Question

EXERCISE 12A-6 Value-Based Pricing; Absorption Costing Approach to Cost-Plus Pricing L012-8, L012–10 Valmont Company has developed a new industrial piece of equipment called the XP-200. The company is considering two methods of establishing a selling price for the XP-200—absorption cost-plus pricing and value-based pricing. Valmont's cost accounting system reports an absorption unit product cost for XP-200 of $8,400. Its markup percentage on absorption cost is 85%. The company's marketing managers have expressed concerns about the use of absorption cost-plus pricing because it seems to overlook the fact that the XP-200 offers superior performance relative to the comparable piece of equipment sold by Valmont's primary competitor. More specifically, the XP-200 can be used for 20,000 hours before replacement. It only requires $1,000 of preventive maintenance during its useful life and it consumes $120 of electricity per 1,000 hours used. These figures compare favorably to the competing piece of equipment that sells for $15,000, needs to be replaced after 10,000 hours of use, requires $2,000 of preventive maintenance during its useful life and consumes $140 of electricity per 1,000 hours used. Required: 1. If Valmont uses absorption cost-plus pricing, what price will it establish for the XP-200? 2. What is XP-200's economic value to the customer (EVC) over its 20,000-hour life? 3. If Valmont uses value-based pricing, what range of possible prices should it consider when setting a price for the XP-200? 4. What advice would you give Valmont's managers when choosing between absorption cost- plus pricing and value-based pricing?

Answer 1

1. Under absorption costing, price would be 8400*1.85 = $ 15,540

2. Economic Value to Customer (EVC) to customer would be Reference Value of closest substitute + Value of difference in the product.

Here, Reference Value of closest substitute is $ 15000.

And, value of difference in the product = value of replacement at 10000 hours of $ 15000 + value of lesser maintenance cost at 20000 hours life (4000-1000) + value of lesser electricity cost (20/hour*20 hours)= 15000+3000+400 = $ 18400

Thus, EVC = 15000 + 18400 = $ 33,400

3. Price range should be from $ 15000 to $ 33400

4. I will advice manager to choose value based pricing as it will cover the R&D expenses incurred, give larger profit for the higher risk taken, give a premium standing to the product.

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