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CHAPTER 12 PRICING DECISIONS AND COST MANAGEMENT

12­1 The three major influences on pricing decisions are 1. Customers 2. Competitors 3. Costs

12­2 Not necessarily. For a one­time­only special order, the relevant costs are only those costs that will change as a result of accepting the order. In this case, full product costs will rarely be relevant. It is more likely that full product costs will be relevant costs for long­run pricing decisions.

12­3 Two examples of pricing decisions with a short­run focus: 1. Pricing for a one­time­only special order with no long­term implications. 2. Adjusting product mix and volume in a competitive market.

12­4 Activity­based costing helps managers in pricing decisions in two ways. 1. It gives managers more accurate product­cost information for making pricing decisions. 2. It helps managers to manage costs during value engineering by identifying the cost impact of eliminating, reducing, or changing various activities.

12­5 Two alternative starting points for long­run pricing decisions are 1. Market­based pricing, an important form of which is target pricing. The market­based approach asks, “Given what our customers want and how our competitors will react to what we do, what price should we charge?” 2. Cost­based pricing which asks, “What does it cost us to make this product and, hence, what price should we charge that will recoup our costs and achieve a target return on investment?”

12­6 A target cost per unit is the estimated long­run cost per unit of a product (or service) that, when sold at the target price, enables the company to achieve the targeted operating income per unit.

12­7 Value engineering is a systematic evaluation of all aspects of the value­chain business functions, with the objective of reducing costs while satisfying customer needs. Value engineering via improvement in product and process designs is a principal technique that companies use to achieve target costs per unit.

12­8 A value­added cost is a cost that customers perceive as adding value, or utility, to a product or service. Examples are costs of materials, direct labor, tools, and machinery. A nonvalue­added cost is a cost that customers do not perceive as adding value, or utility, to a product or service. Examples of nonvalue­added costs are costs of rework, scrap, expediting, and breakdown maintenance.

12­9 No. It is important to distinguish between when costs are locked in and when costs are incurred, because it is difficult to alter or reduce costs that have already been locked in.

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12­10 Cost­plus pricing is a pricing approach in which managers add a markup to cost in order to determine price.

12­11 Cost­plus pricing methods vary depending on the bases used to calculate prices. Examples are (a) variable manufacturing costs; (b) manufacturing function costs; (c) variable product costs; and (d) full product costs.

12­12 Two examples where the difference in the costs of two products or services is much smaller than the differences in their prices follow: 1. The difference in prices charged for a telephone call, hotel room, or car rental during busy versus slack periods is often much greater than the difference in costs to provide these services. 2. The difference in costs for an airplane seat sold to a passenger traveling on business or a passenger traveling for pleasure is roughly the same. However, airline companies price discriminate. They routinely charge business travelers––those who are likely to start and complete their travel during the same week excluding the weekend––a much higher price than pleasure travelers who generally stay at their destinations over at least one weekend.

12­13 Life­cycle budgeting is an estimate of the revenues and costs attributable to each product from its initial R&D to its final customer servicing and support.

12­14 Three benefits of using a product life­cycle reporting format are: 1. The full set of revenues and costs associated with each product becomes more visible. 2. Differences among products in the percentage of total costs committed at early stages in

the life cycle are highlighted. 3. Interrelationships among business function cost categories are highlighted.

12­15 Predatory pricing occurs when a business deliberately prices below its costs in an effort to drive competitors out of the market and restrict supply, and then raises prices rather than enlarge demand. Under U.S. laws, dumping occurs when a non­U.S. company sells a product in the United States at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the United States. Collusive pricing occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade.

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12­16 (20–30 min.) Relevant­cost approach to pricing decisions, special order.

1. Relevant revenues, $4.00 × 1,000 $4,000 Relevant costs

Direct materials, $1.60 × 1,000 $1,600 Direct manufacturing labor, $0.90 × 1,000 900 Variable manufacturing overhead, $0.70 × 1,000 700 Variable selling costs, 0.05 × $4,000 200 Total relevant costs 3,400

Increase in operating income $ 600

This calculation assumes that: a. The monthly fixed manufacturing overhead of $150,000 and $65,000 of monthly

fixed marketing costs will be unchanged by acceptance of the 1,000 unit order. b. The price charged and the volumes sold to other customers are not affected by the

special order.

Chapter 12 uses the phrase “one­time­only special order” to describe this special case.

2. The president’s reasoning is defective on at least two counts: a. The inclusion of irrelevant costs––assuming the monthly fixed manufacturing

overhead of $150,000 will be unchanged; it is irrelevant to the decision. b. The exclusion of relevant costs––variable selling costs (5% of the selling price) are

excluded.

3. Key issues are: a. Will the existing customer base demand price reductions? If this 1,000­tape order is

not independent of other sales, cutting the price from $5.00 to $4.00 can have a large negative effect on total revenues.

b. Is the 1,000­tape order a one­time­only order, or is there the possibility of sales in subsequent months? The fact that the customer is not in Dill Company’s “normal marketing channels” does not necessarily mean it is a one­time­only order. Indeed, the sale could well open a new marketing channel. Dill Company should be reluctant to consider only short­run variable costs for pricing long­run business.

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12­17 (20–30 min.) Relevant­cost approach to short­run pricing decisions.

1. Analysis of special order: Sales, 3,000 units × $75 $225,000 Variable costs:

Direct materials, 3,000 units × $35 $105,000 Direct manufacturing labor, 3,000 units × $10 30,000 Variable manufacturing overhead, 3,000 units × $6 18,000 Other variable costs, 3,000 units × $5 15,000 Sales commission 8,000 Total variable costs 176,000

Contribution margin $ 49,000

Note that the variable costs, except for commissions, are affected by production volume, not sales dollars.

