Module 7

Product Pricing and Profit Analysis

At the end of the module, student should be able to:

 Understand the importance of pricing as a business strategy.
 Illustrate the different models of product pricing.
 Use the different cost-based pricing techniques and compute the mark-up rate.
 Identify cost-based from non-cost based costs and expenses.
 Relate product pricing to profitability.
 Calculate the sales price variance, sales quantity variance, cost price variance, cost quantity
variance, sales mix variance and final sales volume variance.
 Explain the general causes of sales and cost variances affecting profit.

Product Pricing

The operating profit or loss is not only affected by cost and expenses, but also by sales. Sales are affected
by volume and unit sales price. The number of units sold is something not directly controlled by manager
but is influenced by various market factors such as general financial and economic conditions,
technological developments, changes in customer’s needs and wants, competition, and other forces in the
market place.

Let us deal with competition as a force that influences the number of units sold. Among the variables of
competition is price. Product pricing is a delicate, technical and strategic matter. If your product is priced
too exorbitantly, the market would repudiate it. If the product is priced too low, it may stir strong
reactions from competitors that may lead to strenuous and unfavorable operational circumstances. Or, if
the product is priced too low, customers may consider the product cheap and not worth their utility and
possession.

Still, pricing a product is a decision that directly affects the profitability of business operations. This field
of business management has been truly more of an art than science. A sales price is determined by a host
of factors that even experienced companies have been continually monitoring to influence price trends
which are affected not only by competition but by changing customer wants and needs, governmental
regulations, changes in technology, and other external economic factors, to name a few. Because of this,
the field of product pricing has generated various pricing models.

Pricing Models

Setting the price of a product could be done in different perspectives, such as:

 Traditional pricing
o Economist’s model
o Premium pricing (perception –based prestige pricing)
o Controlled market-based pricing

 Strategic pricing
o Target pricing
o Life-cycle-based pricing
o Penetration-based pricing
o Skimming-based pricing
o Predatory pricing
o Loss leader pricing
o Product bundling
o Pricing with additional features

 Tactical pricing
o Time pricing
o Material-based pricing
o Distress pricing
o Transfer pricing
o Cost-based pricing
Traditional Pricing Models

The traditional pricing models follow the basic methods of determining a unit-sales price.

The Economist’s model

This pricing model is based on the principle of scarcity of resources and rationality of men. It anchors on
the universal and basic laws of supply and demand which state that as the demand for a product increases,
the price correspondingly increases, and vice-versa. Likewise, if the supply for a product increases or
exceeds the market needs, the price correspondingly decreases, and vice-versa. Pricing in this model is
fundamentally based on the reaction of the market. The change in price in relation to the change in the
level of demand and supply could either be elastic or inelastic. There is demand elasticity if a minimal
change in price greatly affects the demand of a product. And there is demand inelasticity if a minimal
change in price significantly changes the demand of a product.

Fig. 11.1. Elasticity of Demand

Elasticity of demand = Percentage of change in quantity demanded

Percentage of change in price

Theoretically, if the level of demand and supply does not change, price remains constant.

Note that there is a negative relationship, or negative correlation, between price and demand. As price
decreases, the level of quantity demanded tends to increase, and vice-versa. Given the downward or
negative, slope of the demand curve in relation to price, the negative sign in the numerator has the effect
of making the outcome positive, simply to more conveniently represent the relationship.

If the elasticity of demand is greater than 1, demand is considered elastic. This means that a reduction in
price would increase demand considerably. And if the elasticity of demand is less than 1, demand is
considered inelastic. This means that if price increases, the demand for the product would decline.

The importance of knowing the elasticity of demand is emphasized when critically pricing a product in
periods of hard business adjustments. For example, when cost inflation is higher than sales price inflation
and the product’s demand elasticity is positive, it would not advisable for an enterprise to increase its
sales price to level off the increase in cost prices because an unnecessary increase in sales price would
adversely affect its units sold resulting to lower revenues and consequently lower profit.

Factors Affecting Price Elasticity

There are multitudes of variables affecting price elasticity. Some of the most considered factors affecting
price elasticity are as follows:

 Market definition
 Competition and product availability
 Substitute products
 Complementary products
 Disposable income
 Product necessity
 Consumer habits

Sample Problem 7.1 Demand Elasticity

The following results were tabulated with respect to the relationship of changes in price and units sold
with respect to product “Mozz”:

P0 P1 Average Percentage
Sales price P100 P 120 P 20 P 110 18.18%
Quantity sold 2,000 1,500 (500) 1,750 28.57
= Change
Required: Determine the elasticity of demand.
Solutions/ Discussions:

 Applying the formula, we have:

Elasticity of demand = Percentage in Quantity Demanded

Percentage in Unit Sales Price
= -28.57% / 18.18%
= - 1.57

 The -1.57 elasticity rate means that product Mozz is considerably elastic with the change in its
selling price. Stating more concretely, for every 1% change in price, the quantity demanded
inversely changes by -1.57%.

