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CHAPTER 15Target Costing and Cost Analysis for Pricing Decisions

ANSWERS TO REVIEW QUESTIONS

15-1 Four major influences on pricing decisions are as follows:

(1) Customer demand: Management must consider customers’ demand for their product, which reflects the price that customers are willing to pay for the product.

(2) Actions of competitors: When pricing its product, management must consider the likely pricing decisions and product design decisions of competing firms.

(3) Costs: No organization or industry can price its product below total production costs indefinitely.

(4) Political, legal, and image-related issues: Management must consider the way the public perceives the firm and must adhere to certain laws when setting prices.

15-2 The statement that prices are determined by production costs is too simplistic. Although firms must price their products and services above their total costs in the long run, management cannot ignore demand issues and the economic environment. Setting prices generally is a balance between cost-related issues and economic market forces.

15-3 In the long run, every organization must price its product or service above the total cost of production. While the market for the product also is critically important, costs cannot be ignored.

15-4 It is crucial to define the firm’s product when considering the reaction of competitors, so that the competitors can be identified. For example, is a firm that produces glass bottles competing only with other firms that produce glass bottles, or is the firm competing with all companies that produce containers? Defining the product as glass bottles or containers is an important step in identifying who the firm’s competitors are.

McGraw-Hill/Irwin 2002 The McGraw-Hill Companies, Inc.Managerial Accounting, 5e 15-1

15-5 In most industries, both market forces and cost considerations heavily influence prices. No organization can price its products below their production costs in the long run. On the other hand, no company can set prices at cost plus a markup without keeping an eye on the market. The product or service must be sold at a price customers are willing to pay.

15-6 The profit-maximizing price is the price for which the associated quantity is determined by the intersection of the marginal cost and marginal revenue curves. This intersection is shown in Exhibit 15-3 in the text.

15-7 (a) Total revenue: Price multiplied by quantity sold.

(b) Marginal revenue: The amount by which total revenue increases when one additional unit is sold.

(c) Demand curve: A graphical or mathematical expression of the relationship between the price and the quantity sold.

(d) Price elasticity: The impact of price changes on sales volume.

(e) Cross-elasticity: The extent to which a change in a product’s price affects the demand for substitute products.

15-8 (a) Total cost: Unit cost multiplied by quantity produced.

(b) Marginal cost: Additional cost when one more unit is produced.

15-9 Three limitations of the economic, profit-maximizing model of pricing are as follows:

(1) The firm’s demand and marginal revenue curves are difficult to determine with precision.

(2) The marginal-cost, marginal-revenue paradigm, as described in the text, is not valid for all forms of market organization.

(3) Cost-accounting systems are not designed to measure the marginal changes in cost incurred as production and sales increase unit by unit. To measure marginal cost would entail a very costly information system.

15-10 Determining the best approach to pricing requires a cost-benefit trade-off. While the marginal-cost, marginal-revenue paradigm results in a profit-maximizing price, only a sophisticated and costly information system can collect marginal-cost data. Thus, the firm will incur greater cost in order to obtain better decisions.

McGraw-Hill/Irwin 2002 The McGraw-Hill Companies, Inc.15-2 Solutions Manual

15-11 The general formula for cost-plus pricing is as follows:

Price = cost + (markup percentage cost)

The price is equal to cost plus a markup. Depending on how cost is defined, the markup percentage may differ. Several different definitions of cost, each combined with a different markup percentage, can result in the same price for a product or service.

15-12 The four cost bases commonly used in cost-plus pricing are the following: absorption manufacturing cost, total cost, variable manufacturing cost, and total variable cost. Each of these cost bases can result in the same price under cost-based pricing if the markup percentage used in the cost-plus pricing formula is changed. For example, a lower markup percentage would be applied to total cost than would be applied to total variable cost.

15-13 Four reasons often cited for the widespread use of absorption cost as the cost base in cost-plus formulas are as follows:

(1) In the long run, the price must cover all costs and a normal profit margin.

(2) Absorption-cost and total-cost pricing formulas provide a justifiable price that tends to be perceived as equitable by all parties.

(3) When a company’s competitors have similar operations and cost structures, cost-plus pricing based on full costs gives management an idea of how competitors may set prices.

(4) Absorption-cost information is provided by a firm’s cost-accounting system, because it is required for external financial reporting under generally accepted accounting principles. Since absorption-cost information already exists, it is cost-effective to use for pricing.

15-14 The primary disadvantage of absorption-cost or total-cost pricing formulas is that they obscure the cost behavior pattern of the firm. Since absorption-cost and total-cost data include allocated fixed costs, it is not clear from these data how the firm’s total costs will change as volume changes.

15-15 Three advantages of pricing based on variable cost are as follows:

(1) Variable-cost data do not obscure the cost behavior pattern by unitizing fixed costs and making them appear variable.

(2) Variable-cost data do not require allocation of common fixed costs to individual product lines.


(3) Variable-cost data are exactly the type of information managers need when facing certain decisions, such as whether to accept a special order.

15-16 The behavioral problem that can result from the use of a variable-cost pricing formula is that managers may perceive the variable cost of a product or service as the floor for the price. They may tend to set the price too low for the firm to cover its fixed costs.

15-17 Return-on-investment pricing is an approach under which the price is set so that it will cover costs and also earn a profit that will provide a target return on the invested capital.

15-18 Price-led costing refers to the process under target costing of first determining the acceptable market price for a product or service and then determining the cost at which the product or service must be produced.

15-19 To be successful at target costing, management must listen to the company’s customers. By doing so, management will learn the products, features, and quality that customers are willing to buy as well as the price they are willing to pay.

15-20 Value-engineering is a cost-reduction and process-improvement technique used to help bring the cost of manufacturing a product or providing a service into line with its target cost.

15-21 Tear-down methods can be used in a service-industry firm just as they are used in the manufacturing industry. The various steps in providing a service can be analyzed for cost improvements just as a product’s materials and manufacturing operations can be analyzed for the same purpose.

15-22 Under time-and-material pricing, the price includes a cost-based charge for labor, a cost-based charge for material, and generally a markup on one or both of these production-cost factors.

15-23 When a firm has excess capacity, there is no opportunity cost in accepting an additional production job. Therefore, it is not necessary to reflect such an opportunity cost in setting a bid price. On the other hand, if the firm is already at full capacity, there is an opportunity cost to accepting another production job. In this case, it is appropriate to include in the price an estimate of the opportunity cost associated with the job for which the bid is being prepared.


