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 $10,300. 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 28,000 hours before replacement. It only requires $2,900 of preventive maintenance during its useful life and it consumes $215 of electricity per 1,400 hours used.
These figures compare favorably to the competing piece of equipment that sells for $28,000, needs to be replaced after 14,000 hours of use, requires $5,800 of preventive maintenance during its useful life, and consumes $254 of electricity per 1,400 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 28,000-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?
Explanation
1.
The absorption cost-plus price of $19,055 is computed as follows:
| Unit product cost | $ | 10,300 |
| Markup (85% × $10,300) | 8,755 | |
| Selling price per unit | $ | 19,055 |
2.
The economic value to the customer (EVC) is computed as follows:
EVC = Reference value + Differentiation value
EVC = $28,000 + $37,480
EVC = $65,480
The differentiation value shown above ($37,480) includes three components. First, customers who purchase an XP-200 rather than the competing alternative would avoid the need to buy a second piece of equipment for $28,000 to achieve 28,000 hours of usage. Second, customers who purchase an XP-200 rather than the competing alternative would realize preventive maintenance savings of $8,700 over a 28,000-hour period, computed as follows:
| Competing Equipment | XP-200 | ||||
| Preventive maintenance cost for 28,000 hours: | |||||
| $5,800 × (28,000 hours ÷ 14,000 hours) | $ | 11,600 | |||
| $2,900 × (28,000 hours ÷ 28,000 hours) | $ | 2,900 | |||
| Differentiation value | $8,700 | ||||
| Competing Equipment | XP-200 | ||||
| Electricity cost for 20,000 hours: | |||||
| $254 × (28,000 hours ÷ 1,400 hours) | $ | 5,080 | |||
| $215 × (28,000 hours ÷ 1,400 hours) | $ | 4,300 | |||
| Differentiation value | $780 | ||||
Thus, the total differentiation value is $28,000 + $8,700 + $780 = $37,480.
3.
The range of possible prices is as follows:
Reference value ≤ Value-based price ≤ EVC
$28,000 ≤ Value-based price ≤ $65,480
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