Wendel Stove Company is developing a “professional” model stove aimed at the hom

Question

Wendel Stove Company is developing a “professional” model stove aimed at the home market. The company estimates that variable costs will be $2,000 per unit and fixed costs will be $10,000,000 per year.

a.Suppose the company wants to set its price equal to full plus 30 percent. To determine cost, the company must estimate the number of units it will produce and sell in a year. Suppose the company estimates that it can sell 5,000 units. what price will the company set?

b.What is ‘odd’ about setting the price based on an estimate of how many units will be sold?

c.Suppose the company sets a price as in part a, but the number of units demanded at that price turns out to be 4,000. Revise the price in light of demand for 4,000 units.

d.What will happen to the number of units that will be sold if the price is raised to the one you calculated in part c?

e.Explain why setting price by marking up cost is inherently circular for a manufacturing firm.

Explanation / Answer

a.Suppose the company wants to set its price equal to full plus 30 percent. To determine cost, the company must estimate the number of units it will produce and sell in a year. Suppose the company estimates that it can sell 5,000 units. what price will the company set?

Variable costs        $2,000 x 5,000 units    $10,000,000
Fixed costs                                              $10,000,000
Total costs                                              $20,000,000
Add : Mark-up @30%                                  $6,000,000
Total Sales Revenue                               $26,000,000
Selling price per unit
$26,000,000 / 5000                                     $5,200
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b.What is ‘odd’ about setting the price based on an estimate of how many units will be sold?
   Setting the price based on estimation of sales forecast will depend on external factor beyond the control of the management. Any reduction in sales might result in disaster for the company.  The price affects how many units are sold.

c. Suppose the company sets a price as in part a, but the number of units demanded at that price turns out to be 4,000. Revise the price in light of demand for 4,000 units.

Variable costs        $2,000 x 4,000 units      $8,000,000
Fixed costs                                              $10,000,000
Total costs                                              $18,000,000
Add : Mark-up @30%                                  $5,400,000
Total Sales Revenue                               $23,400,000
Selling price per unit
$23,400,000 / 4000                                     $5,850


d.What will happen to the number of units that will be sold if the price is raised to the one you calculated in part c? The demand might declined further below 4,000 units.

e.Explain why setting price by marking up cost is inherently circular for a manufacturing firm.
   The company starts with an estimate of costs and adds a markup to arrive at a price that allows for a reasonable level of profit. This process is circular for manufacturing firms in that the quantity demanded which is needed to estimate full cost per unit, is determined prior to setting the price, which has a major impact on the quantity demanded. This circular process as increased price, decreased demand, increased cost per unit, increased price is not a strategy used by the companies.

In other words, The sales affects the price, and in return the price affects sales.

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