15-24 The decision to accept or reject a special order and the selection of a price for a special order are similar decisions. If a price has been offered for a special order, management can base its acceptance or rejection decision on whether or not that price covers the incremental cost of producing the order. Another way of viewing the problem is to set the minimum price for the special order at a level sufficient to cover the incremental cost of producing the order.

15-25 (a) Skimming pricing: Setting a high initial price for a new product in order to reap short-run profits. Over time, the price is reduced gradually.

(b) Penetration pricing: Setting a low initial price for a new product in order to penetrate a market deeply and gain a large and broad market share.

(c) Target costing: Conducting market research to determine the price at which a new product will sell and then, given the likely sales price, computing the cost for which the product must be manufactured in order to provide the firm with an acceptable profit margin. Then engineers and cost analysts work together to design a product that can be manufactured for the allowable cost. This process is used widely in the development stages of new products.

15-26 (a) Unlawful price discrimination: Quoting different prices to different customers for the same product or service, even though the different prices cannot be justified by differences in the cost incurred to produce, sell, and deliver the product or service.

(b) Predatory pricing: Temporarily cutting a price to broaden demand for a product with the intention of later restricting the supply and raising the price again.

15-27 Traditional, volume-based product-costing systems often overcost high-volume and relatively simple products while undercosting low-volume and complex products. This practice can result in overpricing high-volume and relatively simple products and underpricing low-volume and complex products. Such strategic pricing errors can have a disastrous impact on a firm’s competitive position.


SOLUTIONS TO EXERCISESEXERCISE 15-28 (30 MINUTES)

1. Tabulated price, quantity, and revenue data:

(1)

QuantitySold perMonth

(2)

UnitSalesPrice

(3)Total

Revenueper

Month*

(4)

Changesin Total

Revenue

20 .......................................$1,000 .....................................................................................$20,000 }}}}

....................

....................

....................

....................

$18,000 16,000 14,00012,000

40 ....................................... 950 ..................................................................................... 38,000 60 ....................................... 900 ..................................................................................... 54,000 80 ....................................... 850 ..................................................................................... 68,000100 ....................................... 800 ..................................................................................... 80,000

*Column (1) times column (2).†Differences between amounts in column (3).


EXERCISE 15-28 (CONTINUED)

2. Total revenue curve:


Quantity sold per month

Curve is increasing throughout its range, but at a declining rate

Dollars

$80,000

$70,000

$60,000

$50,000

$40,000

$30,000

$20,000

$10,000

20 40 60 80 100

Total revenue

EXERCISE 15-29 (30 MINUTES)

1. Tabulated cost and quantity data:

(1)QuantityProduced

and Sold per Month

(2)

AverageCost per

Unit

(3)

TotalCost perMonth*

(4)

Changesin TotalCost

20 .......................................$900 .....................................................................................$18,000}}}}

.....................

.....................

.....................

.....................

$16,000 15,200 19,600 20,200

40 ....................................... 850 ..................................................................................... 34,000 60 ....................................... 820 ..................................................................................... 49,200 80 ....................................... 860 ..................................................................................... 68,800100 ....................................... 890 ..................................................................................... 89,000

*Column (1) times column (2).†Differences between amounts in column (3).


EXERCISE 15-29 (CONTINUED)2. Total cost curve:



Total cost increases at an increasing rate

Dollars

$90,000

$80,000

$70,000

$60,000

$50,000

$40,000

$30,000

$20,000

$10,000

20 40 60 80 100

Total cost

Total cost increases at an declining rate


1. Tabulated revenue, cost, and profit data:

(1)QuantityProducedand Sold

per Month

(2)

SalesPrice

per Unit

(3)Total

Revenueper

Month*

(4)TotalCostper

Month

(5)

Profitper

Month** 20 .......................................$1,000 .....................................................................................$20,000 $18,000 ..............................................................................................................................$2,000 40 ....................................... 950 ..................................................................................... 38,000 34,000 .............................................................................................................................. 4,000 60 ....................................... 900 ..................................................................................... 54,000 49,200 .............................................................................................................................. 4,800 80 ....................................... 850 ..................................................................................... 68,000 68,800 .............................................................................................................................. (800)100 ....................................... 800 ..................................................................................... 80,000 89,000 .............................................................................................................................. (9,000)

*Column (1) times column (2). †Column (1) times average cost per unit given in the preceding exercise.**Column (3) minus column (4).

2. Total revenue and cost curves: see next page.

3. Of the five candidate prices listed, $900 is the optimal price. This price produces a monthly profit of $4,800, which is greater than the profit at the other four candidate prices.


EXERCISE 15-30 (CONTINUED)2. Total revenue and cost curves:


Total revenue


Total profit at the profit-maximizing quantity and

price.

Dollars$90,000

$80,000

$70,000

$60,000

$50,000

$40,000

$30,000

$20,000

$10,000

20 40 60 80 100

Total cost



Dollars per unit

p*Marginal cost

Demand (average revenue)

Marginal revenueQuantity sold

per monthq*

Dollars

Total cost

Total revenue

Total profit at profit-maximizing quantity and price

Quantity sold per monthq*


1. Profit on sales of 60,000 units:

Sales revenue (60,000 6p) ................................................... 360,000pLess: Variable costs:

Manufacturing and administrative (60,000 3p) ..... 180,000pSales commissions (60,000 6p 10%) ................ 36,000 p 216,000 p

Contribution margin ................................................................ 144,000pLess: Fixed costs (60,000p + 5,000p) ..................................... 65,000 p Profit .......................................................................................... 79,000 p

p denotes Argentina’s peso

2. Required price on special order:

Unit contribution margin required on special order =

=

Sales price required = unit variable cost + required unitcontribution margin

= 3p + 2p = 5p per unitAs an alternative approach, let X denote the price required in order to earn additional profit of 20,000p on the special order:

10,000X– 10,000(3p) = 20,000p

10,000X = 50,000p

X = 5p per unit



Answers will vary widely, depending on the company and the product chosen. The answer should include a general discussion of the use of target costing in setting a price for a new product. The target-costing approach includes the following key features: price-led costing; focus on the customer; focus on product design; focus on process design; use of cross-functional teams; analysis of life-cycle costs; and a value-chain orientation. Target costing makes extensive use of value engineering to reduce production costs and bring them into line with the target cost.