If the special order is accepted, operating income would be $1,000,000 + $49,000 = $1,049,000.

2. Whether McMahon’s decision to quote full price is correct depends on many factors. He is incorrect if the capacity would otherwise be idle and if his objective is to increase operating income in the short run. If the offer is rejected, San Carlos, in effect, is willing to invest $49,000 in immediate gains forgone (an opportunity cost) to preserve the long­run selling­price structure. McMahon is correct if he thinks future competition or future price concessions to customers will hurt San Carlos’s operating income by more than $49,000.

There is also the possibility that Abrams could become a long­term customer. In this case, is a price that covers only short­run variable costs adequate? Would Holtz be willing to accept a $8,000 sales commission (as distinguished from her regular $33,750 = 15% × $225,000) for every Abrams order of this size if Abrams becomes a long­term customer?

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12­18 (15­20 min.) Short­run pricing, capacity constraints.

1. Per kilogram of hard cheese:

Milk (10 liters × $1.50 per liter) $15 Direct manufacturing labor 5 Variable manufacturing overhead 3 Fixed manufacturing cost allocated 6 Total manufacturing cost $29

If Vermont Hills can get all the Holstein milk it needs, and has sufficient production capacity, then, the minimum price per kilo it should charge for the hard cheese is the variable cost per kilo = $15+5+3 = $23 per kilo.

2. If milk is in short supply, then each kilo of hard cheese displaces 2.5 kilos of soft cheese (10 liters of milk per kilo of hard cheese versus 4 liters of milk per kilo of soft cheese). Then, for the hard cheese, the minimum price Vermont should charge is the variable cost per kilo of hard cheese plus the contribution margin from 2.5 kilos of soft cheese, or,

$23 + (2.5 × $8 per kilo) = $43 per kilo

That is, if milk is in short supply, Vermont should not agree to produce any hard cheese unless the buyer is willing to pay at least $43 per kilo.

12­19 (25–30 min.) Value­added, nonvalue­added costs.

1. Category Examples

Value­added costs a. Materials and labor for regular repairs $ 800,000 Nonvalue­added costs b. Rework costs

c. Expediting costs caused by work delays g. Breakdown maintenance of equipment Total

$ 75,000 60,000 55,000

$190,000 Gray area d. Materials handling costs

e. Materials procurement and inspection costs f. Preventive maintenance of equipment Total

$ 50,000 35,000 15,000

$100,000

Classifications of value­added, nonvalue­added, and gray area costs are often not clear­cut. Other classifications of some of the cost categories are also plausible. For example, some students may include materials handling, materials procurement, and inspection costs and preventive maintenance as value­added costs (costs that customers perceive as adding value and as being necessary for good repair service) rather than as in the gray area. Preventive maintenance, for instance, might be regarded as value­added because it helps prevent nonvalue­ adding breakdown maintenance.

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2. Total costs in the gray area are $100,000. Of this, we assume 65%, or $65,000, are value­added and 35%, or $35,000, are nonvalue­added.

Total value­added costs: $800,000 + $65,000 $ 865,000 Total nonvalue­added costs: $190,000 + $35,000 225,000 Total costs $1,090,000

Nonvalue­added costs are $225,000 ÷ $1,090,000 = 20.64% of total costs. Value­added costs are $865,000 ÷ $1,090,000 = 79.36% of total costs.

3. Effect on Costs Classified as

Program Value­ Added

Nonvalue­ Added

Gray Area

(a) Quality improvement programs to • reduce rework costs by 75% (0.75 × $75,000) • reduce expediting costs by 75%

(0.75 × $60,000) • reduce materials and labor costs by 5%

(0.05 × $800,000) Total effect

–$ 40,000 –$ 40,000

–$56,250

– 45,000

–$101,250

(b) Working with suppliers to • reduce materials procurement and inspection costs by

20% (0.20 × $35,000) • reduce materials handling costs by 25%

(0.25 × $50,000) Total effect Transferring 65% of gray area costs (0.65 ×

$19,500 = $12,675) as value­added and 35% (0.35 × $19,500 = $6,825) as nonvalue­added

Effect on value­added and nonvalue­added costs –$ 12,675 –$ 12,675

– $ 6,825 – $6,825

–$7,000

–12,500 –19,500

+ 19,500 $ 0

(c) Maintenance programs to • increase preventive maintenance costs by 50%

(0.50 × $15,000) • decrease breakdown maintenance costs by 40%

(0.40 × $55,000) Total effect Transferring 65% of gray area costs (0.65 × $7,500 =

$4,875) as value­added and 35% (0.35 × $7,500 = $2,625) as nonvalue­added

Effect on value­added and nonvalue­added costs +$ 4,875 +$ 4,875

– $22,000 – 22,000

+ 2,625 – $19,375

+$7,500

+ $7,500

– 7,500 $ 0

Total effect of all programs Value­added and nonvalue­added costs calculated in

requirement 2 Expected value­added and nonvalue­added costs as a result of

implementing these programs

– $ 47,800

865,000

$817,200

–$127,450

225,000

$ 97,550

If these programs are implemented in 2007, total costs would decrease from $1,090,000 (requirement 2) to $817,200 + $97,550 = $914,750, and the percentage of nonvalue­added costs would decrease from 20.64% (requirement 2) to $97,550 ÷ 914,750 = 10.66%. These are significant improvements in Marino’s performance.

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12­20 (25−30 min.) Target operating income, value­added costs, service company.

