The Economists' Approach to Pricing; Absorption Costing Approach to Cost-Plus Pricing
Software Solutions, Inc., was started by two young software engineers to market SpamBlocker, a software application they had written that screens incoming e-mail messages and eliminates unsolicited mass mailings. Sales of the software have been good at 50,000 units a month, but the company has been losing money as shown below:
Sales (50,000 units $25 per unit) . . . . . . . . . $1,250,000
Variable cost (50,000 units $6 per unit) . . . . 300,000
Contribution margin . . . . . . . . . . . . . . . . . . . . . 950,000
Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . 960,000
Net operating income (loss) . . . . . . . . . . . . . . . $ (10,000)
The company's only variable cost is the $6 fee it pays to another company to reproduce the software on floppy diskettes, print manuals, and package the result in an attractive box for sale to consumers. Monthly fixed selling and administrative expenses are $960,000.
The company's marketing manager has been arguing for some time that the software is priced too high. She estimates that every 5% decrease in price will yield an 8% increase in unit sales. The marketing manager would like your help in preparing a presentation to the company's owners concerning the pricing issue.
1. To help the marketing manager prepare for her presentation, she has asked you to fi ll in the blanks in the following table. The selling prices in the table were computed by successively decreasing the selling price by 5%. The estimated unit sales were computed by successively increasing the unit sales by 8%. For example, $23.75 is 5% less than $25.00 and 54,000 units is 8% more than 50,000 units.
Selling Estimated Sales Variable Fixed Net Operating Price Unit Sales Cost Expenses Income Income
$25.00 50,000 $1,250,000 $300,000 $960,000 $(10,000)
$23.75 54,000 $1,282,500 $324,000 $960,000 $(1,500)
$22.56 58,320 ? ? ? ?
$21.43 62,986 ? ? ? ?
$20.36 68,025 ? ? ? ?
$19.34 73,467 ? ? ? ?
$18.37 79,344 ? ? ? ?
$17.45 85,692 ? ? ? ?
$16.58 92,547 ? ? ? ?
$15.75 99,951 ? ? ? ?
2. Using the data from the table, construct a chart that shows the net operating income as a function of the selling price. Put the selling price on the X-axis and the net operating income on the Y-axis. Using the chart, determine the approximate selling price at which net operating income is maximized.
3. Compute the price elasticity of demand for the SpamBlocker software. Based on this calculation, what is the profi t-maximizing price?
4. The owners have invested $2,000,000 in the company and feel that they should be earning at least 2% per month on these funds. If the absorption costing approach to pricing were used, what would be the target selling price based on the current sales of 50,000 units? What do you think would happen to the net operating income of the company if this price were charged?
5. If the owners of the company are dissatisfi ed with the net operating income and return on investment at the selling price you computed in (3) above, should they increase the selling price. Explain?
An excel sheet has been provided with step by step calculations. Rationale for the answers have also been included where ever necessary.