accounting 350 458829

PROBLEM A’6 The Economists’ Approach to Pricing; Absorption Costing Approach to Cost-Plus

Pricing [LO1, LO2]

Software Solutions, Inc., was started by two young software engineers to market SpamBlocker, a

software application they had written that screens incoming e-mail messages and eliminates unsolicited

mass mailings. Sales of the software have been good at 50,000 units a month, but the company

has been losing money as shown below:

Sales (50,000 units $25 per unit) . . . . . . . . . $1,250,000

Variable cost (50,000 units $6 per unit) . . . . 300,000

Contribution margin . . . . . . . . . . . . . . . . . . . . . 950,000

Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . 960,000

Net operating income (loss) . . . . . . . . . . . . . . . $ (10,000)

The company’s only variable cost is the $6 fee it pays to another company to reproduce the

software on fl oppy diskettes, print manuals, and package the result in an attractive box for sale to

consumers. Monthly fi xed selling and administrative expenses are $960,000.

The company’s marketing manager has been arguing for some time that the software is priced

too high. She estimates that every 5% decrease in price will yield an 8% increase in unit sales. The

marketing manager would like your help in preparing a presentation to the company’s owners concerning

the pricing issue.

Required:

1. To help the marketing manager prepare for her presentation, she has asked you to fi ll in the

blanks in the following table. The selling prices in the table were computed by successively

decreasing the selling price by 5%. The estimated unit sales were computed by successively

increasing the unit sales by 8%. For example, $23.75 is 5% less than $25.00 and 54,000 units

is 8% more than 50,000 units.

774 Appendix A

Selling

Price

Estimated

Unit Sales Sales

Variable

Cost

Fixed

Expenses

Net

Operating

Income

$25.00 50,000 $1,250,000 $300,000 $960,000 $(10,000)

$23.75 54,000 $1,282,500 $324,000 $960,000 $ (1,500)

$22.56 58,320 ? ? ? ?

$21.43 62,986 ? ? ? ?

$20.36 68,025 ? ? ? ?

$19.34 73,467 ? ? ? ?

$18.37 79,344 ? ? ? ?

$17.45 85,692 ? ? ? ?

$16.58 92,547 ? ? ? ?

$15.75 99,951 ? ? ? ?

2. Using the data from the table, construct a chart that shows the net operating income as a function

of the selling price. Put the selling price on the X-axis and the net operating income on the

Y-axis. Using the chart, determine the approximate selling price at which net operating income

is maximized.

3. Compute the price elasticity of demand for the SpamBlocker software. Based on this calculation,

what is the profi t-maximizing price?

4. The owners have invested $2,000,000 in the company and feel that they should be earning at

least 2% per month on these funds. If the absorption costing approach to pricing were used,

what would be the target selling price based on the current sales of 50,000 units? What do you

think would happen to the net operating income of the company if this price were charged?

5. If the owners of the company are dissatisfi ed with the net operating income and return on investment

at the selling