Emerson Ventures is considering producing a new line of hang gliders. The compan

Question

Emerson Ventures is considering producing a new line of hang gliders. The company estimates that variable costs will be $325 per unit and fixed costs will be $330,000 per year.

Solve:

A: Emerson has a pricing policy that dictates that a product's price must be equal to full cost plus 60 percent. To calculate full cost, Emerson must estimate the number of units it will produce and sell in a year. Emerson estimates at the beginning of the year that they will sell 1,500 gliders and sets their price according to that sales and production volume. What is the price?

B: Right after the beginning of the year, the economy takes a dive and Emerson finds that demand for their gliders has fallen drmastically. Emerson revises its sales and production estimates to just 1,000 gliders for the year. According to company policy, what price msut they now set?

C: What is likely to happen to the number of gliders sold if Emerson follows company policy and raises the glider price to that calculated in Part B?

D: Why is setting price by marking up cost inherently circular for a manufacturing firm?

Explanation / Answer

a.   

Variable cost per unit

$       325

Fixed cost per unit ($330,000 ÷ 1,500)

220

   Total

$       545

Markup of 60%

327

Price

$       872

       b.

Variable cost per unit

$       325

Fixed cost per unit ($330,000 ÷ 1,000)

330

   Total

$       655

Markup of 60%

393

Price

$     1,048

c.     The price in the second scenario is higher because the fixed costs are being spread over fewer units. As the cost goes up, so does the markup and price. However, if price goes up, demand is likely to fall, so the company will not sell as many units as previously estimated.

       d. This situation can turn into a “death spiral,” in that as the cost goes higher, the company sets the price higher, reducing demand further, which in turn drives up cost. It is a vicious cycle in which the company is eventually forced out of the market.

Variable cost per unit

$       325

Fixed cost per unit ($330,000 ÷ 1,500)

220

   Total

$       545

Markup of 60%

327

Price

$       872

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