1. The classification of total costs in 2009 into value­added, nonvalue­added, or in the gray area in between follows:

Value Gray Nonvalue­ Total Added Area added (4) = (1) (2) (3) (1)+(2)+(3)

Doing calculations and preparing drawings 75% × $400,000 $300,000 $300,000 Checking calculations and drawings 4% × $400,000 $16,000 16,000 Correcting errors found in drawings 7% × $400,000 $28,000 28,000 Making changes in response to client requests 6% × $400,000 24,000 24,000 Correcting errors to meet government building code, 8% × $400,000 32,000 32,000 Total professional labor costs 324,000 16,000 60,000 400,000 Administrative and support costs at 40% ($160,000 ÷ $400,000) of professional labor costs 129,600 6,400 24,000 160,000 Travel 18,000 — 18,000 Total $471,600 $22,400 $84,000 $578,000

Doing calculations and responding to client requests for changes are value­added costs because customers perceive these costs as necessary for the service of preparing architectural drawings. Costs incurred on correcting errors in drawings and making changes because they were inconsistent with building codes are nonvalue­added costs. Customers do not perceive these costs as necessary and would be unwilling to pay for them. Carasco should seek to eliminate these costs by making sure that all associates are well­informed regarding building code requirements and by training associates to improve the quality of their drawings. Checking calculations and drawings is in the gray area (some, but not all, checking may be needed). There is room for disagreement on these classifications. For example, checking calculations may be regarded as value added.

2. Reduction in professional labor­hours by a. Correcting errors in drawings (7% × 8,000) 560 hours b. Correcting errors to conform to building code (8% × 8,000) 640 hours Total 1,200 hours Cost savings in professional labor costs (1,200 hours × $50) $ 60,000 Cost savings in variable administrative and support costs (40% × $60,000) 24,000

Total cost savings $ 84,000 Current operating income in 2009 $102,000 Add cost savings from eliminating errors 84,000 Operating income in 2009 if errors eliminated $186,000

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3. Currently 85% × 8,000 hours = 6,800 hours are billed to clients generating revenues of $680,000. The remaining 15% of professional labor­hours (15% × 8,000 = 1,200 hours) is lost in making corrections. Carasco bills clients at the rate of $680,000 ÷ 6,800 = $100 per professional labor­hour. If the 1,200 professional labor­hours currently not being billed to clients were billed to clients, Carasco’s revenues would increase by 1,200 hours × $100 = $120,000 from $680,000 to $800,000.

Costs remain unchanged Professional labor costs $400,000 Administrative and support (40% × $400,000) 160,000 Travel 18,000 Total costs $578,000

Carasco’s operating income would be Revenues $800,000 Total costs 578,000 Operating income $222,000

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12­21 (25–30 min.) Target prices, target costs, activity­based costing.

1. Snappy’s operating income in 2008 is as follows:

Total for 250,000 Tiles

(1) Per Unit

(2) = (1) ÷ 250,000 Revenues ($4 × 250,000) Purchase cost of tiles ($3 × 250,000) Ordering costs ($50 × 500) Receiving and storage ($30 × 4,000) Shipping ($40 × 1,500) Total costs Operating income

$1,000,000 750,000 25,000 120,000 60,000 955,000

$ 45,000

$4.00 3.00 0.10 0.48 0.24 3.82 $0.18

2. Price to retailers in 2009 is 95% of 2008 price = 0.95 × $4 = $3.80; cost per tile in 2009 is 96% of 2008 cost = 0.96 × $3 = $2.88.

Snappy’s operating income in 2009 is as follows: Total for

250,000 Tiles (1)

Per Unit (2) = (1) ÷ 250,000

Revenues ($3.80 × 250,000) Purchase cost of tiles ($2.88 × 250,000) Ordering costs ($50 × 500) Receiving and storage ($30 × 4,000) Shipping ($40 × 1,500) Total costs Operating income

$ 950,000 720,000 25,000 120,000 60,000 925,000

$ 25,000

$3.80 2.88 0.10 0.48 0.24 3.70 $0.10

3. Snappy’s operating income in 2009, if it makes changes in ordering and material handling, will be as follows:

Total for 250,000 Tiles

(1) Per Unit

(2) = (1) ÷ 250,000 Revenues ($3.80 × 250,000) Purchase cost of tiles ($2.88 × 250,000) Ordering costs ($25 × 200) Receiving and storage ($28 × 3,125) Shipping ($40 × 1,500) Total costs Operating income

$950,000 720,000 5,000 87,500 60,000 872,500 $ 77,500

$3.80 2.88 0.02 0.35 0.24 3.49 $0.31

Through better cost management, Snappy will be able to achieve its target operating income of $0.30 per tile despite the fact that its revenue per tile has decreased by $0.20 ($4.00 – $3.80), while its purchase cost per tile has decreased by only $0.12 ($3.00 – $2.88).

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12­22 (20 min.) Target costs, effect of product­design changes on product costs.

1. and 2. Manufacturing costs of HJ6 in 2008 and 2009 are as follows:

2008 2009 Per Unit Per Unit

Total (2) = Total (4) = (1) (1) ÷ 3,500 (3) (3) ÷ 4,000

Direct materials, $1,200 × 3,500; $1,100 × 4,000 $4,200,000 $1,200 $4,400,000 $1,100 Batch­level costs, $8,000 × 70; $7,500 × 80 560,000 160 600,000 150 Manuf. operations costs, $55 × 21,000;

$50 × 22,000 1,155,000 330 1,100,000 275 Engineering change costs, $12,000 × 14;

$10,000 × 10 168,000 48 100,000 25 Total $6,083,000 $1,738 $6,200,000 $1,550

3. Target manufacturing cost per unit of HJ6 in 2009 =

Manufacturing cost per unit in 2008 × 90%

= $1,738 × 0.90 = $1,564.20

Actual manufacturing cost per unit of HJ6 in 2009 was $1,550. Hence, Medical Instruments did achieve its target manufacturing cost per unit of $1,564.20

