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Pricing Products and Services:

Learning Objectives of the Articles:

1. Compute the profit maximizing price of a product and service using the price
elasticity of demand and variable cost.
2. Compute the selling price of a product using the absorption costing approach.
3. Calculate the target cost for a new product or service.
4. Calculate and use billing rates used in time and material pricing

Pricing is not a problem for some businesses. They make products or provide a service that
is in competition with others, identical products or services for which a market price already
exists. Customers will not pay more that this price, and there is no reason to charge less.
Under these circumstances, the company simply charges the prevailing market price.
Markets for basic raw materials such as farm products and minerals follow this pattern.

Here we are concerned with the more common situation in which a company is faced with
the problem of setting its own prices. Clearly, the pricing decision can be critical. If the price
is too high, customers will avoid purchasing the company's products. If the price is set too
low, the company's costs may not be covered.

the usual approach in pricing is to mark up cost. A product's markup is the difference
between its selling price and its cost. The markup is usually expressed as a percentage of
cost. This approach is called cost plus pricing because the predetermined markup
percentage is applied to the cost base to determine a target selling price.

[Selling price = Cost + (Markup × Cost)]

For example, if a company uses a markup of 50%, to the costs of its products to determine
the selling price. If a product costs $10, then it would charge $15 for the products.

Two key issues must be addressed when the cost plus approach to pricing is used. First,
What cost should be used? Second, how should the markup be determined? Several
alternatives approaches are considered here, starting with the generally favored by
economists.
Price Elasticity of Demand--Economists' Approach to Pricing:

If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing
is a delicate balancing act in which the benefits of higher revenues per unit are traded off
against the lower volume that results from charging higher prices. The sensitivity of unit
sales to changes in prices is called the price elasticity of demand.

Absorption Costing Approach to Cost Plus Pricing:

The absorption costing approach to cost plus pricing differs from the economists' approach
(price elasticity of demand) both in what costs are marked up and in how markup is
determined. Under the absorption costing approach to cost plus pricing, the cost base is the
absorption costing unit product cost rather than variable costing.

Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product
and then developing a prototype that can be profitably made for that maximum target cost
figure.

Time and Material Pricing in Service Companies:

Some companies--particularly in service industries-- use a variation of cost plus pricing

called time and material pricing. Under this method, two pricing rates are established--
one based on direct labor time and other based on the cost of direct materials used.
Price Elasticity of Demand--Economists'
Approach to Pricing:
If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing is a delicate
balancing act in which the benefits of higher revenues per unit are traded-off against the lower volume
that results from charging higher prices. The sensitivity of unit sales to changes in prices is called the
price elasticity of demand.

1. Definition and explanation of price elasticity of demand

2. Formula of Price elasticity of demand
3. Profit maximizing price

Elasticity of Demand--Definition and Explanation:

A product's price elasticity should be a key element in setting its price. The price elasticity of demand
measures the degree to which the unit sales of a product or service are affected by a change in price.
Demand for a product is said to be inelastic if a change in price has little effect on the number of units
sold. The demand for designer perfumes sold by trained personnel at cosmetic counters in department
stores is relatively inelastic. Lowering prices on these luxury goods has little effect on sales volume;
factors other than price are more important in generating sales. On the other hand, demand for a product
is said to be elastic if a change in price has a substantial effect on the volume of units sold. An example
of a product whose demand is elastic is gasoline. If a gas station raises its prices for gasoline, there will
usually be a substantial drop in volume as customers seek lower prices elsewhere.

Price elasticity is very important in determining prices. Managers should set higher markups over cost
where customers are relatively insensitive to price (i.e., demand is inelastic) and lower markups where
customers are relatively sensitive to price (i.e., demand is elastic). This principle is followed in
departmental stores. Merchandise sold in the bargain basement has a much lower markup than
merchandise sold elsewhere in the store because customers who shop in the bargain basement are
much more sensitive  to price i.e., demand is elastic.