Premium Pricing (or perception – based pricing)

This pricing model resides on the psychology of the market participants. If a product offers good utility
and value, buyers are willing to pay for more. That is, their satisfaction is heightened. Otherwise, if the
product offers inferior value and use, the market would absorb the product if the price is lowered.
Reversing the perspective, we could say that if the price of a product is high, the value and utility (i.e.,
quality) of that product is also high, and vice-versa. This reversed-market analysis led to the development
of product branding, product differentiation, and similar marketing models.

Controlled-market-based pricing

This product pricing model based its prices on government regulations or implied agreements among key
players in the market. Gas and oil companies, mining companies, and utility companies use this model.

Strategic Pricing Models

Target Pricing

In this model, the company looks at the market, determines the prevailing market price, establishes its
desired profit, then computes the should be amount of cost to be incurred in producing and selling a
product. Once the cost is determined, processes, activities, systems are established accordingly to produce
a product not in excess of the determined cost, otherwise, the profit will suffer. Costs become targets for
improvement. To improve costs means to reduce it. To reduce costs, continuous improvements are
needed. This model, like the life-cycle costing, is in line with the trend of increasing efficiency,
productivity and competitiveness for long-term survival.

Life-cycle-based pricing

Here, a price is established that would be applicable over the life-span of a product. The price is
determined by dividing the total costs (i.e., locked-in costs and operational costs) over the total estimated
units to be produced and sold.

The life stages of a product are normally divided into four, namely: infancy (or start-up) stage, growth
stage, expansion stage, and maturity/ decline stage. In the life-cycle-based pricing, another stage is
included which is the pre-infancy (or conception stage). This stage precedes the infancy stage. During this
pre-infancy stage, strategic decisions are made and costs are locked-in. Locked-in costs (or designed-in
costs) are not yet incurred but are expected to be incurred in the future, as caused by decisions made
during the infancy stage. To effectively reduce costs, locked-in costs should be minimized.

Life-cycle-based pricing includes all costs relative to a product. These are costs in research and
development, design, production, marketing, distribution, and customer services. A significant portion of
a product’s life-cycle costs are incurred even before the start of commercial operations. And ignoring the
effects of these costs incurred and committed prior to commercial production would understate the true
amount of costs and may lead to lower sales price and reduced profitability.

One of the pre-commercial expenditures that has a great impact on operational costs is the cost of design.
An excellent product design that meets customer’s acceptance effectively puts in place efficient and
economical manufacturing system that brings lesser costs relative to retraining, retooling, production
setups, spoilage, and design changes after production has started.
Problem Sample 7.2. Life-cycle based pricing

King Lion Company is contemplating to introduce a product which is expected to be sold in the market
for five years. The product feasibility has been prepared and the following data were presented.

Life-cycle stage Costs Production

Infancy and pre-infancy P 20,000,000 50,000
Growth 8,000,000 250,000
Expansion 5,000,000 500,000
Maturity and decline 1,000,000 200,000
Total P 34,000,000 1,000,000

The company would like to apply the life-cycle based costing and price its product based on the strategic
life-cycle costs. It is studying the pricing strategy it has to adopt under each of the following schemes:

Life-cycle stage Scheme 1 Scheme 2

Infancy and pre-infancy 20% higher 1,000% higher
Growth 500% higher 1,000% higher
Expansion 1,000% higher 800% higher
Maturity and decline 10% higher 10% higher

It is also estimated that all units produced would be sold.

Required: Determine for each of the schemes mentioned above the following:
1. Life-cycle costs per unit.
2. Unit sales prices under each scheme for each life cycle stages.
3. Product life-cycle profit under each pricing scheme.

Solutions/ Discussions:
1. The life-cycle cost per unit is computed as follows:

Life-cycle cost per unit = P 34,000,000 / 1,000,000 = P 34.00

2. The unit sales price under each scheme for each life cycle stages would be:

Scheme 1 Scheme 2
Life-cycle stage Computations Unit sales price Computations Unit sales price
Infancy and pre-infancy P 34 x 120% P 40.80 P 34 x 1,100% P 374.00
Growth P 34 x 600% 204.00 P 34 x 1,100% 374.00
Expansion P 34 x 1,100% 374.00 P 34 x 900% 306.00
Maturity and decline P 34 x 110% 37.40 P 34 x 110% 37.40

3. The product life-cycle profit for each pricing scheme would be

Scheme 1 Scheme 2
Life-cycle Production Unit sales Amount Production Unit sales Amount
price (000’s) price (000’s)
Infancy and pre-infancy 50,000 P 40.80 P 2,040 50,000 P 374.00 P 18,700
Growth 250,000 204.00 51,000 250,000 374.00 93,500
Expansion 500,000 374.00 187,000 500,000 306.00 153,000
Maturity and decline 200,000 37.40 7,480 200,000 37.40 7,480
Total product sales 247,520 272,680
- Total product costs 34.00 34,000
Profit P 213,520 P 238,680

Apparently, Scheme 2 would bring more profit to the enterprise and therefore would be the better
strategic option.