Markup percentageapplied to cost base in

cost-pluspricing formula

=

profit required toachieve target ROI +

total annual costs notincluded in cost base

annualvolume

cost base per unitused in cost-pluspricing formula

1. Markup percentage =

=

=

= 131.25%

Thus the Wave Darter’s price would be set equal to $925, where $925 = $400 + ($400 131.25%).



In the preceding formula:$60,000 = target profit (given)

480 = annual volume of Wave Darter production and sales (from Exhibit 15-5)$400 = variable manufacturing cost per unit (from Exhibit 15-5)$50 = variable selling and administrative cost per unit (from Exhibit 15-5)

$250 = applied fixed manufacturing cost per unit (from Exhibit 15-5)$100 = allocated fixed selling and administrative cost per unit (from Exhibit 15-5)

2. Markup percentage =

=

=

= 42.31% (rounded)

Thus the Wave Darter’s price would be set equal to $925, where $925 = $650 + ($650 42.31%) with rounding.

*$650 = absorption manufacturing cost (from Exhibit 15-5).

The other amounts used in this formula were defined in requirement (1).



1. Price = total unit cost + (markup percentage total unit cost)

$450 = total unit cost + (12.5% total unit cost)

$450 = total unit cost 1.125

Total unit cost = = $400

Allocated fixedselling and

administrative cost=

totalunitcost

–all

manufacturingcosts

–variable

selling andadministrative cost

= $400 – ($250 + $50) – $60

= $40

Cost-Plus Pricing Formula2. a. Variable manufacturing cost ...................................................$250 $450 = $250 + (80% $250)*

Applied fixed manufacturing cost .......................................... 50

b. Absorption manufacturing cost .............................................$300 $450 = $300 + (50% $300)

Variable manufacturing cost ...................................................$250Variable selling and administrative cost .......................................................................................... 60

c. Total variable cost ...................................................................$310 $450 = $310 + (45.16% $310)**

*($450 – $250) ÷ $250 = 80% †($450 – $300) ÷ $300 = 50%**($450 – $310) ÷ $310 = 45.16% (rounded)



Cost-Plus Pricing Formula(1) Variable manufacturing cost ...................................................$200 $400 = $200 + (100% $200)a

Applied fixed manufacturing cost .......................................... 70

(2) Absorption manufacturing cost .............................................$270 $400 = $270 + (48.15% $270)b

Variable selling and administrative cost ............................... 30Allocated fixed selling and administrative cost ................................................................ 50

(3) Total cost $350 $400 = $350 + (14.29% $350)c

Variable manufacturing cost ...................................................$200Variable selling and administrative cost ............................... 30

(4) Total variable cost ...................................................................$230 $400 = $230 + (73.91% $230)d

Explanatory Notes:

a($400 – $200) ÷ $200 = 100%b($400 – $270) ÷ $270 = 48.15% (rounded)c($400 – $350) ÷ $350 = 14.29% (rounded)d($400 – $230) ÷ $230 = 73.91% (rounded)


1. Material component of time and material pricing formula:

2. Material component of price, using formula developed in requirement (1):

[$8,000 + ($8,000 .04)] 1.05 = $8,320 1.05 = $8,736



New price to be quoted on yacht refurbishment:Total price of job = time charges + material charges

= $9,000* + $8,736**

= $17,736

*From Exhibit 15-7.**From requirement (1).


SOLUTIONS TO PROBLEMSPROBLEM 15-38 (25 MINUTES)

1. The manufacturing overhead rate is $18.00 per standard direct-labor hour, and the standard product cost includes $9.00 of manufacturing overhead per pressure valve. Accordingly, the standard direct-labor hours per finished valve is 1/2 hour ($9 ÷ $18). Therefore, 30,000 units per month would require 15,000 direct-labor hours.

2. The analysis of accepting the Glasgow Industries’ order of 120,000 units is as follows:

Per UnitTotals for

120,000 UnitsIncremental revenue ................................................................ $19 .00 $2,280,000

Incremental costs: Variable costs: Direct material ................................................................. $ 5.00 $ 600,000 Direct labor ...................................................................... 6.00 720,000 Variable overhead ........................................................... 3 .00 360,000 Total variable costs .................................................... $14 .00 $1,680,000

Fixed overhead: Supervisory and clerical costs (4 months @ $12,000) ........................................................ 48,000Total incremental costs ........................................................... $1,728,000Total incremental profit ........................................................... $ 552,000

The following costs are irrelevant to the analysis:

Shipping

Sales commission

Fixed manufacturing overhead (both traceable and allocated)


PROBLEM 15-38 (CONTINUED)

3. The minimum unit price that Badger Valve and Fitting Company could accept without reducing net income must cover the variable unit cost plus the additional fixed costs.

Variable unit cost: Direct material ...................................................................... $ 5.00 Direct labor ........................................................................... 6.00 Variable overhead ................................................................ 3 .00 $14.00Additional fixed cost ($48,000 ÷ 120,000) .............................. .40 Minimum unit price .................................................................. $14.40

4. Badger’s management should consider the following factors before accepting the Glasgow Industries order:

The effect of the special order on Badger’s sales at regular prices.

The possibility of future sales to Glasgow Industries and the effects of participating in the international marketplace.

The company’s relevant range of activity and whether or not the special order will cause volume to exceed this range.

The effect on machinery or the scheduled maintenance of equipment.

Other possible production orders that could come in and require the capacity allocated to the Glasgow job.


PROBLEM 15-39 (25 MINUTES)

1. Direct-labor hours (DLH) required for job = = 500 DLH

Traceable out-of-pocket costs:

Direct labor ($8.00 500) ....................................................................... $4,000 Variable overhead ($6.00 500) ........................................................... 3,000 Administrative cost ................................................................................. 1,000 Total traceable out-of-pocket costs................................................... $8,000

Minimum price per dose =

=

= $.008

2. As in requirement (1), 500 direct-labor hours are required for the job.

Direct labor ($8.00 500) ........................................................................... $4,000Variable overhead ($6.00 500) ................................................................ 3,000Fixed overhead ($10.00 500) .................................................................. 5,000Administrative cost ..................................................................................... 1,000 Total cost .................................................................................................. $13,000Maximum allowable return (15%) ............................................................... 1,950 Total bid price .......................................................................................... $14,950

Bid price per dose =

=

= $.01495 per dose



3. Under the supposition that the price computed by North American Pharmaceuticals, Inc. using Wyant’s criterion is greater than $.015, the factors that North American’s management should consider before deciding whether or not to submit a bid at the maximum allowable price include whether North American has excess capacity, whether there are available jobs on which earnings might be greater, and whether the maximum bid of $.015 contributes toward covering fixed costs.