Formula and Example of Price Elasticity of Demand:

Price elasticity of demand for a product or service can be estimated using the following formula:

[Price Elasticity of Demand = In(1+ % Change in quantity sold) / In(1 + % Change in price)]

 The term In( ) is the natural log function. You can compute natural log of any number using the LN or lnx key on your calculator.
For example, ln(0.85) = –0.1625
 This formula assumes that the price elasticity of demand is constant. This occurs when the relationship between the selling price,
P, and the unit sales, q, can be expressed in the following form: ln(q) = a + elasticity of demand ln(p). Even if this is not precisely
true, the formula provides a useful way to estimate a product's real price elasticity.
For example, suppose that the managers of Nature's Garden Inc. believe that every 10% increase in the
selling price of their apple-almond shampoo will result in a 15% decrease in the number of bottles of
shampoo sold. The Calculation of the price elasticity of demand for this product would be as follows:

Price elasticity of Demand = In(1 + ( – (0.15)) / In(1 + (1.10))

In(0.85) / In(1.10)

= – 1.71

 The estimated change in unit sales should take into account competitor's responses to a price change.

For comparison purposes, the managers of Nature's Garden Inc. believe that another product, strawberry
glycerin soap, will experience 20% drop in unit sales if its price is increased by 10%. (Purchasers of this
product are more sensitive  to price than the purchasers of the apple-almond shampoo). The calculation
of the price elasticity of demand for the strawberry glycerin soap is:

Price elasticity of Demand = In(1 + ( – (0.20)) / In(1 + (1.10))

In(0.80) / In(1.10)

= – 2.34

Both of these products, like other normal products, have a price elasticity that is less than – 1. Not also
that the price elasticity of demand for the strawberry glycerin soap is larger (in absolute value) that the
price elasticity of demand for the apple-almond shampoo. The more sensitive customers are to price, the
larger (in absolute value) in the price elasticity of demand. In other words, a larger (in absolute value)
price elasticity of demand indicates a product whose demand is more elastic. The price elasticity of
demand will be used to calculate selling price that maximizes the profits of the company.

Profit Maximizing Price:

Under certain conditions, it can be shown that the profit-maximizing price can be determined by
marking up variable cost using the following formula:

*[Profit-maximizing markup on variable cost = (Price elasticity of demand / 1 + Price elasticity of

demand) – 1]

*The formula assumes that:

 The price elasticity of demand is constant.

 Total cost = Total fixed cost + Variable cost per unit × q
 The price of the product has no effect on the sales or costs of any other product. The formula can be derived using calculus.

Using the above markup is equivalent to setting the selling price using this formula:

[Profit-maximizing price = (Price elasticity of demand / 1 + Price elasticity of demand) Variable

cost per unit]
The profit maximizing prices for two Nature's Garden products are computed below using these formulas:

  Apple-Almond Shampoo Strawberry Glycerin Soap

Price elasticity of demand – 1.71 – 2.34
Profit maximizing markup on variable cost (a) (– 1.71 / – 1.71 + 1) – 1 (– 2.34 / – 2.34 + 1) – 1
   2.41 – 1 = 1.41 or 141% 1.75 – 1 = 0.75 or 75%
Variable cost per unit--given (b) $2.00 $0.40
Markup, (a) × (b) 2.82 0.30
  ------------ -----------
Profit maximizing price $4.82 $0.70
  ======= =======

Note that the 75% markup for the strawberry glycerin soap is lower that 140% markup for the apple
almond shampoo. The reason for this is that the purchasers of strawberry glycerin soap are more
sensitive to price than the purchasers of apple-almond shampoo. This could be because strawberry
glycerin soap is a relatively common product with close substitutes available in nearly every grocery store.

Caution is advised when using these formulas to establish a selling price. The assumptions underlying
the formulas are probably not completely valid, and the estimate of the percentage change in unit sales
that would result from a given percentage change in price is likely to be inexact. Nevertheless, the
formulas can provide valuable clues regarding whether prices should be increased or decreased.
Suppose, for example, that the strawberry glycerin soap is currently being sold for $0.60 per bar. The
formula indicates that the profit maximizing price is $0.70 per bar. Rather than increasing the price by
$0.10, it would be prudent to increase the price by a more modest amount to observe what happens to
unit sales and to profits.

The formula for the profit maximizing price also convey a very important lesson. The optimal selling
price should depend on two factors--the variable cost per unit and how sensitive unit sales are to changes
in price. In particular, fixed costs play no role in setting the optimal price. If the total fixed costs are the
same whether the company charges $0.60 or $0.70, they cannot be relevant in the decision of which
price to charge for the soap. Fixed costs are relevant when deciding whether to offer a product but are not
relevant when deciding how much to charge for the period.