Penetration Pricing

This pricing model is applied when a company wants to enter a market where entry is relatively easy due
to minimal amount of investment needed, absence of high-level technological requirements, and a market
not controlled by one or few players. To penetrate a market, pricing is se at a lower level to gain
widespread market acceptance. Penetration pricing is most applicable in a buyers market where the
behavior of the market is significantly influenced by buyers than by sellers.

Skimming Pricing

This pricing model is applicable in a seller’s market. This market is difficult to enter due to some entry
barriers such as great amount of investment requirement, need for a high-level of technological
applications, and presence of only a few sellers in the market. At this instance, the seller influences the
level of pricing and normally sets the price at a higher level. This pricing model gives more protection to
sellers than that of the penetration pricing.

Predatory (or anti-competition) pricing

In this model, a company sets a very low price purposely to gain greater share of and ultimately control
the market. The price set is so low that ordinary producers and sellers would not dare follow to avoid
incurrence and recurrence of operational loss. This pricing model drives away operationally inefficient
and financially insufficient players who do not have the critical financial string to absorb operational
losses and maintain their market presence. This technique is considered not conducive to a healthy trade
and developmental business environment. Other countries have laws against predatory pricing.

Loss Leader Pricing

Loss leader pricing applies when there is a main product with subsequent sales of parts and services. The
main product is priced at a very low price that sometimes is lower than the cost of producing it but
company would recover later by selling unique parts, consumables, rendering highly technical services
that are priced at a much higher amount. Examples are low-priced computer printer with high-priced
cartridges, low-priced gadget with high-priced supplies (e.g. razor as the main product and razor blades as
the “extra” or supplies), and free or very low cost of installing phone connection with relatively expensive
monthly fees.

Pricing with Additional Features

Main products are sometimes sold with additional features or “ extras” . With the “extras” on the product,
the price of the product would logically change. At what price level depends on the acceptability of the
additional features to the customers, whether the “extras” add value to their use of the product or not.

Product Bundling

Product bundling is packaging the interrelated products together to make a complete set and offered to
customers at a temptingly low price. This technically sets the average price and margin for all the
products included in the bundle. It has the advantage of selling slow moving products and still maintain
the desired overall financial performance of an enterprise. It also has an advantage of creating savings in
product handling, packaging, and invoicing costs.

Bundling is proven to be successful when used to matured products and customer loyalty is already high.
However, issues are to be handled on the reaction of competitors on the bundling policy and the
customers reactions when products are unbundled later.

Tactical Pricing

 Time pricing. This pricing model considers time as the basis in setting a price. This applies to
professionals (such as lawyers, accountants, doctors, consultants)and non-professionals (such as
repairmen and technicians) alike.

 Materials-based pricing–In this model, price is based on the expected amount of materials to be
used. For example, construction companies estimate contract prices substantially based on
materials to be used in a given construction project.
  Distress (or incremental) pricing – This pricing techniques is used when there is an idle
capacity, competition is very stiff, and businesses have to sell hard their products to at least
breakeven. In this case, sales price is based not on the regular production costs but on relevant
(i.e., incremental) costs to produce and sell a product. Here, profitability is subordinated to
recoverability of cost and sustainability of operations.

 Transfer pricing- This pricing model applies when there is an inter-company oriented-divisional
transfer of products between affiliated companies and company or divisional managers are
evaluated based on their operating performances. Transfer prices may be based on market, cost,
negotiated prices, arbitrary or dual prices.

 Cost-based pricing – This pricing model rationalizes that price equals cost plus markup. This
model is explained more in the next three pages.

Cost-based Pricing

This is a traditional and simple technique of setting a sales price. You only have to determine the costs of
producing a product and operating a business, then add your desired profit and you will arrive at a sales
price. This relationship is depicted below:

Costs (and expenses) Px

Add: Profit x
Sales price Px

Costs have different meanings. A cost may pertain to materials costs, prime costs, conversion costs, total
production costs, variable production costs, variable costs and expenses, total costs and expenses or any
other definition of cost. Because of this, sales price is restated as follows:

Cost-based P x (as defined)

Add: Markup x (includes profit plus non-cost-based)
Sales price Px

Cost-based is anchored to the definition of cost. If the sales price is based on absorption cost, then the cost
based pricing includes the costs of materials, labor, variable overhead, and fixed overhead. If the cost is
defined as prime cost, then the cost-based is the sum of direct materials and direct labor.

