Question

3.40 (LO 6) General pricing; markups Taylor Pennington produces and sells hammocks. One day during lunch he complained to his friend Steven Green, an economist, that he was having trouble setting prices. When he raised his prices, demand went down as expected, but he could never predict how much demand would change. “I understand my costs quite well,” Taylor commented. “I can produce hammocks for $80 each, and I incur $350,000 in fixed costs each year. I think I could manage my business much better if I had a better idea of the demand for hammocks at different prices.” Steve said he would take a look at several years’ worth of sales data and try to estimate a demand curve for the hammocks. He came up with the following table:

Sales Price	Demand	Sales Price	Demand
$200	40,657	$140	69,768
$190	44,486	$130	76,338
$180	48,675	$120	83,527
$170	53,259	$110	91,393
$160	58,275	$100	100,000
$150	63,763

Required

1. Which of the above sales price/demand combinations will result in the highest operating income?
2. What is the markup on variable cost at the price you selected in part (a)?
3. What is the markup on variable cost when the sales price is $200? $100?
4. What can you conclude about the value of cost-plus pricing compared to pricing based on a demand schedule?

Answer 1

(a) Selling price of $190 with demand of 44,486 units will result in highest operating income of $4,543,460.

(b) Markup on variable cost at selling price of $190 is 137.50% (Contribution margin / Variable cost i.e. $110 / $80)

(c) Markup on variable cost at selling price of $200 is 150% (i.e. $120 / $80)

Markup on variable cost at selling price of $100 is 25% (i.e. $20 / $80)

(d) Cost plus pricing helps to increase the contribution margin per unit but fails to consider important aspects of market like competitors price. Therefore, cost plus pricing can result in decreased demand of the product.

Note: Be careful while reading numbers in working notes image (with commas).