Incidentally we can directly verify that an increase in selling price for the strawberry glycerin soap from the
current price of $0.60 per bar is warranted, based just on the forecast that a 10% increase in selling price
would lead to a 20% decrease in unit sales. Suppose, for example, that Nature's Garden is currently
selling 200,000 bars of the soap per year at the price of $0.60 a bar. If the change in price has no effect
on the company's fixed costs or on other products, the effect on profits of increasing the price by 10% can
be computed as follows:

  Percent
  Price
Higher Price
 
Selling price $0.60 $0.60 + (0.10  $0.60) = $0.66
  200,000  (0.20  200,000) =
Unit sales 200,000
160,000
 
Sales $120,000 $105,600
 
Variable cost 80,000 64,000
   
---------- ----------
 
Contribution margin $40,000 $41,600
 

Despite the apparent optimality of prices based on marking up variable costs according to the price
elasticity of demand, surveys consistently reveal that most managers approach the pricing problem from a
completely different perspective. They prefer to mark up some version of full, not variable, costs, and the
markup is based on desired profits rather than on factors related to demand.
Absorption Costing Approach to Cost Plus Pricing:
The absorption costing approach to cost plus pricing differs from the economists' approach (price
elasticity of demand) both in what costs are marked up and in how markup is determined. Under the
absorption costing approach to cost plus pricing, the cost base is the absorption costing unit product cost
rather than variable costing.

1. Setting a target selling price using the absorption costing approach .

2. Determining and calculating markup percentages.
3. Problems with the absorption costing approach.

Setting a Target Selling Price Using the Absorption Costing Approach:

For example, let us assume that the management of Ritter Company wants to set the selling price of a
product that has just undergone some design modification. The accounting department has provided cost
estimates for the redesigned product as shown below:

 
  Per Unit Total
 
Direct materials $6  
 
Direct labor 4  
 
Variable manufacturing overhead 3  
 
Fixed manufacturing overhead   $70,000
  Variable selling, general, and administrative
2  
expenses
  Fixed selling, general and administrative
  60,000
expenses

The first step in the absorption costing approach to cost plus pricing is to compute the unit product cost.
For Ritter Company, this amounts to $20 per unit at a volume of 10,000 units as calculated below:

 
Direct materials $6
 
Direct labor 4
 
Variable manufacturing overhead 3
 
Fixed manufacturing overhead ($70,000 / 10,00 units) 7
 
  -------
 
Unit product cost $20
 
  ====

Ritter company has a general policy of marking up unit product costs by 50%. A price quotation sheet for
the company prepared using the absorption costing approach is presented below:

 
Direct materials $6
 
Direct labor 4
 
Variable manufacturing overhead 3
 
Fixed manufacturing overhead (based on 10,000 units) 7
 
  --------
 
Unit product cost 20
  Markup to cover selling, general, and administrative expenses
10
and desired profit--50% of unit manufacturing cost
 
  --------
 
Target selling price $30

Note that selling, general and administrative (SG&A) costs are not included in the cost base. Instead, the
markup is supposed to cover these expenses. Let us see how some companies compute these markup
percentages.

Determining Markup Percentages:

How did Ritter Company arrive at is markup percentage of 50% in the above schedule? This figure could
be a widely used rule of thumb in the industry or just a company tradition that seems to work. The markup
percentage may also be the result of an explicit computation. As we have discussed, the markup over
cost ideally should be largely determined by market conditions. However a particular approach is to at
least start with markup based on cost and desired profit. The reasoning goes like this. The markup must
be large enough to cover sales, general and Administrative (SG&A) expenses and provide an adequate
return on investment (ROI).

Given the forecasted unit sales, the markup can be calculated by using the following formula:

Markup percentage on absorption cost = [(Required return on investment × Investment) + SG&A

expenses] / Units sales × Unit product cost

To show how the formula above is applied, assume Ritter Company must invest $100,000 to produce and
market 10,000 units of the product each year. The $100,000 investment covers purchase of equipment
and funds needed to carry inventories and accounts receivable. If Ritter Company requires a 20% return
on investment (ROI), then the markup for the product would be calculated as follows:

Markup percentage on absorption cost = (20% × 100,000) + ($2 × 10,000 + $60,000) / 10,000 × $20

= ($20,000) + ($80,000) / $200,000

50%

This markup of 50% leads to a target selling price of $30 for Ritter company. As verified by the following
calculations:

