In: Accounting
Company Epsilon is considering entering the active marketing advisory service and there has been much discussion regarding how much a marketing advisor should charge per hour of service. The company has budgeted to supply 500,000 hours of advisory service for the forthcoming year. Its variable cost is estimated at $25 per hour and its fixed costs are estimated at $500,000 for the forthcoming year. The company has been discussing whether to use a cost-plus approach or perhaps examining the demand levels. The marketing department has the following information on demand levels at different prices:
Price per hour |
Demand in hours |
$27 |
520,000 |
$28 |
500,000 |
$29 |
400,000 |
$30 |
300,000 |
$31 |
225,000 |
Required:
1. Calculate the price per hour Company Epsilon should charge based on a cost-plus approach for pricing the service at full cost plus 15%.
2. Considering the company can meet any demand level in the table above and that fixed costs will remain unchanged for all the preceding demand levels, what price per hour should the company charge?
3. Explain whether the different approaches lead to a different or identical price per hours and which approach should the company choose for the active marketing advisory service.
Answer to Part 1 :
Budgeted Supply = 5,00,000 hours
Variable cost (VC) per hour = $ 25.
Fixed Costs = $ 5,00,000
Hence, Total Cost or Full Cost = Total Variable Cost + Fixed Costs
i.e. = 5,00,000 * 25 + 5,00,000
i.e. = $ 13,000,000
Hence, Total Service Price based on Cost-plus approach = Full Cost + 15%
i.e. $ 13,000,000 + 15% = $ 14,950,000
Price per hour = $ 14,950,000 / 5,00,000 = $ 29.90 per hour.
Answer to Part 2 :
For determining the optimum price per hour that company should charge, we have to find which price-demand combination from the given table yields highest total contribution. (as fixed cost remains unchanged, it is irrelevant).
Price per hour | Variable Cost per hour | Contribution per
hour (Price - VC) |
Demand in hours | Total
Contribution (Contribution per hour * Demand) |
$27 | $25 | $2 | 520,000 | $1,040,000 |
$28 | $25 | $3 | 500,000 | $1,500,000 |
$29 | $25 | $4 | 400,000 | $1,600,000 |
$30 | $25 | $5 | 300,000 | $1,500,000 |
$31 | $25 | $6 | 225,000 | $1,350,000 |
Hence, from the above analysis, it is evident that total contribution is highest at $ 1,600,000 when price is $ 29 per hour. Hence, company should charge $ 29 per hour to get a profit of $ 1,600,000 - $ 5,00,000 = $ 1,100,000.
Answer to Part 3 :
The cost-plus approach and price-demand based approach to service pricing lead to different prices per hour. The price-demand based pricing approach (done in Part 2) should be chosen as it is more practical as it gives consideration to economy theory price-demand relationship. The cost-plus approach tells to sell 5,00,000 hours at $ 29.9 per hour. But to sell 5,00,000 hours, the price needs to be $ 28 per hour as per price-demand relationship. Hence, it is not practical to give effect to cost-plus approach. On the other hand, price-demand approach is more pragmatic and hence advisable.