4. To reduce the manufacturing cost per unit in 2009, Medical Instruments reduced the cost per unit in each of the four cost categories—direct materials costs, batch­level costs, manufacturing operations costs, and engineering change costs. It also reduced machine­hours and number of engineering changes made—the quantities of the cost drivers. In 2008, Medical Instruments used 6 machine­hours per unit of HJ6 (21,000 machine­hours ÷3,500 units). In 2009, Medical Instruments used 5.5 machine­hours per unit of HJ6 (22,000 machine­hours ÷ 4,000 units). Medical Instruments reduced engineering changes from 14 in 2008 to 10 in 2009. Medical Instruments achieved these gains through value engineering activities that retained only those product features that customers wanted while eliminating nonvalue­added activities and costs.

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12­23 (20 min.) Cost­plus target return on investment pricing.

1. Target operating income = target return on investment × invested capital Target operating income (25% of $1,000,000) $250,000 Total fixed costs 358,000 Target contribution margin $608,000

Target contribution per room­night, ($608,000 ÷ 16,000) $38 Add variable costs per room­night 4 Price to be charged per room­night $42

Proof Total room revenues ($42 × 16,000 room­nights) $672,000 Total costs: Variable costs ($4 × 16,000) $ 64,000 Fixed costs 358,000

Total costs 422,000 Operating income $250,000

The full cost of a room = variable cost per room + fixed cost per room The full cost of a room = $4 + ($358,000 ÷ 16,000) = $4 + $22.375 = $26.375

Markup per room = Rental price per room – Full cost of a room = $42 – $26.375 = $15.625

Markup percentage as a fraction of full cost = $15.625 ÷ $26.375 = 59.24%

2. If price is reduced by 10%, the number of rooms Beck could rent would increase by 10%. The new price per room would be 90% of $42 $37.80 The number of rooms Beck expects to rent is 110% of 16,000 17,600 The contribution margin per room would be $37.80 – $4 $33.80 Contribution margin ($33.80 ×17,600) $594,880

Because the contribution margin of $594,880 at the reduced price of $37.80 is less than the contribution margin of $608,000 at a price of $42, Beck should not reduce the price of the rooms. Note that the fixed costs of $358,000 will be the same under the $42 and the $37.80 price alternatives and hence, are irrelevant to the analysis.

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12­24 (20−25 min.) Cost­plus, target pricing, working backwards.

1. Investment $2,400,000 Return on investment 20% Operating income (20% × $2,400,000) $480,000 Operating income per unit of RF17 ($480,000 ÷ 20,000) $24 Full cost per unit of RF17 $300 Selling price ($300 + $24) $324 Markup percentage on full cost ($24 ÷ $300) 8%

With a 50% markup on variable costs, Selling price of RF17 = Variable cost per unit of RF17 × 1.50, so:

Variable costs per unit of RF17 = Selling price of RF17 1.50

= 50 . 1 324 $ = $216

2. Fixed cost per unit = $300 – $216 = $84 Total fixed costs = $84 per unit × 20,000 units = $1,680,000 At a price of $348, sales = 20,000 units × 0.90 18,000 Revenues ($348 × 18,000) $6,264,000 Variable costs ($216 × 18,000) 3,888,000 Contribution margin ($132 × 18,000) 2,376,000 Fixed costs 1,680,000 Operating income $ 696,000

If Waterbuy increases the selling price of RF17 to $348, its operating income will be $696,000. This would be more than the $480,000 operating income Waterbury earns by selling 20,000 units at a price of $324, so, if its forecast is accurate, and based on financial considerations alone, Waterbury should increase the selling price to $348.

3. Target investment in 2009 $2,100,000 Target return on investment 20% Target operating income in 2009, 20% × $2,100,000 $420,000

Anticipated revenues in 2009, $315 × 20,000 $6,300,000 Less target operating income in 2009 420,000 Target full costs in 2009 5,880,000 Less: total target fixed costs 1,680,000 Total target variable costs in 2009 $4,200,000

Target variable cost per unit in 2009, $4,200,000 ÷ 20,000 = $210

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12­25 Life­cycle product costing.

1. Variable cost per unit = Production cost per unit + Mktg and distribn. cost per unit = $50 + $10 = $60

Total fixed costs over life of Yew = $6,590,000 $1,450,000 $19,560,000 5,242,000 $2,900,000 + + + + = $35,742,000

BEP in units = Fixed costs $35,742,000 Selling price Variable cost per unit $110 $60

= − −

= 714,840 units

2a. Revenues ($110×1,500,000 units) $165,000,000 Variable costs ($60×1,500,000 units) 90,000,000 Fixed costs 35,742,000 Operating income $ 39,258,000

2b. Revenues Year 2 ($240×100,000 units) $ 24,000,000 Years 3 & 4 ($110×1,200,000 units) 132,000,000 Total revenues 156,000,000

Variable costs ($60×1,300,000 units) 78,000,000 Fixed costs 35,742,000 Operating income $ 42,258,000

Over the product’s life­cycle, Option B results in an overall higher operating income of $3,000,000.

3. Before selecting its pricing strategy, Intentical managers should evaluate whether the same pricing policy will be adopted globally. Different markets may need different pricing. For example, special taxes on imports may mean higher prices in foreign markets. Intentical’s pricing strategy must be sensitive to changing customer preferences and reactions of competitors.

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12­26 (30 min.) Relevant­cost approach to pricing decisions.