1. Target costing is more appropriate. MPE is limited in terms of what price it can charge due to market conditions. A cost-plus-markup approach will use the desired markup for the company; however, the resulting price may too high and not competitive. In such an environment it makes more sense to use target costing, which begins with the price to be charged and works backward to determine the allowable cost.

2. Target profit = asset investment x rate of return = $18,000,000 x 12% = $2,160,000

3. Revenue = target profit + variable cost + fixed cost= $2,160,000 + (25,000 hours x $22) + $1,900,000= $4,610,000

Since total revenue must equal $4,610,000, the revenue per hour must be $184.40 ($4,610,000 ÷ 25,000 hours).

4. Target profit = asset investment x rate of return = $18,000,000 x 14% = $2,520,000

Revenue = target profit + variable cost + fixed cost= $2,520,000 + (25,000 hours x $22) + $1,900,000= $4,970,000

No. A 14% return requires that MPE generate revenue per service hour of $198.80 ($4,970,000 ÷ 25,000 hours), which is clearly in excess of the $175 market price.



5. To achieve a 14% return and a $175 revenue-per-hour figure, the company must trim its costs. MPE could use value engineering, a technique that utilizes information collected about a service’s design and associated production process. The goal is to examine the design and process and then identify improvements that would produce cost savings.


1. Cost-plus pricing begins by computing an item’s cost and then adds an appropriate markup. The result is the item’s selling price. In contrast, target costing begins by determining an appropriate selling price. A target profit is next subtracted from that price to yield the cost (i.e., the “target cost”) that must be achieved.

Target costing could be labeled price-led costing because it begins by determining a target selling price. In contrast, cost-plus pricing methods begin with the cost and culminate in determination of the selling price.

2. The current selling price is $225:

Direct material……………………………... $ 30Direct labor………………………………… 75Manufacturing overhead………………… 50Selling and administrative expenses…. 25

Total cost………………………………. $180Markup ($180 x 25%)……………………... 45 Selling price………………………………... $225

3. Leno’s markup is $45, which is 20% of the current $225 selling price ($45 ÷ $225). To achieve a 20% markup on a $195 selling price, the company must reduce its costs by $24.

Selling price……………………………….. $195Less: 20% markup ($195 x 20%)………. 39 Target cost………………………………… $156

Current cost……………………………….. $180Less: Target cost…………………………. 156 Required cost reduction………………… $ 24



4. Yes. The company should focus its efforts on trimming non-value-added costs. These costs are associated with non-value-added activities (i.e., activities that are either (a) unnecessary and dispensable or (b) necessary, but inefficient and improvable).

5. If costs cannot be reduced below $180, Leno will have to reduce its markup to remain competitive. Assuming a desire to achieve the going market price of $195, the markup must equal $15 ($195 - $180), or 8.33 % of cost ($15 ÷ $180). Given that the current markup on cost is 25%, a reduction of 16.67% is needed (25.00% - 8.33%).

6. The statement means that selling prices are a function of market conditions; however, the selling prices must cover a company’s costs in the long run. Also, in a number of industries, prices are based on costs. Yet, the prices are subject to the reaction of customers and competitors.


1. Target costing is market driven, beginning with a determination of the selling price that customers are willing to pay. That price is dependent on the product they purchase and the product’s features. It is only natural that a marketing team becomes heavily involved in this process, since customer feedback is crucial to the design process.

2. Add cabinet doors: [(10 x 1) + (20 x 2) + (30 x 3) + (60 x 4) + (80 x 5)] = 780; 780 ÷ 200 = 3.900

Expand storage area: [(10 x 1) + (40 x 2) + (70 x 3) + (50 x 4) + (30 x 5)] = 650; 650 ÷ 200 = 3.250

Add security lock: [(30 x 1) + (60 x 2) + (50 x 3) + (40 x 4) + (20 x 5)] = 560; 560 ÷ 200 = 2.800

New appearance for table top: [(10 x 1) + (20 x 2) + (50 x 3) + (60 x 4) + (60 x 5)] = 740; 740 ÷ 200 = 3.700

Extend warranty: [(40 x 1) + (70 x 2) + (30 x 3) + (35 x 4) + (25 x 5)] = 535; 535 ÷ 200 = 2.675



Ranking (from strongest to weakest):1—Add cabinet doors (3.900)2—New appearance for table top (3.700)3—Expand storage area (3.250)4—Add security lock (2.800)5—Extend warranty (2.675)

3. (a) DF currently earns a $16 profit on each table sold ($80 - $64), which translatesinto a 20% markup on sales ($16 ÷ $80). The current competitive market price is $95, which means that if DF maintains the 20% markup, it will earn $19 ($95 x 20%) per unit. The maximum allowable cost is therefore $76 ($95 - $19).

(b) Customers feel most strongly about adding cabinet doors and giving the table top a new appearance. Both of these features can be added, and DF will be able to earn its 20% markup. The third and fifth most desirable features (the expanded storage area and extended warranty) are too costly. If it desires, DF could also add a lock to the storage area. (Calculations follow.)

Maximum allowable cost…………... $76.00Less: Current cost…………………... 64.00 Cost of additional features………… $12.00

1—Add cabinet doors………………. $ 6.002—New appearance for table top… 4.25

Subtotal…………………………… $10.254—Add security lock……………….. 1.65

Total……………………………….. $11.90

4. An expanded storage area would be the most logical additional feature in view of its no. 3 ranking. DF might use value engineering to study the design and production process of both the table as currently manufactured as well as the proposed new features. The goal is to identify improvements and associated reductions in cost that may allow the company to add previously rejected options.



1. The order will boost Graydon’s net income by $27,900, as the following calculations show.Sales revenue...................................................... $165,000Less: Sales commissions (10%)........................ 16,500 $148,500Less manufacturing costs:

Direct material................................................ $ 29,200Direct labor..................................................... 56,000Variable manufacturing overhead*.......................... 16,800 Total manufacturing costs 102,000

Income before taxes............................................ $ 46,500Income taxes (40%)............................................. 18,600 Net income ...................................................... $ 27,900

*Based on an analysis of the year just ended, variable overhead is 30 percent of direct labor ($2,250 ¸ $7,500). For Premier’s Foods’ order:

Direct-labor cost x .30 = $56,000 x .30 = $16,800.

