticket $ 8.27 $ 7.90 $ 10.06
 Effect of Avoidable Costs
Book price = $20 Sales < 1,000 copies/year

Contribution margin = $4 Sale price considered = $10??

Production = 2,000 copies/year

Exhibit 2.2
Years inventory held
1 2 3 4 5 6 7 8
Interest cost to hold $1.80 3.90 6.43 9.39 12.88 16.99 21.85 27.59
inventory1
1Interest cost to year n = $10 (1.18n - 1).
 Pricing Decisions and the Use of Accounting Data
Sales revenue
-- Cost of goods sold
Gross profit
-- Selling expenses
-- Depreciation
-- Administrative overhead
Operating profit
-- Interest expense
Pretax profit
-- Taxes
Net profit

Sales revenue
-- Incremental, avoidable variable costs
Total contribution margin
-- Incremental, avoidable fixed costs
Profit contribution
-- Other fixed or sunk costs
Pretax profit
-- Income taxes
Net profit
 Percent Contribution Margin
and Pricing Strategy

% CM = Total Contribution Margin X 100

Sales Revenue

$ CM = Price - Variable Cost

% CM = $CM
Price
Exhibit 2.3 Effect of contribution margin on breakeven sales changes
Company A Company B
Percentage of selling price accounted for by:
Variable Cost 80.0 20.0
Fixed or sunk costs 10.0 70.0
Net profit margin 10.0 10.0
Contribution margin 20.0 80.0

Break-even sales change (%) for a:

5% price reduction/advantage +33.3 + 6.7

10% price reduction/advantage +100.0 +14.3
20% price reduction/advantage ---- +33.3

5% price increase/premium -20.0 - 5.9

10% price increase/premium -33.3 -11.1
20% price increase/premium -50.0 -20.0

Strategy for COMPANY A?

Price reductions to increase sales may not be a viable option