1. Revenues (1,000 crates at $100 per crate) $100,000 Variable costs:

Manufacturing $40,000 Marketing 14,000

Total variable costs 54,000 Contribution margin 46,000 Fixed costs:

Manufacturing $20,000 Marketing 16,000 Total fixed costs 36,000

Operating income $ 10,000

Normal markup percentage: $46,000 ÷ $54,000 = 85.19% of total variable costs.

2. Only the manufacturing­cost category is relevant to considering this special order; no additional marketing costs will be incurred. The relevant manufacturing costs for the 200­crate special order are:

Variable manufacturing cost per unit $40 × 200 crates $ 8,000

Special packaging 2,000 Relevant manufacturing costs $10,000

Any price above $50 per crate ($10,000 ÷ 200) will make a positive contribution to operating income. Therefore, based on financial considerations, Stardom should accept the 200­crate special order at $55 per crate that will generate revenues of $11,000 ($55 × 200) and relevant (incremental) costs of $10,000.

The reasoning based on a comparison of $55 per crate price with the $60 per crate absorption cost ignores monthly cost­volume­profit relationships. The $60 per crate absorption cost includes a $20 per crate cost component that is irrelevant to the special order. The relevant range for the fixed manufacturing costs is from 500 to 1,500 crates per month; the special order will increase production from 1,000 to 1,200 crates per month. Furthermore, the special order requires no incremental marketing costs.

3. If the new customer is likely to remain in business, Stardom should consider whether a strictly short­run focus is appropriate. For example, what is the likelihood of demand from other customers increasing over time? If Stardom accepts the 200­crate special offer for more than one month, it may preclude accepting other customers at prices exceeding $55 per crate. Moreover, the existing customers may learn about Stardom’s willingness to set a price based on variable cost plus a small contribution margin. The longer the time frame over which Stardom keeps selling 200 crates of canned peaches at $55 a crate, the more likely it is that existing customers will approach Stardom for their own special price reductions. If the new customer wants the contract to extend over a longer time period, Stardom should negotiate a higher price.

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12­27 (25–30 min.) Target rate of return on investment, activity­based costing.

1. Operating Income Statement, April 2009 Revenues (12,000 disks × $22 per disk) $264,000 Materials (12,000 disks × $15 per disk) 180,000 Gross margin 84,000 Ordering (40 vendors × $250 per vendor) 10,000 Cataloging (20 new titles × $100 per title) 2,000 Delivery and support (400 deliveries × $15 per delivery) 6,000 Billing and collection (300 customers × $50 per customer) 15,000 Operating Income $ 51,000 Rate of return on investment ($51,000÷$300,000 ) 17.00%

2. The table below shows that if the selling price of game disks falls to $18 and the cost of each disk falls to $12, monthly gross margin falls to $72,000 (from $84,000 in April), and this results in a return on investment of 13%, which is below EA’s target rate of return on investment of 15%. EA will have to cut costs to earn its target rate of return on investment.

Operating Income Statement, May 2009 Revenues (12,000 disks × $18 per disk) $216,000 Materials (12,000 disks × $12 per disk) 144,000 Gross margin 72,000 Ordering (40 vendors × $250 per vendor) 10,000 Cataloging (20 new titles × $100 per title) 2,000 Delivery and support (400 deliveries × $15 per delivery) 6,000 Billing and collection (300 customers × $50 per customer) 15,000 Operating Income $ 39,000 Rate of return on investment ($39,000÷$300,000 ) 13.00%

3. After EA’s workforce has implemented process improvements, its monthly support costs are $31,500, as shown below.

Monthly support costs after process improvements, May 2009 Ordering (30 vendors × $200 per vendor) $ 6,000 Cataloging (15 new titles × $100 per title) 1,500 Delivery and support (450 deliveries × $20 per delivery) 9,000 Billing and collection (300 customers × $50 per customer) 15,000 Total monthly support costs $31,500

EA now earns $6 ($18 – $12) gross margin per disk. Suppose it needs to sell X game disks to earn at least its 15% target rate of return on investment of $300,000. Then X needs to be such that:

$6 X – $31,500 >= $300,000 ×15% = $45,000 $6 X >= $76,500

X >= $76,500 ÷ $6 = 12,750 game disks i.e., EA must now sell at least 12,750 game disks per month to earn its target rate of return on investment of 15%.

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12­28 (25 min.) Cost­plus, target pricing, working backward.

1. In the following table, work backwards from operating income to calculate the selling price Selling price $ 9.45 (plug) Less: Variable cost per unit 2.50 Unit contribution margin $ 6.95 Number of units produced and sold ×500,000 units Contribution margin $3,475,000 Less: Fixed costs 3,250,000 Operating income $ 225,000

a) Total sales revenue = $9.45×500,000 units = $4,725,000 b) Selling price = $9.45 (from above) Alternatively,

Operating income $ 225,000 Add fixed costs 3,250,000 Contribution margin 3,475,000 Add variable costs ($2.50 × 500,000 units) 1,250,000 Sales revenue $4,725,000

Sales revenue $4,725,000 Selling price = $9.45 Units sold 500,000

= =

c) Rate of return on investment = Operating income $225,000 Total investment in assets 2,500,000

= = 9%

d) Markup % on full cost Total cost = ($2.50×500,000 units) + $3,250,000 = $4,500,000

Unit cost = $4,500,000 500,000 units

= $9

Markup % = $9.45 $9 $9

− = 5%

Or $4,725,000 $4,500,000 $4,500,000

− = 5%

2. New fixed costs = $3,250,000 $250,000 = $3,000,000 New variable costs = $2.50 $0.50 = $2 New total costs = ($2×500,000 units) + $3,000,000 = $4,000,000 New total sales (5% markup) = $4,000,000×1.05 = $4,200,000 New selling price = $4,200,000 ÷ 500,000 units = $8.40 Alternatively, New unit cost = $4,000,000 ÷ 500,000 units = $8 New selling price = $8×1.05 = $8.40

3. New units sold = $500,000 × 90% = $450,000 units Budgeted Operating Income

For the year ending December 31, 20xx Revenues ($8.40×450,000 units) $3,780,000 Variable costs ($2.00×450,000 units) 900,000 Contribution margin 2,880,000 Fixed costs 3,000,000 Operating income (loss) $ (120,000)

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12­29 (40–45 min.) Target prices, target costs, value engineering, cost incurrence, locked­ in cost, activity­based costing.