2. Yes. Although this amount is below the $165,000 full-cost price, the order is still profitable. Graydon can afford to pick up some additional business, because the company is operating at 75 percent of practical capacity.Sales revenue............................................................. $127,000Less: Sales commissions (10%).............................. 12,700 $114,300Less manufacturing costs:

Direct material...................................................... $ 29,200Direct labor........................................................... 56,000Variable manufacturing overhead...................... 16,800 Total manufacturing costs 102,000

Income before taxes.................................................. $ 12,300Income taxes (40%)................................................... 4,920 Net income ............................................................. $ 7,380

Note that the fixed manufacturing overhead and fixed corporate administration costs are not relevant in this decision, because these amounts will remain the same regardless of what Graydon’s management decides about the order.



3. The break-even price is $113,333, computed as follows:

Let P = break-even bid price

P – 0.1P - $102,000 = 0

0.9P = $102,000

P = $113,333

Income taxes can be ignored, because there is no tax at the break-even point.

4. Profits will probably decline. Graydon originally used a full-cost pricing formula to derive a $165,000 bid price. A drop in the selling price to $127,000 signifies that the firm is now pricing its orders at less than full cost, which would decrease profitability.

Reduced prices could lead to an increase in income if the company is able to generate additional volume. This situation will not occur here, because the problem states that Graydon has operated and will continue to operate at 75 percent of practical capacity.


1. Target costing is the design of a product, and the processes used to produce it, so that ultimately the product can be manufactured at a cost that will enable a firm to make a profit when the product is sold at an estimated market-driven price. This estimated price is called the target price, the desired profit margin is called the target profit, and the cost at which the product must be manufactured is called the target cost.

2. Value engineering (or value analysis) refers to a cost-reduction and process improvement technique that utilizes information collected about a product's design and production processes and then examines various attributes of the design and processes to identify candidates for improvement efforts.

Value engineering focuses on improving those qualities that the customer desires, while reducing or eliminating unnecessary moves, queues, setups, and other such activities that the customer will not pay for. The process is reengineered to eliminate non-value-added work and thereby enhance the value of the process to the customer.



3. Pharsalia Electronics' current profit on sales is 10 percent [($350-$315)/$350]. Therefore, the target cost for the new product must be $300 less 10 percent, or $270 [$300 – ($300 10%)].

4. The proposed changes to the just-in-time cell manufacturing process at Pharsalia Electronics will bring costs down to $266 per unit, which is below the $270 target cost limit. Adjusted costs under the JIT cell manufacturing process are calculated as follows:

CurrentIncrease/

(Decrease) Revised

Material:Purchased components................................... $110 $110All other............................................................. 40 40

Labor:Manufacturing, direct....................................... 65 $ 15 80Setups................................................................ 9 (9) 0Material handling.............................................. 18 (18) 0Inspection.......................................................... 23 (23) 0

Machining:All....................................................................... 35 (5) 30

Other:Finished-goods warehousing.......................... 5 (5) 0Warranty*........................................................... 10 (4) 6

Total JIT Cost.......................................................... $315 $(49) $266

*40% reduction



1. (a) Time charges:

Hourly labor cost + +

= $16 + + $4

= $29 per labor hour

(b) Material charges:

=

2. PRICE QUOTATION

Time charges: Labor time .....................................................................................................400 hours Rate ........................................................................................................... $29 per hourTotal ..............................................................................................................$11,600

Material changes: Cost of materials for job .............................................................................$60,000+ Charge for material handling and storage ............................................. 6,000*Total ..............................................................................................................$66,000

Total price of job: Time ...............................................................................................................$11,600Material ......................................................................................................... 66,000Total ..............................................................................................................$77,600

*Charge for material handling and storage):10% = $25,000 ÷ $250,000; 10% $60,000 = $6,000



3. Price of job without markup on material costs (from requirement 2) .... $77,600Markup on total material costs ($66,000 10%) ...................................... 6,600Total price of job .......................................................................................... $84,200


1. Gargantuan Industries should price the standard compound at $22 per case and the commercial compound at $30 per case. The contribution margin is the highest at these prices as shown in the following calculations:

Standard CompoundSelling price per case ..................................................................................$ 18 $ 20 $ 21 $ 22 $ 23Variable cost per case ................................................................................. 16 16 16 16 16Contribution margin per case .....................................................................$ 2 $ 4 $ 5 $ 6 $ 7Volume in cases (in thousands) ................................................................. 120 100 90 80 50 Total contribution margin (in thousands) .................................................$240 $400 $450 $480 $350

Commercial CompoundSelling price per case ..................................................................................$ 25 $ 27 $ 30 $ 32 $ 35Variable cost per case ................................................................................. 21 21 21 21 21Contribution margin per case .....................................................................$ 4 $ 6 $ 9 $ 11 $ 14Volume in cases (in thousands) ................................................................. 175 140 100 55 35 Total contribution margin (in thousands) .................................................$700 $840 $900 $605 $490


PROBLEM 15-46 (CONTINUED)2. a. Gargantuan Industries should continue to operate during the final six months of

the current year because any shutdown would be temporary. The company intends to remain in the business and expects a profitable operation during the next year. This is a short-run decision problem. Therefore, the fixed costs are irrelevant to the decision, because they cannot be avoided in the short run. The products do have a positive contribution margin so operations should continue.

GARGANTUAN INDUSTRIESBOISE PLANT

PROJECTED CONTRIBUTION MARGINFOR THE SIX-MONTH PERIOD ENDING DECEMBER 31

(IN THOUSANDS)Standard Commercial Total

Sales ..............................................................................................................$1,150 $1,225 $2,375Variable costs: Selling and administrative ......................................................................$ 200 $ 245 $ 445 Manufacturing .......................................................................................... 600 490 1,090 Total variable costs ............................................................................$ 800 $ 735 $1,535Contribution margin ....................................................................................$ 350 $ 490 $ 840

b. Gargantuan Industries should consider the following qualitative factors when making the decision about the Boise Plant.

The effect on employee morale.

The effect on market share.

The disruption of production and sales due to a shutdown.