Non-cost based refers to all other costs and expenses not included in the cost-based. If the cost-based is
prime cost, the non-cost-based includes variable overhead, fixed overhead, variable expenses and fixed
expenses. To emphasize, consider the classification of costs and expenses below, either as cost-based or
non-cost-based, in relation to cost-based pricing analysis:

Cost is defined as
Costs and Expenses Prime Cost Absorption cost
Materials Px Cost-based
Labor x Cost-based
Variable overhead x
Fixed overhead x
Non-cost based
Variable expenses x
Non-cost based
Fixed expenses x

The determination of cost-based and non-cost based depends on the definition of cost used in the pricing
model.

Markup does not only refer to profit. It is the sum of profit and non-cost based. Markup is computed by
multiplying cost-based with markup ratio. Markup ratio is markup over cost-based. The summary of this
mathematical relationship is given on the next page:
 Sales price = Cost-based + Markup where:
Markup = Cost-based x Markup ratio markup = non-cost based + profit
Markup ratio = Markup / Cost-based
or:
Markup ratio = (Non-cost-based + Profit) / Cost-based
To illustrate, let us assume the data given on sample problem 1 below:

Sample Problem 7.3. Sales Price Setting Using Cost-Based Model

The Accounting Department of Baguio Corporation has assembled the following data relative to product
Cold:

Per Unit
Direct materials P 10.00
Direct labor 20.00
Variable overhead 5.00
Fixed overhead 6.00
Variable expenses 5.00
Fixed expenses 4.00
Total costs and expenses P 50.00

The company wants a 20% return on its investment of P 3 million. It expects to sell 40,000 units of cold
in the coming period.

Required: Determine the (a) unit sales price and (b) markup percentage of product cost assuming that the
cost-based model is used:
1. Absorption method
2. Contribution margin (or marginal costing) method
3. Prime cost
4. Conversion cost
5. Material cost

Solutions/ Discussions:

 Basically, the sales price is computed in details as follows:

Per Unit
Direct materials P 10.00
Direct labor 20.00
Variable overhead 5.00
Fixed overhead 6.00
Variable expenses 5.00
Fixed expenses 4.00
Total costs and expenses P 50.00
Add: Profit (P 3 million x 20% / 40,000 units) 15.00
Unit sales price P 65.00

 The sales prices under various cost definitions are:

(1) (2) (3) (4) (5)

Cost-based P 41.00 P 40.00 P 30.00 P 25.00 P 10.00
Markup*
(P 41 x 58.54%) 24.00
(P 40 x 62.50%) 25.00
(P 30 x 116.67%) 35.00
(P 25 x 160.00%) 40.00
(P 10 x 550.00%) 55.00
Unit sales price P 65.00 P 65.00 P 65.00 P 65.00 P 65.00
__________________________________
Markup = Cost-based x markup ratio
  Markup ratio is profit plus non-cost based divided by cost-based. The markup ratios are
calculated below:
Absorption Marginal Prime Conversion Material
cost cost cost cost cost
Profit P 15.00 P 15.00 P 15.00 P 15.00 P 15.00
Non-cost based
(P 50 – P 41) 9.00
(P 50 – P 40) 10.00
(P 50 – P 30) 20.00
(P 50 – P 25) 25.00
(P 50 – P 10) 40.00
Markup 24.00 25.00 35.00 40.00 55.00
/ Cost-based 41.00 40.00 30.00 25.00 10.00
Markup ratio 58.54% 62.50% 116.67% 160.00% 550.00%
___________________________________________________
(*Non-cost based= Total costs and expenses (i.e., P 50) less cost-based)

 Notice that the sales price remains the same regardless of the cost-based used. This is correct
because the purpose of setting the markup ratio is not to change the sales price, neither to change
the profit but to expedite and simplify the determination of the unit sales price. There are
variations in the definition of cost-based inasmuch as the process of accumulating and the timing
of accumulating accounting data vary from a company to another. Some companies can instantly
determine cost-data on materials while others can quickly assemble data on conversion costs, or
other costs data. This explains why cost-based is defined differently.

Gross Profit Variation Analysis

Profitability is determined not only to measure a department’s performance but that of a manager as well.
It serves as a feedback information on the what and why of operating performance, productivity and
profitability wise. It gives a glimpse on what happened to the business operations. It is also an indicator in
identifying excellent managerial techniques to sustain organizational effectiveness and in determining
causes of operational failures.

