Weave Stove Company is developing a “professional” model stove aimed at the home
ID: 2435607 • Letter: W
Question
Weave Stove Company is developing a “professional” model stove aimed at the home market. The company estimates that variable costs will be $2,000 per unit and fixed costs will be $10,000,000 per year.Required: Suppose the company wants to set its price equal to full cost plus 30%. To determine cost, the company must estimate the number of units it will produce and sell in a year. Suppose the company estimates that it can sell 5,000 units. What price will the company set? What is the “odd” about setting the price based on an estimate of how many units will be sold? Suppose the company sets a price, but the number of units demanded at that price turns out to be 4,000. Revise the price n light of 4,000 units. What will happen to the number of units that will be sold if the prices are raised to the one calculated. Explain why setting price by marking up cost is inherently circular for a manufacturing firm.
Explanation / Answer
1) Suppose the company estimates that it can sell 5,000 units. What price will the company set?
Total Variable cost $2,000 X 5000 $10,000,000
Fixed cost $10,000,000
Total cost $20,000,000
Add : 30% profit $600,000
Total Sales Revenue $20,600,000
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Selling price per unit $20,600,000 / 5,000 = $4,120
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What is the “odd” about setting the price based on an estimate of how many units will be sold?
Setting the price based on estimate of how many units will be sold is odd due to existence of external forces beyond the control of the manufacturing company, governing the product demand. In this scenarieo the company will match its product quality with those available at par in the market and should try to reduce the cost to attract more demand. Without making effort to reduce its own costs and estimating the demand on the basis os expected units to be sold may throw out the company out of the market in long run.
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Suppose the company sets a price, but the number of units demanded at that price turns out to be 4,000. Revise the price n light of 4,000 units.
Total Variable cost $2,000 X 4000 $8,000,000
Fixed cost $10,000,000
Total cost $18,000,000
Add : 30% profit $540,000
Total Sales Revenue $18,540,000
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Revised Selling price per unit $20,600,000 / 4,000 = $4,635
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What will happen to the number of units that will be sold if the prices are raised to the one calculated.
The demand at this price may further decrease if other products at comparatively less price are available in the market. Economic Substitution theory may apply to the product demand.
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Explain why setting price by marking up cost is inherently circular for a manufacturing firm.
Cost-plus pricing is inherently circular for manufacturing firm because these firms markup the fixed cost per unit which requires the estimation fo quantity demanded before setting price and these can be very dangerous because the quantity demanded depends on the price. If the price will be higher than expected by the customers, the demand will be lower, cost per unit will raise (since it will be spread over fewer units) and also cost-plus price will increase(the circular process will occur).
Influence on price
1) Customer demand
2) Competitors’ behavior/prices/actions
3) Costs
4) Regulatory environment – legal, political and image related
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