The effect on the local community.



1. The minimum price per blanket that Omaha Synthetic Fibers, Inc. could bid without reducing the company’s net income is $24 calculated as follows:

Raw material (6 lbs. @ $1.50 per lb.) .......................................................... $ 9.00Direct labor (.25 hrs. @ $7.00 per hr.) ........................................................ 1.75Machine time ($10.00 per blanket) ............................................................. 10.00Variable overhead (.25 hrs. @ $3.00 per hr.) ............................................. .75Administrative costs ($2,500 ÷ 1,000) ........................................................ 2 .50 Minimum bid price ................................................................................... $24 .00

2. Using the full cost criteria and the maximum allowable return specified, Omaha Synthetic Fibers, Inc.’s bid price per blanket would be $29.90 calculated as follows:

Relevant costs from requirement (1) ......................................................... $24.00Fixed overhead (.25 hrs. @ $8.00 per hr.) .................................................. 2 .00 Subtotal .................................................................................................... $26.00Allowable return (.15 $26) ....................................................................... 3 .90 Bid price ................................................................................................... $29 .90

3. Factors that management should consider before deciding whether to submit a bid at the maximum acceptable price of $25 per blanket include the following:

The company should be sure there is sufficient excess capacity to fill the order and that no additional investment is necessary in facilities or equipment that would increase fixed costs.

If the order is accepted at $25 per blanket, there will be a $1 contribution per blanket to fixed costs. However, the company should consider whether there are other jobs that would make a greater contribution.

Acceptance of the order at a low price could cause problems with current customers who might demand a similar pricing arrangement.



1. Budgeted overhead costs:

Department I Department IIVariable overhead Department I: 37,500 $8 .....................................................................$300,000 Department II: 37,500 $4 ..................................................................... $150,000Fixed overhead ............................................................................................ 150,000 150,000Total overhead .............................................................................................$450,000 $300,000Total budgeted overhead for both departments ($450,000 + $300,000) ......................................................... $750,000Total expected direct-labor hours for both departments (37,500 + 37,500) ......................................................... 75,000

Predetermined overhead rate =

=

= $10 per direct-labor hour

2. Basic AdvancedTotal cost ......................................................................................................$400 $500Markup (15% of cost) Basic: $400 .15 ................................................................................... 60 Advanced: $500 .15 ............................................................................. 75Price ..............................................................................................................$460 $575

3. Department I Department IIBudgeted overhead (from requirement 1)..................................................$450,000 $300,000Budgeted direct-labor hours ...................................................................... 37,500 37,500Calculation of predetermined overhead rate ............................................

Predetermined overhead rate ..................................................................... $12 $8



4. Basic AdvancedDirect material ..............................................................................................$160 $260Direct labor ................................................................................................... 140 140Manufacturing overhead: Department I: Basic: 2 $12 ..................................................................................... 24 Advanced: 8 $12 ............................................................................. 96 Department II: Basic: 8 $8 ....................................................................................... 64 Advanced: 2 $8 ............................................................................... 16Total cost ......................................................................................................$388 $512

5. Basic AdvancedTotal cost (from requirement 4)...................................................................$388.00 $512.00Markup (15% of cost) Basic: $388 .15 ....................................................................................58.20 Advanced: $512 .15 ............................................................................. 76 .80 Price ..............................................................................................................$446 .20 $588 .80

6. The management of Sounds Fine, Inc. should use departmental overhead rates. The overhead cost structures in the two production departments are quite different, and departmental rates more accurately assign overhead costs to products. When the company used a plantwide overhead rate, the Basic speakers were overcosted and the Advanced speakers were undercosted. This in turn resulted in the Basic model being overpriced and the Advanced model being underpriced. The cost and price distortion resulted from the following facts: (1) the Basic speakers spend most of their production time in Department II, which is the least costly of the two departments; and (2) the Advanced speakers spend most of their production time in Department I, which is more costly than Department II.



1. Bid based on standard pricing policy:

Direct material ............................................................................................ $256,000Direct labor (11,000 DLH @ $15) ............................................................... 165,000Manufacturing overhead (11,000 DLH @ $9) ........................................... 99,000 Full manufacturing costs ...................................................................... $520,000Markup (50% of full cost) ........................................................................... 260,000Standard pricing policy bid ....................................................................... $780,000

2. Minimum bid acceptable to Zylar:

Direct material ............................................................................................ $256,000Direct labor (11,000 DLH @ $15) ............................................................... 165,000Variable manufacturing overhead (11,000 @ $5.40a) .............................. 59,400Opportunity cost of lost salesb .................................................................. 35,200Minimum bid ............................................................................................... $515,600

aProportion of variable overhead =

=

= 60%

Variable overhead rate =

= ($9.00) (.6)

= $5.40


Problem 15-49 (Continued)

bSelling price per unit of standard product................................................ $12,000 Variable costs per unit Direct material .....................................................................................$2,500 Direct labor (250 DLH @ $15) .............................................................3,750 Variable overhead (250 DLH @ $5.40) ............................................... 1,350 7,600Net contribution per unit ............................................................................. $ 4,400Standard product requirements (12,000 DLH 3) ...................................36,000 DLHSpecial order requirements ........................................................................11,000 DLHTotal hours required ....................................................................................47,000 DLHPlant capacity per quarter (15,000 DLH 3) ............................................45,000 DLHShortage in hours ........................................................................................ 2,000 DLHLost unit sales (2,000 DLH ÷ 250 DLH) ...................................................... 8 Lost contribution ......................................................................................... $35,200

Lyan Company’s assistant purchasing manager is not acting ethically. The details of the bid submitted by Zylar Industries are confidential between Zylar Industries and Lyan Company. It is unfair and unethical to give this information to Zylar’s competitor. If Lyan Company had wanted competing bids on the specialized equipment, the bids should have been solicited at the same time from the relevant set of manufacturers. Each competing firm should receive the same specifications on the customized equipment and be given the same time frame in which to complete the bid. Moreover, the competing firms should be made aware that more than one bid is being solicited.



1. The lowest price Biloxi Corporation would bid for a one-time special order of 25,000 pounds (25 lots) would be $34,750, which is equal to the variable costs of the order calculated as follows:

(a) Direct material:

On a one-time only special order, chemicals used in manufacturing the firm’s main product have a relevant cost of their expected future cost, represented by the current market price per pound. Chemicals not used in current production have a relevant cost of their value to the firm. RH-3: (400 pounds per lot) (25 lots) = 10,000 pounds.