The first line of profitability is measured by the gross profit under the absorption costing method and
contribution margin using the variable costing method. The gross profit variance analysis is illustrated in
this chapter. The contribution margin variance analysis follows the pattern of analyzing the gross profit
variations.

Gross profit is the difference of sales and cost of goods sold. Ergo, a change in gross profit is caused by a
change in sales and cost of goods sold. Sales is a factor of number of units sold and sales price. Therefore,
a change in sales, which causes a change in gross profit, is affected by a change in units sold and unit
sales price.

Similarly, cost of goods sold is a factor of units sold and unit cost. Therefore, a change in cost, which also
causes a change in gross profit, is affected by a change in units sold and unit cost price. This relationship
is presented on the next page.

Sales P x (quantity sold x unit sales price)

Cost of goods sold x (quantity sold x unit cost price)
Gross profit P x
A gross profit variance is a difference between the actual gross profit and a base gross profit. Normally,
the base gross profit is the gross profit in the last year. The base in computing the gross profit variance
may also be the budgeted data, industry averages, or a chief competitor’s data. For purposes of our
illustration, we will use the last year’s data as the basis of computing a gross profit variance. The gross
profit variance may be summarized as follows:

This Year Last Year Net Variance

Sales P x P x P x
Less: Cost of goods sold x x x
Gross profit P x P x P x
Data treated as Actual Standard
The Sales Variances

The net sales variance is composed of the sales price variance and sales quantity variance. These
variances are computed as follows:

SPV = (USPTY – USPLY) QSTY = USP x QSTY

SQV = (QSTY – QSLY) USPLY = Q x USPLY
where: SPV = Sales price variance
SQV = Sales quantity variance
USPTY = Unit sales price this year (i.e., actual price)
USPLY = Unit sales price last year (i.e., standard price)
QSTY = Quantity sold this year (i.e., actual quantity)
QSLY = Quantity sold last year (i.e., standard quantity)

The Cost of Sales Variances

CPV = (UCPTY – UCPLY) QSTY = UCP x QSTY

CQV = (QSTY – QSLY) UCPLY = Q x UCP
where:
CPV = Cost price variance
CQV = Cost quantity variance
UCPTY = Unit cost price this year (i.e., actual price)
QSTY = Quantity sold this year (i.e., actual quantity)
QSLY = Quantity sold last year (i.e., standard quantity)

The Gross Profit Variances

The gross profit variance is normally accounted for following the sources and operational classification of
variances as follows:
Sales variances:
Sales price variance Px
Sales quantity variance x P x
Cost of goods sold variances:
Cost price variance x
Cost quantity variance x x
Gross profit variance P x
The gross profit variance may also be classified as price factor and quantity factor (i.e., volume factor):

Price factor:
Sales price variance Px
Cost price variance x P x
Net price variance
Quantity factor:
Sales quantity variance x
Cost quantity variance x x
Net quantity variance
 Gross profit variance P x
(You may also say that gross profit is affected by at least three major variables – unit sales price, unit
cost price, and unit sold)

The gross profit variance analysis follows the direct materials variance analysis

Notice the formula used in the computing sales and cost variances follow the same pattern as used in the
direct materials price variance and quantity variance, discussed and reviewed below.

Materials Price Variance = (Actual Unit Price – Standard Unit Price) x Actual Quantity Sold
Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Unit Price
If:
Actual unit price = Unit sales price this year
Standard unit price = Unit sales price last year
Actual quantity = Quantity sold this year
Standard quantity = Quantity sold last year
By substitution, we have the sales variances as:
SPV = (USPTY – USPLY) QSTY = USP x QSTY
SQV = (QSTY – QSLY) USPLY = Q x USPLY
(The analysis of cost variances follow the patterns as that of the sales analysis.)
The variances are normally identified as U for unfavorable and F for favorable.

To illustrate the applications of these formula, let us consider the following:

Sample Problem 7.4. Basic gross profit variance analysis
The management of Triple Star Corporation is analyzing the factors that cause an increase in its gross
profit in 2020. The information shown below is assembled for this purpose.
2019 2020 Increase
(Decrease)
Sales P 2,640,000 P 2,750,000 P 110,000
Less: Cost of goods sold 1,760,000 2,125,000 365,000
Gross profit P 880,000 P 625,000 P (255,000)
Units sold 22,000 25,000 3,000
Unit sales price P 120.00 P 110.00 P (10.00)
Unit cost price P 80.00 P 85.00 P 5.00
Analyze the gross profit variation, using the:
1. 2-way variance analysis.
2. 3-2ay analysis
Solutions/ Discussions:
1. 2-way variance analysis.
The variances are calculated as follows (refer to formula guidelines on page ):
Price variance:
Sales price variance [P (10) UF x 25,000 units] P (250,000) U
Cost price variance (P 5 UF x 25,000 units) 125,000 U
Net price variance P (375,000) U
Quantity variance:
Sales quantity variance (3,000 F x P 120) 360,000 F
Cost quantity variance (3,000 UF x P 80) 240,000 U
Net quantity variance 120,000 F
Gross profit variance P (255,000) U
Notice that the quantity variance, both for sales quantity variance and cost quantity variance, are based on
the same quantities. Hence, when used in analysis, the term quantity variance refers to the net quantity
variance, which in this case is P 120,000 favorable.