Direct materials $6
 
Direct labor 4
 
Variable manufacturing overhead 3
 
Fixed manufacturing overhead ($70,000 / 10,000 units) 7
 
  -------
 
Unit product cost $20
  ======
 

INCOME STATEMENT AND RETURN ON INVESTMENT ANALYSIS--RITTER

COMPANY ACTUAL UNIT SALES PRICE  = 10,000 UNITS; SELLING PRICE
= $30
  Ritter Company
Absorption Costing Income Statement
Sales ($30 per unit × 10,000 units) $300,000

Less cost of goods sold ($20 per unit × 10,000 units) 200,000

  --------------

Gross margin 100,000

Less selling, general, and administrative expenses ($2 per unit 

80,000
10,000 units + $60,000)

  --------------

Net operating income $20,000

  =======

Return on investment ROI

Return on investment (ROI) = Net operating income / Average operating assets

= $20,000 / $100,000

= 20%

If the company actually sell 10,000 units of the product at this price, the company's return on investment
(ROI) on this product will indeed be 20%. If it turns out that more than 10,000 units are sold at this price,
the ROI will be greater than 20%. If less than 10,000 units are sold. the return on investment (ROI) will be
less than 20%. The required return on investment (ROI) will be attained only if the forecasted unit sales
volume is attained.

Problems | Disadvantages and Limitations with the Absorption Costing Approach:

Using the absorption costing approach, the pricing problem looks deceptively simple. All you have to
do is calculate cost, decide how much profit you want, and then set your price. It appears that you can
ignore demand and arrive at a price that will safely yield profit whatever profit you want. However, as
noted above, the absorption costing approach relies on a forecast of unit sales. Neither the markup nor
the unit product cost can be computed without such a forecast. The absorption costing approach
essentially assumes that the consumers need the forecasted sales and will pay whatever price the
company decides to charge. However, customers have a choice. If the price is too high, they can buy
from a competitor or they may choose not to buy at all. Suppose, for example, that when Ritter Company
sets its price at $30, it sells only 7,000 units rather than the 10,000 units forecasted. As shown in above
calculations, the company would then have a loss of $25,000 on the product instead of a profit of
$20,000. Some managers believe that the absorption costing approach to pricing is safe. This is an
illusion. This approach is safe only as long as customers choose to buy at least as many units as
managers forecasted they buy.

 
Direct materials $6
 
Direct labor 4
 
Variable manufacturing overhead 3
 
Fixed manufacturing overhead ($70,000 / 7,000 Units) 10
 
  --------
 
Unit product cost $23
 
  =====
 
 
INCOME STATEMENT AND RETURN ON INVESTMENT ANALYSIS--RITTER
COMPANY ACTUAL UNIT SALES PRICE  = 7,000 UNITS; SELLING PRICE = $30
  Ritter Company
Absorption Costing Income Statement
 
Sales ($30 per unit × 7,000 units) $210,000
 
Less cost of goods sold ($23 per unit × 7,000 Units) 161,000
 
  ------------
 
Gross margin 49,000
 
Less selling, general and administrative expenses ($2 per unit × 7,000 units + $60,000) 74,000
 
  ------------
 
Net operating income $(25,000)
 
  =======
 
Return On Investment (ROI)
Return on investment (ROI) = Net operating income / Average operating assets
 
= – $25,000 / $100,000

=  – 25%

Rather than focusing on costs--which can be dangerous if forecasted unit volume does not materialize--
many managers focus on customer value

Target Costing Approach to Pricing:

In traditional costing system it is presumed that a product has already been developed, has been costed,
and is ready to be marketed as soon as a price is set. In many cases, the sequence of events is just the
reverse. That is, the company already knows what price should be charged, and the problem is to
develop a product that can be marketed profitably at the desired price. Even in this situation, where the
normal sequence of events is reversed, cost is still a crucial factor. The company can use an approach
called target costing.

1. Definition and Explanation of Target Costing

2. Reasons for Using Target Costing Technique
3. Example of Target Costing Process
4. Advantages and Disadvantages of Target Costing

Definition, Explanation and Formula of Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product and then
developing a prototype that can be profitably made for that maximum target cost figure. A number of
companies--primarily in Japan--use target costing, including Compaq, Culp, Cummins Engine, Daihatsu
Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT, NEC, and Toyota etc.