1. Old

CE100 Cost Change New CE100

Direct materials costs Direct manufacturing labor costs Machining costs Testing costs Rework costs Ordering costs Engineering costs Total manufacturing costs

$182,000 28,000 31,500 35,000 14,000 3,360 21,140

$315,000

$2.20 × 7,000 = $15,400 less $0.50 × 7,000 = $3,500 less Unchanged because capacity same (20% × 2.5 × 7,000) $2 = $7,000 (See Note 1) (See Note 2) Unchanged because capacity same

$166,600 24,500 31,500 28,000 5,600 2,100 21,140

$279,440

Note 1: 10% of old CE100s are reworked. That is, 700 (10% of 7,000) CE100s made are reworked. Rework costs = $20 per unit reworked × 700 = $14,000. If rework falls to 4% of New CE100s manufactured, 280 (4% of 7,000) New CE100s manufactured will require rework. Rework costs = $20 per unit × 280 = $5,600.

Note 2 : Ordering costs for New CE100 = 2 orders/month × 50 components × $21/order

= $2,100

Unit manufacturing costs of New CE100 = $279,440 ÷ 7,000 = $39.92

2. Total manufacturing cost reductions based on new design = $315,000 – $279,440 = $35,560

Reduction in unit manufacturing costs based on new design = $35,560 ÷ 7,000 = $5.08 per unit.

The reduction in unit manufacturing costs based on the new design can also be calculated as

Unit cost of old design, $45 ($315,000 ÷ 7,000 units) – Unit cost of new design, $39.92 = $5.08

Therefore, the target cost reduction of $6 per unit is not achieved by the redesign.

3. Changes in design have a considerably larger impact on costs per unit relative to improvements in manufacturing efficiency ($5.08 versus $1.50). One explanation is that many costs are locked in once the design of the radio­cassette is completed. Improvements in manufacturing efficiency cannot reduce many of these costs. Design choices can influence many direct and overhead cost categories, for example, by reducing direct materials requirements, by reducing defects requiring rework, and by designing in fewer components that translate into fewer orders placed and lower ordering costs.

12­18

12­30 (25 min.) Cost­plus, target return on investment pricing.

1. Target operating income = Return on capital in dollars = $13,000,000×10% = $1,300,000

2. Revenues* $6,000,000 Variable costs [($3.50 + $1.50)×500,000 cases 2,500,000 Contribution margin 3,500,000 Fixed costs ($1,000,000 + $700,000 + $500,000) 2,200,000 Operating income (from requirement 1) $1,300,000 * solve backwards for revenues

Selling price = $6,000,000 500,000 cases

= $12 per case.

Markup % on full cost Full cost = $2,500,000 + $2,200,000 = $4,700,000 Unit cost = $4,700,000 ÷ 500,000 cases = $9.40 per case

Markup % on full cost = $12 ­ $9.40 $9.40

=27.66%

3. Budgeted Operating Income

For the year ending December 31, 20xx Revenues ($14×475,000 cases*) $6,650,000 Variable costs ($5×475,000 cases) 2,375,000 Contribution margin 4,275,000 Fixed costs 2,200,000 Operating income $2,075,000 * New units = 500,000 cases×95% = 475,000 cases

Return on investment = $2,075,000 $13,000,000

= 15.96%

Yes, increasing the selling price is a good idea because operating income increases without increasing invested capital, which results in a higher return on investment. The new return on investment exceeds the 10% target return on investment.

12­19

12­31 (20 min.) Cost­plus, time and materials.

1. The different markup rates used by Mazzoli for direct materials and direct labor may represent the approximate overheads (plus a profit margin) associated with each: for example, direct materials would incur ordering and handling overhead, and direct labor would incur overheads such as benefits, insurance, etc., and these may be approximately 50% and 100% of costs. These markups could also be driven by industry practice and competitive factors.

2. As shown in the table below, Bariess will tell White that she will have to pay $270 get the clutch plate repaired and $390 to get it replaced.

COST Labor Materials Total Cost Repair option (3.5 hrs. × $30 per hr.; $40) $105 $ 40 $145 Replace option(1.5 hrs. × $30 per hr.; $200) 45 200 245

PRICE (100% markup on labor cost; 50% markup on materials) Labor Materials Total Price Repair option ($105 × 2; $40 × 1.5) $210 $ 60 $270 Replace option ($45 × 2; $200 × 1.5) 90 300 390

3. If the repair and replace options are equally safe and effective, White will choose to get the clutch plate repaired for $270 (rather than spend $390 on a replacement plate).

4. Mazzoli Brothers will earn a greater contribution toward overhead in the replace option ($145 = $390 – $245) than in the repair option ($125 = $270 – $145). If we assume that Mazzoli Brothers earns a constant profit margin on each job, it will earn a larger profit by replacing the clutch plate on Johanna White’s car for $390 than by repairing it for $270. Therefore, Bariess will recommend the replace option to White, which is not the one she would prefer. Recognizing this conflict, Bariess may even present only the replace option to Johanna White, or suggest that the repair option will result in a less­than­safe car. Of course, he runs the risk of White walking away and thinking of other options (at which point, he could present the repair option as a compromise). The problem is that Bariess has superior information about the repairs needed but his incentives may cause him to not reveal his information and instead use it to his advantage. It is only the seller’s desire to build a reputation, to have a long­term relationship with the customer, and to have the customer recommend the seller to other potential buyers of the service that encourages an honest discussion of the options.