2. 3-way variance analysis

When using the 3-way analysis, the “joint variance” is included in the analysis on top of the basic price
and quantity variances, as follows:

Price variances:
Sales price variance [P (10) U x 22,000 units] P (220,000) U
Cost price variance (P 5 U x 22,000 units) 110,000 U P (330,000) U
Quantity variance:
Sales quantity variance (3,000 F x P 120) 360,000 F
Cost quantity variance (3,000 UF x P 80) 240,000 U 120,000 F
Joint variances:
Joint sales price-quantity variance [P (10) U x 3,000 F] (30,000) U
Joint cost price-quantity variance [P 5 U x 3,000 UF) 15,000 U 45,000 U
Net decrease in gross profit P (255,000) U

Contribution margin variance analysis

The procedures used in analyzing contribution margin variance follows that of the gross profit variance
analysis.

Sample Problem 7.5 Contribution Margin Variance Analysis

The comparative partial income statement of Crispy Corporation in 2019 and 2020 is shown below.

Crispy Corporation
Comparative Income Statement Data
For the Years Ended, December 31, 2019 and 2020
(in thousands)

2019 2020 Increase

(Decrease)
Sales P 90,000 P 96,000 P 6,000
Less: Variable costs 54,000 52,000 (2,000)
Contribution margin P 36,000 P 44,000 P 8,000
Units sold 3,600 4,000 400
Unit sales price P 25 P 24 (1)
Unit variable costs 15 13 (2)

Analyze the contribution margin variance analysis using the 2-way analysis.
Solutions/Discussions:
 The contribution margin variances are computed and presented below:
Sales variances:
Sales price variance [P (1) UF x 4,000 units] P (4,000) UF
Sales quantity variance (400 F x P 24) 10,000 F P 6,000 F
Variable cost variances:
Variable cost price variance [(2)F x 4,000 units) (8,000) F
Variable cost quantity variance (400 F x P 15) 6,000 UF (2,000) F
Net contribution margin variance P 8,000 F
Gross Profit Variance Analysis... Only a variance rate is given

At times data are not all available. The unit sales price, unit cost price and units sold may not be given on
their absolute values but are given in terms of percentage change. The variances to be computed shall be
the same, but the procedural computations are slightly reconfigured.

The sales variances may also be analyzed as follows:

Sales this year = QSTY x USPTY

Sales price variance
Applied sales this year = QSTY x USPLY
Sales quantity variance
Sales last year = QSLY x USPLY

The sales this year and sales last year are normally available. The item to be calculated is the amount of
sales this year at unit sales prices last year. To compute this amount we have to know a sales variance
ratio. A sales variance ratio given may be a sales price variance ratio or a sales quantity variance ratio.
For example, say the last year’s unit sales price is P 200 and it increase by P 40 this year, then, the sales
price variance ratio is 20% (i.e., P 40/P 200). Assume again that the units sold last year was 40,000 units
and decreases to 44,000, then, the sales quantity variance ratio is 10% (i.e., 4,000/40,000 where 4,000 =
44,000 less 40,000).

The sales this year at sales prices last year (STY @ USPLY) is calculated as follows:

If the given is Then,

1. Sales price variance rate : STY @ USPLY = Sales this year / (1 + Sales price variance ratio)
2. Sales quantity variance rate : STY @ USPLY = Sales last year x (1 + Sales quantity variance ratio)

The cost variance are analyzed as follows:

Cost this year = QSTY x UCPTY

Cost price variance
Applied cost this year = QSTY x UCPLY
Cost quantity variance
Cost last year = QSLY x UCPLY

The cost this year and cost last year are normally available. The item to be calculated is the amount of
cost of goods sold this year at unit sales prices last year. To compute this amount we have to know a cost
variance ratio. A cost variance ratio given may be a cost price variance ratio or a cost quantity variance
ratio.