The target costing for a product is calculated by starting with the product's anticipated selling price and
then deducting the desired profit. Following formula or equation further explains this concept:

[Target Cost = Anticipated selling price – Desired profit]

The product development team is then given the responsibility of designing the product so that it can be
made for no more than the target cost.

Following set of activities further explains the concept of target costing technique:
 TARGET COSTING PROCESS DIAGRAM

 
Determine Customer Wants and Price Sensitivity
 
↓
 
Planned Selling Price is Set
 
↓
 
Target Cost is Determined As: Selling Price Less Desired Profit
 
↓
  Teams of Employees from Various Areas and Trusted Vendors
Simultaneously
 
↓
  Determine Manufacturing Determine Necessary
Design Product
Process Raw Materials
 
↓
  Costs are Considered Throughout this Process. The Process Requires
Trade-offs to Meet Target Costs
 
↓
Once Target Cost is Achieved the Manufacturing Begins and Product is
Sold

Reasons for Using Target Costing Technique:

The target costing approach was developed in recognition of two important characteristics of markets
and costs. The first is that many companies have less control over price than they would like to think. The
market (i.e., supply and demand) really determines prices, and a company that attempts to ignore this
does so at its peril. Therefore, the anticipated market price is taken as a given in target costing. The
second observation is that most of the cost of a product is determined in the design stage. Once a
product has been designed and has gone into production, not much can be done to significantly reduce
its cost. Most of the opportunities to reduce cost come from designing the product so that it is simple to
make, uses inexpensive parts, and is robust and reliable. If the company has little control over market
price and little control over cost once the product has gone into production, then it follows that the major
opportunities for affecting profit come in the design stage where valuable features that customers are
willing to pay for can be added and where most of the costs are really determined. So that it is where the
effort is concentrated--in designing and developing the product. The difference between target costing
and other approaches to product development is profound. Instead of designing the product and then
finding out how much it costs, the target cost is set first and then the product is designed so that the target
cost is attained.

Example of Target Costing:

To provide a simple numerical example of target costing, assume the following situations:

Handy Appliance Company feels that there is a market niche for a hand mixer with certain new features.
Surveying the features and prices of hand mixers already in the market, the marketing department
believes that a price of $30 would be about right for the new mixer. At that price, marketing estimates that
40,000 of new mixers could be sold annually. To design, develop, and produce these new mixers, an
investment of $2,000,000 would be required. The company desires a 15% return on investment (ROI).
Given these data, the target cost to manufacture, sell, distribute, and service one mixer is $22.50 as
calculated below:

 
Projected sales (40,000 mixers  $30 per mixer ) $1,200,000
 
Less desired profit (15%  $2,000,000) 300,000
 
  ------------
 
Target cost for 40,000 mixers $9,00,000
 
  =======
 
Target cost per mixer ($9,00,000 / 40,000 mixer) $22.50

This $22.5 target cost would be broken into target cost for the various functions: manufacturing,
marketing, distribution, after-sales service, and so on. Each functional area would be responsible for
keeping its actual costs within target.

Advantages and Disadvantages of Target Costing Approach:

Target costing has the following main advantages or benefits:

1. Proactive approach to cost management.

2. Orients organizations towards customers.
3. Breaks down barriers between departments.
4. Implementation enhances employee awareness and empowerment.
5. Foster partnerships with suppliers.
6. Minimize non value-added activities.
7. Encourages selection of lowest cost value added activities.
8. Reduced time to market.

Target costing approach has the following main disadvantages or limitations:

1. Effective implementation and use requires the development of detailed cost data.
 2. its implementation requires willingness to cooperate
3. Requires many meetings for coordination
4. May reduce the quality of products due to the use of cheep components which may be of inferior
quality.

Time and Material Pricing in Service

Companies:

Contents:

1. Definition and explanation of time and material pricing .

2. Time component
3. Material component
4. Example

Definition and Explanation of Time and Materials Pricing:

Some companies--particularly in service industries-- use a variation of cost plus pricing called time and
material pricing. Under this method, two pricing rates are established--one based on direct labor time
and other based on the cost of direct materials used. This pricing method is used in repair shops, in
printing shops, and by many professionals such as physicians and dentists. The time and material rates
are usually market determined. In other words, the rates are determined by the interplay of supply and
demand and by competitive conditions in the industry. However, some companies set the rates using a
process similar to the process followed in the absorption costing approach to cost plus pricing. In this
case, the rates include allowances for selling, general and administrative expenses; other direct and
indirect costs; and a desired profit. This page will show how the rates might be set using the cost-plus
approach.

