Question

NuCo Inc., a medical supplies manufacturing company, is developing a new product, which will compete with similar products introduced within the last year. NuCo’s strategy has traditionally been to compete on price, because of its ability to keep costs under control. For the new product, NuCo is planning a selling price lower than the existing products, possibly appealing to a broader customer base. A financial analyst is determining the selling price for the new product launch.

The company requires a 15% after-tax return on investment (ROI) and their effective income tax rate is 35%. Forecasted data for the new product are shown here.

Plant investment	$ 2,500,000
Annual fixed costs	350,000
Annual working capital	750,000
Direct labor per hour	$25
Direct materials per pound	3
Variable overhead per direct labor hour	10
Annual unit sales	10,000
Direct labor hours per unit	2
Materials quantity per unit	25

Required:

1. Using cost plus–based pricing, what selling price should be set for the new product? Show your calculations.
2. Assume that the marketplace will accept a price of $200. Using market-based pricing, what target cost would allow NuCo to reach its required 15% after-tax ROI? Show your calculations.
3. Identify and describe one way to reduce fixed costs, working capital, and direct labor hours per unit, respectively.
4. Explain the difference between cost-based pricing and market-based pricing.
5. Define target pricing and identify the main steps in developing target prices and target costs.
6. Define and explain the role of price elasticity of demand in pricing decisions. Explain how the level of elasticity affects the way changing prices can change total revenue.

Answer 1

1.

Calculation of Cost of New Product
Particulars	Amount in $
Labour (10,000 units * 2hr/Unit * $ 25)	5,00,000.00
Material (10,000 Units * 25 pounds per units * $ 3)	7,50,000.00
Variable Overhead (10 per Direct labour Hour* 20,000)	2,00,000.00
Total Variable Costs	14,50,000.00
Annual Fixed Costs	3,50,000.00
Total Cost of Product	18,00,000.00
Expected ROI Before Tax - 15 = x(1-.35) = 23.07% - Note No: 1	7,49,775.00
Tax @ 35 %	2,62,421.25
Expected ROI @ 15%	4,87,353.75
Hence Total Sales value should be (Expected ROI + Total Cost of Product)	25,49,775.00
Hence Cost per Product - Sales Value / 10,000 Units	254.98

Capital Employed = Fixed Capital + Working Capital = 25,00,000 + 7,50,000 = 32,50,000 $

ROI after Tax = 15 %

Therefore ROI Before Tax = 15 * 1/.65 ie ROI after tax * 1 divided by (1 - Tax rate)

=23.07%

2. Selling Target cost of Rs200$ per Unit

ROI = 15 %

ROI before Tax is Tax = 23.07% which is equal to 23.07 % of Capital Employed = 32,50,000 * 23.07% = 7,49,775

Sales Value/Revenue = 10,000 Units * 200 $ = 20,00,000

Profit = Sales - Total Cost of Product

Hence = Cost = Sales - Profit (ROI Before Tax) = 20,00,000 - 7,49,775 = 12,50,225 $

Target Cost per Unit = Total Cost divided by Number of Units = 12,50,225/10,000 = 125.02 $

3. To reduce the fixed costs, working capital, and direct labor hours per unit, the production of units should be brought up to large scale.

4. Cost Based Pricing - If the product is like monopoly or uniqur product, the manufacturer can determine the method of Cost based pricing without considering the market or competitors. Product with high product value can be priced like this.

Market Based pricing is depended on customer expectation and demand. Companies in competitive market depends on market based pricing.

5. Target Pricing is when the price of the product is determine first. Target price is determined considering the market and pricing dynamically. Target Cost are taken from market insights and studying the cost of available inputs for the product.

6. Manufacturers where the competition is intense and demand is price elastic is to follow target pricing in order to be competitive in the market. Price elastic demand means the level of demand changes in accordance with the changes in prices. If price increases, demand decreases, and vice - versa.

The industries where the competition is intense and demand is price elastic follow target pricing in order to be competitive in the market. Price elastic demand means the level of demand changes in accordance with the changes in prices. If price increases, demand decreases, and vice versa. A product has to be priced , wherby the price is acceptable to market.