Substitute CN-5 on a one-for-one basis to its total of 5,500 pounds. The relevant cost is the salvage value. ................................ $ 500

The remaining 4,500 pounds would be RH-3 at a relevant cost of $.90 per pound, its expected future cost. ........................................... 4,050

JX-6: (300 pounds per lot) (25 lots) = 7,500 pounds at$.60 per pound. ..................................................................................... 4,500

MZ-8: (200 pounds per lot) (25 lots) = 5,000 pounds at$1.60 per pound. ................................................................................... 8,000

BE-7: (100 pounds per lot) (25 lots) = 2,500 pounds.

The relevant cost per pound is $.65 – $.10 (handling charge) = $.55.The amount the company could realize by selling BE-7. is 2,500 pounds at $.55 per pound............................................................ 1,375

Total direct material cost ................................................................... $18,425



(b) Direct labor:

(60 DLH per lot) (25 lots) = 1,500 direct-labor hours (DLH)

Because only 800 hours can be scheduled during regular time this month, overtime would have to be used for the remaining 700 hours; therefore, overtime is a relevant cost of this order.(1,500 DLH) ($7.00 per DLH) ...................................................................................$10,500(700 DLH) ($3.50 per DLH) ...................................................................................... 2,450Total direct-labor cost .................................................................................................$12,950

(c) Overhead:

This special order will not increase fixed overhead costs. Therefore, fixed overhead is not relevant, and the relevant overhead charge is the variable overhead rate:

(1,500 DLH) ($2.25 per DLH) = ................................................................................ 3,375

Total cost of special order ..........................................................................................$34,750*

*$34,750 = $18,425 + $12,950 + $3,375

2. Calculation of the price for recurring orders of 25,000 pounds (25 lots) is as follows.

(a) Direct material:

Because of the possibility of future orders, raw materials must all be charged at their expected future cost represented by the current market price per pound.

RH-3: (10,000 pounds) ($.90 per pound) ............................................................................... $ 9,000

JX-6: (7,500 pounds) ($.60 per pound) .............................................................................................................................................................................................) 4,500

MZ-8: (5,000 pounds) ($1.60 per pound) ........................................................................... 8,000

BE-7: (2,500 pounds) ($.65 per pound) ............................................................................. 1,625

Total direct-material cost .................................................................. $23,125



(b) Direct labor:

60% of the production of a batch (900 DLH) can be done on regular time; the remaining 600 DLH cause overtime to be incurred and are a relevant cost of this new product.

Regular time (1,500 DLH) ($7.00 per DLH) .................................................................................$10,500Overtime premium (600 DLH) ($3.50 per DLH) .................................................................................... 2,100Total direct-labor cost .................................................................................................$12,600

(c) Overhead:

All new products should contribute to fixed overhead as well as cover all variable costs and provide a markup. Therefore, the overhead charge would be:

(1,500 DLH) ($6.00 per DLH) ...................................................................................$9,000

(d) Markup and price calculation:

Full manufacturing cost ..............................................................................................$44,725 *Markup (25%) ................................................................................................................11,181 †

Full manufacturing cost plus 25% markup ...............................................................$55,906

*$44,725 = $23,125 + $12,600 + $9,000†Rounded.

3. The owner of Taylor Nursery is not acting ethically in this situation. It is inappropriate to allow Biloxi Corporation to revise its bid on the basis of confidential information included in the details of the Dalton Industries bid. All firms competing for the Taylor Nursery contract should be given the same product specifications, information, and time frame with which to prepare a bid.


SOLUTIONS TO CASESCASE 15-51 (45 MINUTES)

1. The total sales price can be determined by the following formula:

Let S = IC + T + NIATWhere S = total price

IC = incremental costT = taxesT = (S – IC)tt = tax rate

NIAT = net income after taxesNIAT = S desired return on total price

Substituting for the known items, the formula is revised to read:

S = IC + (S – IC) .4 + .10S

The incremental costs for the three-year order are calculated as shown in the following schedule.


CASE 15-51 (CONTINUED)

Cost Item

CurrentAmounts

(in thousands)ContractIncrease

InflationRate Years

Details ofCalculations

Amount(in

thousands)Direct material $200 10% 5% 3 (200 .10 1.05 3) $ 63.0Direct labor 400 10% 10% 3 (400 .10 1.10 3) 132.0Indirect labor 100 — — — — — Supplies 40 10% 10% 3 (40 .10 1.10 3) 13.2Additional supplies — $4 10% 3 (4 1.10 3) 13.2Power 120 10% 20% 3 (120 .10 1.20 3) 43.2Additional power — $10 20% 3 (10 1.20 3) 36.0Factory administration 60 $15* 10% 3 (15 1.10 3) 49.5Depreciation 70 — — — — —†

Sales commission — $10 — — — 10.0Total incremental costs $360.1

*The current amount of factory administration, $60,000, will be unchanged, but an additional part-time factory supervisor will be hired at an annual cost of $15,000. †The company has idle capacity that will be fully utilized by this order. The capacity costs (i.e., depreciation) would be expensed whether management accepted the order or not. Therefore, the depreciation is a sunk cost and is not considered an incremental cost of the order.



The total price needed by Polaski for the three-year order is $432,120 as shown in the calculations below:

S = IC + (S – IC) .4 + .10SS = $360,100 + (S – $360,100).4 + .10SS = $360,100 + .4S – $144,040 + .10S

.5S = $216,060S = $432,120

2. If the three-year order is to contribute nothing to net income after taxes, Polaski would set the total price at $360,100, an amount equal to the incremental costs to produce the order.

CASE 15-52 (60 MINUTES)

MemorandumDate: TodayTo: President, CPIFrom: I.M. StudentSubject: Convention fee

CPI can maximize its contribution from its annual convention by charging a single, flat fee of $300. Using this fee structure, CPI’s contribution will be $400,925 as shown by the detailed calculations for the separate pricing option and the three single, flat fee options that follow.