The cost this year at cost prices last year (CTY @ UCPLY) is calculated as follows:

If the given is Then,

1. Cost price variance rate : CTY @ UCPLY = Cost this year / (1 + Cost price variance ratio)
2. Cost quantity variance rate : CTY @ UCPLY = Cost last year x (1 + Cost quantity variance ratio)

To illustrate, assume the following:

Sample Problem 7.6. Gross profit variance analysis with only a variance ratio given.

Arabian Corporation decreased its sales price by 10% in 2020 as compared with 2019. Its gross profit data
are provided below.

2019 2020 Change +(-)

Sales P 2,000,000 P 2,340,000 P 340,000
Less: Cost of goods sold 1,400,000 1,911,000 511,000
Gross profit P 600,000 P 429,000 P (171,000)

Compute the gross profit variances.

Solutions/ Discussions:

Sales price variance

Sales this year P 2,340,000
- Sales this year at unit sales prices last year
(P 2,340,000/ 90%) 2,600,000 (1) P (260,000) U
Sales quantity variance:
Sales this year at unit sales prices last year P 2,600,000 (2)
- Sales last year 2,000,000 600,000 F
Cost price variance
Cost this year P 1,911,000
- Cost this year at unit cost prices last year 1,820,000 (3) 91,000 U
Cost quantity variance:
Cost this year at unit cost prices last year P 1,820,000 (4)
- Cost last year 1,400,000 420,000 U
Gross profit variance P 171,000 U

(1) The sales price rate is given, so the computation starts from the sales price variance. Since the sales
price variance rate is given at 10% decrease, then, STY @ USPLY = Sales this year / 90% (i.e., P
2,340,000/ 90%).

(2) Consequently, the sales quantity variance is computed by getting the difference between the STY at
USPLY and sales last year. Inasmuch as the sales quantity variance is already taken, the sales quantity
variance ratio may not be determined, as follows:

Sales quantity variance rate = Sales quantity variance/ Sales last year
= P 600,000 F/ P 2,000,000
= 30% F (Increase)

A favorable sales quantity variance indicates the quantity sold this year is greater than the quantity sold
last year.

(3) The quantity variance rate applies to both sales and cost of goods sold. Since the quantity variance rate
is determined to be 30% increase, then the cost quantity variance may now be computed. In the
computation of cost quantity variance, the CTY @ UCLY is unknown. This may now be calculated as,
CTY @ UCPLY = Cost last year x 130%. This gives us an amount of P 1,820,000. The cost quantity
variance is now determined at P 420,000 U (i.e., P 1,800,000 – P 1,400,000) and the cost price variance is
subsequently computed at P 91,000 U (i.e., P 1,911,000 – P 1,820,000)

After computing the cost price variance, the cost price variance rate may now be calculated as follows:
Cost price variance rate = Cost price variance / CTY @ UCPLY
= P 91,000 U / P 1,820,000
= 5% UF (Increase)

An unfavorable cost price variance means that cost price this year is greater than the cost prices last year.
As such, there is an increase in unit cost price.

(4) By using the sales price variance of P 260,000 unfavorable, we can check the percentage change in
sales price as follows:
Sales price variance rate = Sales price variance/ STY @ USPLY
= P 260,000 U / P 2,600,000 = 10% UF (Decrease)
An unfavorable sales price variance indicates that the sales price this year decreases compared that of last
year.
(5) The given variance rate indicates where to start the variance analysis. From the first computation of
variance, the implied variance rates of prices and quantity may be determined as follows:

Variance rates Formulas

a. Sales price variance rate Sales price variance / STY @ USPLY
b. Sales quantity variance rate Sales quantity variance / Sales last year
c. Cost price variance rate Cost price variance / CTY @ UCLY
 b. Cost quantity variance rate Cost quantity variance / Cost last year
where: STY @ USPLY also means Applied Sales This Year
CTY @ UCLY also means Applied Cost This Year

Multi-Product Gross Profit Variances

In many instances, companies operate in a multi-product sales operations. In this case, the net quantity
variance may be divided into sales mix variance and sales yield variance. The sales yield variance is
sometimes called as the final sales volume variance. The sales price variance and the cost price variance
computations will still be the same.

In a sales mix analysis, the following variance computations constitute the accounting for gross profit
variation:

Sales price variance = USP x QSTY Px

Cost price variance = UCP x QSTY x
Sales mix variance:
Gross profit this year at UGP last year Px
- Gross profit this year @ Average unit
gross profit last year x
Sales mix variance x
Sales yield variance (Final sales volume variance)
Gross profit this year @ Average unit gross
profit last year x
- Gross profit last year x
Sales yield variance x
Net gross profit variance P x

To illustrate the applications of the above formulas, let us consider the following sample problem.

Sample Problem 7.7. Multi-Product Profit Variances

Android Corporation sells three products – A, B, and C. The sales, cost of goods sold, and gross profit of
the three products in 2019 and 2020 are given below.