12­20

12­32 (25 min.) Cost­plus and market­based pricing.

1. California Temps’ full cost per hour of supplying contract labor is

Variable costs $12 Fixed costs ($240,000 ÷ 80,000 hours) 3 Full cost per hour $15

Price per hour at full cost plus 20% = $15 × 1.20 = $18 per hour.

2. Contribution margins for different prices and demand realizations are as follows:

Price per Hour (1)

Variable Cost per Hour

(2)

Contribution Margin per

Hour (3) = (1) – (2)

Demand in Hours (4)

Total Contribution (5) = (3) × (4)

$1617

$1212

$4 5

120,000 100,000

$480,000 500,000

181920

121212

6 7 8

80,000 70,000 60,000

480,000 490,000 480,000

Fixed costs will remain the same regardless of the demand realizations. Fixed costs are, therefore, irrelevant since they do not differ among the alternatives.

The table above indicates that California Temps can maximize contribution margin ($500,000) and operating income by charging a price of $17 per hour.

3. The cost­plus approach to pricing in requirement 1 does not explicitly consider the effect of prices on demand. The approach in requirement 2 models the interaction between price and demand and determines the optimal level of profitability using concepts of relevant costs. The two different approaches lead to two different prices in requirements 1 and 2. As the chapter describes, pricing decisions should consider both demand or market considerations and supply or cost factors. The approach in requirement 2 is the more balanced approach. In most cases, of course, managers use the cost­plus method of requirement 1 as only a starting point. They then modify the cost­plus price on the basis of market considerations—anticipated customer reaction to alternative price levels and the prices charged by competitors for similar products.

12­21

12­33 Cost­plus and market­based pricing.

1. Single rate = $1,262,460 106,000 testing hours

= $11.91 per testing hour

Billing rate = $11.91×1.45 = $17.27

2. Labor and supervision = $ 491,840 106,000 test­hours

= $4.64 per test­hour

Setup and facility costs = $402,620 800 setup hours

= $503.275 per setup hour

Utilities = $368,000 10,000 MH

= $36.80 per MH

3.

HTT ACT Total Labor and supervision (60%, 40%) $295,104 $196,736 $ 491,840 Setup and facility cost (25%, 75%) 100,655 301,965 402,620 Utilities (50%, 50%) 184,000 184,000 368,000 Total cost $579,759 $682,701 $1,262,460 Number of testing hours (TH) 1 ÷63,600 TH ÷42,400 TH Cost per testing hour $ 9.12 per TH $ 16.10 per TH Markup ×1.45 ×1.45 Billing rate per testing hour $ 13.22 per TH $ 23.35 per TH

1 106,000 testing hours×60% = 63,600 TH; 106,000 testing hours×40% = 42,400 TH

The billing rates based on the activity­based cost structure make more sense. These billing rates reflect the ways the testing procedures consume the firm’s resources.

4. To stay competitive, Best Test needs to be more efficient in arctic testing. Roughly 44% of

arctic testing’s total cost ( 301,965 44% 682,701

= ) occurs in setups and facility costs. Perhaps the setup

activity can be redesigned to achieve cost savings.

12­22

12­34 (25–30 min.) Life­cycle costing.

1. Projected Life Cycle Income Statement

Revenues [$500× (16,000 + 4,800)] $10,400,000 Variable costs: Production [$225× (16,000 + 4,800)] 4,680,000 Distribution [($20×16,000) + ($22×4,800)] 425,600

Contribution margin 5,294,400 Fixed costs: Design costs 700,000 Production ($9,000×48 mos.) 432,000 Marketing [($3,000×32 mos.) + ($1,000×16 mos.)] 112,000 Distribution [($2,000×32 mos.) + ($1,000×16 mos.)] 80,000

Life cycle operating income $ 3,970,400

Average profit per desk = $3,970,400 (16,000 4,800)

= +

$190.88

2. Projected Life Cycle Income Statement

Revenues ($400×16,000) $6,400,000 Variable costs: Production ($225×16,000) 3,600,000 Distribution ($20×16,000) 320,000

Contribution margin 2,480,000 Fixed costs: Design costs 700,000 Production ($9,000×32 mos.) 288,000 Marketing ($3,000×32 mos.) 96,000 Distribution ($2,000×32 mos.) 64,000

Life cycle operating income $1,332,000

The new desk design is still profitable even if FFM drops the product after only 32 months of

( ) $1,332,000 production. However, the operating income per unit falls to only $83.25 per desk. 16,000 desks

3. Life cycle operating income (requirement 2) $1,332,000 Additional fixed production costs ($9,000×16 mos.) 144,000 Revised life cycle operating income $1,188,000

No, the answer does not change even if FFM continues to incur the fixed production costs for the full 48 months. The revised operating income for the new executive desk becomes $1,188,000,

which translates into $74.25 ( $1,188,000 16,000 desks

) operating income per desk.

12­23

12­35 (30 min.) Airline pricing, considerations other than cost in pricing.

1. If the fare is $500, a. Air Americo would expect to have 200 business and 100 pleasure travelers. b. Variable costs per passenger would be $80. c. Contribution margin per passenger = $500 – $80 = $420.

If the fare is $2,000, a. Air Americo would expect to have 190 business and 20 pleasure travelers. b. Variable costs per passenger would be $180. c. Contribution margin per passenger = $2,000 – $180 = $1,820.

