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Business Overhead Cost Recovery by Eric Dontigney Overhead cost recovery helps businesses recoup indirect costs. Appendix A-2 Learning Objective A-1 Compute the profit- maximizing price of a product or service using the price elasticity of demand and variable cost. Appendix A-3 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 are affected by a change in unit price.
Appendix A-4 Price Elasticity of Demand Demand for a product is inelastic if a change in price has little effect on the number of units sold. Appendix A-5 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. Appendix A-7 Price Elasticity of Demand Є d = ln(1 + % change in quantity sold) ln(1 + % change in price) Natural log function Price elasticity of demand I can estimate the price elasticity of demand for a product or service using the above formula. Appendix A-8 Apple Almond 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. Appendix A-11 Price Elasticity of Demand The price elasticity of demand for the strawberry glycerin soap is larger, in absolute value, than the apple-almond shampoo.
Appendix A-13 The Profit-Maximizing Price Lets determine the profit-maximizing price for the apple-almond shampoo sold by Natures Garden. Appendix A-14 The Profit-Maximizing Price Now lets turn to the profit-maximizing price for the strawberry glycerin soap sold by Natures Garden. Appendix A-15 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. Appendix A-16 The Profit-Maximizing Price This graph depicts how the profit-maximizing markup is generally affected by how sensitive unit sales are to price. Appendix A-17 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. Appendix A-19 Learning Objective A-2 Compute the selling price of a product using the absorption costing approach. Appendix A-20 The Cost Base Under the absorption approach to cost-plus pricing, the cost base is the absorption costing unit product cost rather than the variable cost. Appendix A-21 Setting a Target Selling Price Here is information provided by the management of Ritter Company. Appendix A-22 Setting a Target Selling Price Ritter has a policy of marking up unit product costs by 50%.
Appendix A-23 Setting a Target Selling Price The second step is to calculate the target selling price ($30) by assigning the appropriate markup ($10) to the unit product cost ($20).
Appendix A-24 Determining the Markup Percentage Markup % on absorption cost (Required ROI ? Investment) + S & A expenses Unit sales ? Unit product cost = A markup percentage can be based on an industry rule of thumb, company tradition, or it can be explicitly calculated.


Appendix A-25 Determining the Markup Percentage Lets assume that Ritter must invest $100,000 in the product and market 10,000 units of product each year.
Appendix A-27 Problems with the Absorption Costing Approach The absorption costing approach essentially assumes that customers need the forecasted unit sales and will pay whatever price the company decides to charge.
Appendix A-28 Problems with the Absorption Costing Approach Lets assume that Ritter sells only 7,000 units at $30 per unit, instead of the forecasted 10,000 units. Appendix A-29 Problems with the Absorption Costing Approach Lets assume that Ritter sells only 7,000 units at $30 per unit, instead of the forecasted 10,000 units. Appendix A-31 Target Costing Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be made for that maximum target cost figure.
Appendix A-33 Reasons for Using Target Costing Target costing was developed in recognition of the two characteristics summarized on the previous screen. Appendix A-34 Reasons for Using Target Costing Target costing focuses a companys cost reduction efforts in the product design stage of production.
Appendix A-35 Target Costing Handy Appliance feels there is a niche for a hand mixer with special features.
Example The demand for designer perfumes sold at cosmetic counters in department stores is relatively inelastic. 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.
This indicates that the demand for strawberry glycerin soap is more elastic than the demand for apple-almond shampoo. This is because the demand for strawberry glycerin soap is more elastic than the demand for apple- almond shampoo. 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 cost base includes direct materials, direct labor, and variable and fixed manufacturing overhead.
Assuming Ritter will produce and sell 10,000 units of the new product, and that Ritter typically uses a 50% markup percentage, lets determine the unit product cost. The equation for determining a target price is shown below: Target cost = Anticipated selling price – Desired profit Once the target cost is determined, the product development team is given the responsibility of designing the product so that it can be made for no more than the target cost.
Target costing begins the product development process by recognizing and responding to existing market prices. Other approaches attempt to squeeze costs out of the manufacturing process after they come to the realization that the cost of a manufactured product does not bear a profitable relationship to the existing market price. The marketing department believes that a price of $30 would be about right and that about 40,000 mixers could be sold.


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. The first step in the absorption costing approach to cost- plus pricing is to compute the unit product cost.
The markup must be high enough to cover S & A expenses and to provide an adequate return on investment. Absorption costing approach to pricing is a safe approach only if customers choose to buy at least as many units as managers forecasted they would buy. Business overhead recovery aims to recoup some or most of the indirect costs and expenses through appropriate product and service pricing. For example, a fixed cost such as a mortgage payment on the building and a variable cost such as utilities continue to come due and require payment, even if the business manufactures no products and sells no services. Other common overhead costs include cleaning staff, product inspection and certain kinds of facility infrastructure costs, such as computer equipment. Costing refers to determining how much the business spends directly on making a product or delivering a service. Manufacturing businesses often use a standard costing approach, in which engineers provide a per-unit estimate based on the projected cost of inputs. To accommodate such problems as rising overhead or variable costs -- sudden increases in input prices, for example -- businesses often turn to activity-based costing. Activity-based costing aims to loop in the full range of activities associated with manufacturing the product or delivering services. This approach provides a more accurate view of the costs and allows for more accurate pricing. Businesses that employ a standard costing approach must include an add-on to the per-unit cost established by the engineers to cover overhead, but assessment of the cost of intangibles, such as vendor relationships, may prove difficult to fully capture. Activity-based costing folds as many of these costs into the unit price as possible, making the per-unit price one that builds in overhead cost recovery. Activity-based costing systems are often resource intensive and expensive to install and maintain. The systems also generate reports that require careful analysis and often fail to meet the norms established by generally accepted accounting principles, which makes them of limited value in preparing mandatory financial reports.



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