2019 2020
Sales A (8,000 units x P 8) P 64,000 (20,000 units x P 6) P 120,000
B (26,000 units x P 4) 104,000 (22,000 units x P 5) 110,000
C (12,000 units x P 10) 120,000 (13,000 units x P 12) 156,000
288,000 386,000
Costs A (8,000 units x P 5) 40,000 (20,000 units x P 4) 80,000
A (26,000 units x P 2) 52,000 (22,000 units x P 4) 88,000
A (12,000 units x P 6) 72,000 (13,000 units x P 6) 78,000
164,000 246,000
Gross profit (46,000 x P 2.69565) P 124,000 (55,000 units x P 2.32727) P 140,000

Required: Compute the sales price variance, cost price variance, sales mix variance, and sales yield
variance.

Solutions/ Discussions:
 The change in gross profit variance to be analyzed is:
Gross profit this year P 140,000
Less: Gross profit last year 124,000
Increase in gross profit P 16,000 F

 The increase in gross profit is analyzed as follows:

Sales price variance = USP x QSTY
A = (P 2) U x 20,000 units = P (40,000) U
B = P 1 F x 22,000 units = 22,000 F
C = P 2 F x 13,000 units = 26,000 F
Net sales price variance P 8,000 F
 Cost price variance = UCP x QSTY
A = (P 1) F x 20,000 units = (20,000) F
B = P 2 U x 22,000 units = 44,000 U
C = 0 x 13,000 units = 0
Net cost price variance 24,000 U
Sales mix variance:
Gross profit this year at UGP last year
A = (20,000 units x P 3)* = 60,000
B = (22,000 units x P 2) = 44,000
C = (13,000 units x P 4) = 52,000
Total 156,000
- Gross profit this year @ Average unit gross
profit last year (55,000 units x P 2.69565)** 148,261
Net sales mix variance 7,739 F
Sales yield variance
Gross profit this year @ Average unit gross
profit last year 148,261
- Gross profit last year 124,000
Net sales yield variance 24,261 F
Net gross profit variance P 16,000 F

* UGP last year = USP last year – UC last year

e.g., Product A (P 8 – P 5) P3
Product B (P 4 – P 2) 2
Product C (P 10 – P 6) 4
** UGP last year = GP last year/ Total units sold last year
= P 124,000 / (8,000 +26,000 + 12,000)
= P 2.69565

You may refer to our previous discussions on sales price variance and cost price variance in sample
problem no. 1 for the formula guidelines.

 The sales mix variance may be alternatively computed as follows:

(a) b (c) (d= b-c) E (f = d x e)
Product Actual Actual qty. sold at Mix Var Unit gross Mix Variance in
Qty. sold standard sales mix (F) UF profit last pesos – F (UF)
year
A 20,000 (55,000 x 8/46) = 9,565 10,435 F P3 P 31,305 F
B 22,000 (55,000 x 26/46) = 31,087 (9,087) U 2 (18,174) U
C 13,000 (55,000 x 12/46) = 14,348 (1,348) U 4 (5,392) U
55,000
Net sales mix variance P 7,739 F
The total units sold in 2012 is 55,000 units (i.e., 20,000 + 22,000 + 13,000). The fractions 8/46,
26/46, and 12/46 were developed based on the standard sales mix last year (where A = 8,000
units, B = 26,000 units, and C = 12,000 units). The third column (quantity sold this year at
standard sales mix) determines the expected quantity sold based on standard sales mix of the last
year. If the actual quantity sold per product is greater than the actual quantity at standard sales
mix, the mix variance is unfavorable, otherwise, the mix variance is favorable.
 The sales yield variance may be alternatively computed as follows:
Quantity sold this year 55,000 units
- Quantity sold last year 46,000
Yield variance in units 9,000 F
x Average unit gross profit last year P 2.69565
Yield variance in pesos P 24,261 F
 The sum of the sales mix variance and the sales yield variance is the net quantity variance:
Quantity variance = Q x Unit gross profit rate last year
A = 12,000 F x P 3 P 36,000 F
B = (4,000) U x P 2 (8,000)U
C = 1,000 F x P 4 4,000 F
Net quantity variance P 32,000 F
 The changes in quantity ( Q) are computed as follows:
A = (24,000 units – 8,000 units) = 12,000 units F
B = (22,000 units – 26,000 units) = (4,000) U
C = (13,000 units – 12,000 units) = 1,000 F

To check, we have:
Sales mix variance P 7,739 F
Sales yield variance 24,261 F
Net quantity variance P 32,000 F

Reference used:

Agamata, Franklin T. Management Services 2019 Edition. GIC Enterprises & Co., Inc, 2019