Contribution margin from business travelers at prices of $500 and $2,000, respectively, follow:

At a price of $500: $420 × 200 passengers = $ 84,000 At a price of $2,000: $1,820 × 190 passengers = $345,800

Air Americo would maximize contribution margin and operating income by charging business travelers a fare of $2,000.

Contribution margin from pleasure travelers at prices of $500 and $2,000, respectively, follow:

At a price of $500: $420 × 100 passengers = $42,000 At a price of $2,000: $1,820 × 20 passengers = $36,400

Air Americo would maximize contribution margin and operating income by charging pleasure travelers a fare of $500. Air Americo would maximize contribution margin and operating income by a price differentiation strategy, where business travelers are charged $2,000 and pleasure travelers $500.

In deciding between the alternative prices, all other costs such as fuel costs, allocated annual lease costs, allocated ground services costs, and allocated flight crew salaries are irrelevant. Why? Because these costs will not change whatever price Air Americo chooses to charge.

2. The elasticity of demand of the two classes of passengers drives the different demands of the travelers. Business travelers are relatively price insensitive because they must get to their destination during the week (exclusive of weekends) and their fares are paid by their companies. A 300% increase in fares from $500 to $2,000 will deter only 5% of the business passengers from flying with Air Americo.

In contrast, a similar fare increase will lead to an 80% drop in pleasure travelers who are paying for their own travels, unlike business travelers, and who may have alternative vacation plans they could pursue instead.

3. Since business travelers often want to return within the same week, while pleasure travelers often stay over weekends, a requirement that a Saturday night stay is needed to qualify for the $500 discount fare would discriminate between the passenger categories. This price discrimination is legal because airlines are service companies rather than manufacturing companies and because these practices do not, nor are they intended to, destroy competition.

12­24

12­36 (25 min.) Ethics and pricing.

1. Baker prices at full product costs plus a mark­up of 10% = $80,000 + 10% of $80,000 = $80,000 + $8,000 = $88,000.

2. The incremental costs of the order are as follows: Direct materials $40,000 Direct manufacturing labor 10,000 30% of overhead costs (30% × $30,000) 9,000 Incremental costs $59,000

Any bid above $59,000 will generate a positive contribution margin for Baker. Baker may prefer to use full product costs because it regards the new ball­bearings order as a long­term business relationship rather than a special order. For long­run pricing decisions, managers prefer to use full product costs because it indicates the bare minimum costs they need to recover to continue in business rather than shut down. For a business to be profitable in the long run, it needs to recover both its variable and its fixed product costs. Using only variable costs may tempt the manager to engage in excessive long­run price cutting as long as prices give a positive contribution margin. Using full product costs for pricing thereby prompts price stability.

3. Not using full product costs (including an allocation of fixed overhead) to price the order, particularly if it is in direct contradiction of company policy, may be unethical. In assessing the situation, the specific “Standards of Ethical Conduct for Management Accountants,” described in Chapter 1 (p. 16), that the management accountant should consider are listed below.

Competence Clear reports using relevant and reliable information should be prepared. Reports prepared on the basis of excluding certain fixed costs that should be included would violate the management accountant’s responsibility for competence. It is unethical for Lazarus to suggest that Decker change the cost numbers that were prepared for the bearings order and for Decker to change the numbers in order to make Lazarus’s performance look good.

Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Lazarus’s motivation for wanting Decker to reduce costs was precisely to earn a larger bonus. This action could be viewed as violating the standard for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. In this regard, both Lazarus’s and Decker’s behavior (if Decker agrees to reduce the cost of the order) could be viewed as unethical.

Credibility The Standards of Ethical Conduct for Management Accountants require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, reducing fixed overhead costs in deciding on the price to bid are clearly violating both of these precepts. For the reasons cited above, the behavior described by Lazarus and Decker (if he goes along with Lazarus’s wishes) is unethical.

Decker should indicate to Lazarus that the costs were correctly computed and that determining prices on the basis of full product costs plus a mark­up of 10% are required by company policy. If Lazarus still insists on making the changes and reducing the costs of the order, Decker should raise the matter with Lazarus’s superior. If, after taking all these steps, there is continued pressure to understate the costs, Decker should consider resigning from the company, rather than engaging in unethical behavior.

12­25

12­37 (30 min.) Target prices, target costs, value engineering.

1. Direct materials $14.98 Direct manufacturing labor ($15 per hr.× 0.5 hr.) 7.50

Engineering $14 25,000 hrs. ( ) 50,000 units

× 7.00

Testing ($12 per hr.×0.25 hr.) 3.00 Full cost per unit of TX40 $32.48

2. Markup % = $40.60 $32.48 $32.48

− = 25%

3. These new units will require direct costs and testing, but no additional engineering since there will be no incremental R&D and design costs to produce 10,000 more units.

Incremental revenues $40.60 Direct costs ($14.98 + $7.50) 22.48 Testing costs 3.00 Contribution margin $15.12 Increase in units sold ×10,000 units Increased contribution margin $151,200 Less : Advertising costs (200,000) Operating income (loss) $ (48,800)

No, the increase in units sold are insufficient to cover the extra advertising costs and incremental costs of production. Avery will incur an operating loss on these extra units and should not pursue this strategy.

4. Direct costs ($22.48×60,000 units) $1,348,800 Engineering ($14×25,000 hrs.) 350,000 Testing ($3×60,000 units) 180,000 Advertising 200,000 Full cost of TX40 $2,078,800 Divide by number of units ÷60,000 units Full cost per unit of TX40 $34.65 Markup ×1.25 New selling price $43.31