Time Component:

The time component is typically expressed as a rate per hour of labor. The rate is computed by adding
together three elements:

1. The direct costs of the employee, including salary and fringe benefits.
2. A pro rata allowance for selling, general, and administrative expenses of the organization.
3. An allowance for a desired profit per hour of employee time.
In some organizations (such as a repair shop), the same hourly rate will be charged regardless of which
employee actually works on the job; in other organizations, the rate may vary by employee. For example,
in a public accounting firm, the rate charged for a new assistant accountant's time will generally be less
than the rate charged for an experienced senior accountant or for a partner.

Material Component:

The material component is determined by adding a material loading charge to the invoice price of any
materials used on the job. The material loading charge is designed to cover the costs of ordering,
handling, and carrying materials in stock, plus a profit margin on the materials themselves.

Example of Time and Material Pricing:

To provide a numerical example of time and material pricing, consider the following:

Quality Auto Shop uses time and material pricing for all of its repair work. The following costs have been
budgeted for the coming year:

 
  Repairs Parts
 
Mechanics' wages $300,000  
 
Service manager--salary 40,000  
 
Parts manager--salary   $36,000
 
Clerical assistant--salary 18,000 15,000
  Retirement and insurance--16% of salary and
57,280 8,160
wages
 
Supplies 720 540
 
Utilities 36,000 20,800
 
Property taxes 8,400 1,900
 
Depreciation 91,600 37,600
 
Invoice cost of parts used   400,000
 
     
 
Total budgeted cost    

The company expects to bill customers for 24,000 hours of repair time. A profit of $7 per hour of repair
time is considered to be feasible, given the competitive conditions in the market. For parts, the
competitive markup on the invoice cost of parts used is 15%.

The following schedule shows the calculation of the billing rate and the material loading charge to be used
over the next year.
 TIME AND MATERIALS PRICING

  Time Component: Parts: Material

  Repairs Loading Charge
  Per
  Total Total Percent**
Hour*
 
Cost of mechanics' time:        
 
Mechanics' wages $300,000      
 
Retirement and insurance (16% of wages) 48,000      
 
  -------------      
 
Total cost 348,000 $14.5    
  For repairs--other cost of repair service. For
parts--cost of ordering handling, and storing        
parts:
 
Repairs service manager--salary 40,000      
 
Parts manager salary     $36,000  
 
Clerical assistant salary 18,000   15,000  
 
Retirement and insurance (16% of salaries) 9,280   8,160  
 
Supplies 720   540  
 
Utilities 36,000   20,800  
 
Property taxes 8,400   1,900  
 
Depreciation 91,600   37,600  
 
  -------------   -------------  
 
Total cost 204,000 8.50 120,000 30%
 
  -------------   -------------  
 
Desired profit:        
 
24,000 hours × $7per hour 168,000 7.00    
 
15% × $400,000     60,000 15%
  -------------- -------------
  -------- -------
- -
 
Total amount to be billed $720,000 $30.00 $180,000 45%
 
  ======== ===== ======= ====
 
*Based on 24,000 hours
  **Based on $400,000 invoice cost of parts. The charge for ordering, handling, and storing
parts, for example, is computed as follows: $120,000 cost / $400,000 invoice cost = 30%

Note that the billing rate, or time component, is $30 per hour of repair time and the material loading
charge is 45% of the invoice cost of parts used. Using these rates, a repair job that requires 4.5 hours of
mechanics time and $200 in parts would be billed as follows:

 
Labor time: 4.5 hours  $30 per hour   $135
 
Parts used:    
 
Invoice cost $200  
 
Material loading charge: 45%  $200 90 290
 
  -------- ------
 
Total price of the job   $425
 
    =====

Rather than using labor hours as the basis for calculating the time rate, a machine shop, a printing shop,
or a similar organization might use machine-hours.

This method of setting prices is a variation of the absorption costing approach. As such, it is not surprising
that is suffers from the same problem. Customers may not be willing to pay the rates that have been
computed. If actual business is less that the forecasted 24,000 hours and $400,000 worth of parts, the
profit objectives will not be met and the company may not even break even.