Pricing Option ContributionSeparate pricing $374,200Flat fee options:

$325 400,100 300 400,925 275 387,550


CASE 15-52 (CONTINUED)(a) Contribution analysis for separate pricing

(estimated hotel registrations = 60% 2,000 = 1,200):

FunctionEstimated

Attendance Revenue ExpenseContri-bution

Registration ......................... 100% 2,000 = 2,000 $100,000 $ -0- $100,000Reception ............................ 100% 2,000 = 2,000 -0- 50,000 (50,000)Annual meeting* ................. 100% 2,000 = 2,000 -0- -0-* -0- Keynote luncheon .............. 90% 2,000 = 1,800 72,000 45,000 27,000Six concurrent sessions* ... 70% 2,000 = 1,400 84,000 -0-* 84,000Plenary session* ................. 70% 2,000 = 1,400 70,000 -0-* 70,000Six workshops .................... 50% 2,000 = 1,000 100,000 -0-* 100,000Banquet ............................... 90% 2,000 = 1,800 90,000 54,000 36,000Hotel credit for free rooms

$125 .8 3

(7,200 ) 7,200Total ..................................... $516,000 $141,800 $374,200

*Meeting rooms and halls are free when 1,000 members are expected to register at the hotel.†Reflects 20% discount.



(b) Contribution analysis for flat fee pricing.

$325Fee

$300Fee

$275Fee

Number of attendees (given) 1,600 1,750 1,900Estimated hotel registrations (60%) 960 1,050 1,140Number of free rooms (registration divided by 50, with no fractional credit) 19 21 22Revenue (fee attendees) $520,000 $525,000 $522,500Expenses Reception ($25 100% attendees) $ 40,000 $ 43,750 $ 47,500 Annual meeting* 2,000 -0- -0- Keynote luncheon ($25 90% attendees)

36,000 39,375 42,750

Six concurrent sessions* 1,200 -0- -0- Plenary session* 2,000 -0- -0- Six workshops 1,200 -0- -0- Banquet ($30 90% attendees) 43,200 47,250 51,300 Total expenses $125,600 $130,375 $141,550Revenue less expenses $394,400 $394,625 $380,950 Room credit ($300 free rooms) 5,700 6,300 6,600Contribution $400,100 $400,925 $387,550

*Meeting rooms and halls are free when 1,000 members are expected to register at the hotel.†Reflects 20% discount.


CURRENT ISSUES IN MANAGERIAL ACCOUNTINGISSUE 15-53

“HIGH FUEL PRICES MAY HURT STORES, NOT CONSUMERS," THE WALL STREET JOURNAL, SEPTEMBER 28, 2000, DANIEL MACHALABA AND REBECCA QUICK.

1. Retailers will absorb increased shipping costs instead of passing them along to customers for the holiday season discussed in this article. The highly competitive nature of the season determines that the cost of retail goods will be determined by market-based pricing.

2. Cost-based pricing is when sellers determine their costs and add a profit margin. Market-based pricing is when a competitive price is determined at which the product will sell. As mentioned above, market-based pricing is likely to prevail in this scenario.

ISSUE 15-54

“CAR MAKERS MAY TRY TO ALTER PRICING PRACTICES," THE WALL STREET JOURNAL, JANUARY 24, 2000, JOSEPH B. WHITE AND FARA WARNER.

U. S. auto dealers are changing their pricing policies as a result of the surge in online auto trading by adjusting their online prices on a daily basis. A growing number of dealers already are abandoning the practice of negotiating down from an MSRP, as more consumers come to showrooms armed with invoice price information downloaded from the internet.


ISSUE 15-55

“AUTO MAKERS BOOST CHARGES FOR SHIPPING NEW CARS BECAUSE OF HIGHER FUEL COSTS," THE WALL STREET JOURNAL, OCTOBER 25, 2000, SHOINN FREEMAN.

1. The issue involved in the decision to pass on to consumers the higher prices of fuel costs are increased pressure on profit margins as real prices for new cars actually decline.

2. As all auto makers feel the decline in profits, cost-based pricing takes priority across the industry. Without profits the auto industry cannot stay in business, and therefore all makers have to raise prices. The auto makers do not have to compete against each other on an unbalanced price-competitive field.

ISSUE 15-56

“VOLKSWAGEN AG PLANS ONLINE SUPPLY MARKET IN MOVE TO CUT COSTS," THE WALL STREET JOURNAL, APRIL 13, 2000.

In a competitive bidding situation, two or more companies submit sealed bids for a product, service, or project to a buyer. The buyer selects one of the companies for the job on the basis of the bid price and the design specifications for the job. Volkswagen hopes to take the lead in establishing a European Internet-supply network. Although the supply network could result in competitive bidding, its focus will be on the efficiency of the supply chain.

ISSUE 15-57

“CHANGING CODE: FOR POLICY MAKERS, MICROSOFT SUGGESTS NEED TO RECAST MODELS - AGENCIES SCRAMBLE AS WEB POSES GOOD MONOPOLIES, SKEWS CLASSIC ECONOMICS - AVALANCHE VS. THERMOSTAT, " THE WALL STREET JOURNAL, JUNE 9, 2000, ALAN MURRAY.

1. Several car manufacturers recently joined together to form a single linked exchange that big auto companies will use for purchasing parts. The combined purchasing platform is being done so the auto industry can have standards. The end result will be more competition.

2. In information businesses, the desire for everyone to be part of the same network is intense. This is the network effect.

ISSUE 15-58


“TARGET COSTING CAN BOOST YOUR BOTTOM LINE, " STRATEGIC FINANCE, JULY 1999, GERMAIN BOER AND JOHN ETTLIE.

Using the bottom-up approach engineers can add the estimated prices of purchased components and estimated production costs for each part that goes into a new product. Databases containing current component purchase prices, product routings, and bills of material for existing parts enable design engineers to estimate the cost of new parts. Another approach is to deduct the desired margin for a product from the predicted selling price. This approach is consistent with the Japanese concept of price-down, cost-down, which says production costs must decline as the price of a product declines. In other words, the market determines the acceptable cost for a product.

ISSUE 15-59

“MACHINE CIGARETTE VENDORS SUE PHILIP MORRIS ON PRICES," THE WALL STREET JOURNAL, FEBRUARY 4, 1999.

Price discrimination is when a vendor sells their products at different prices to various buyers, usually using such techniques as merchant rebates, buybacks and other promotional fees. Whether the case in question constitutes price discrimination will be determined by the courts.

ISSUE 15-60

“HOW SHOULD WE PRICE OUR PRODUCTS? " CONVERTING, AUGUST 2000, SKIP HEINTZELMAN.

The article discusses several methods of pricing products, including full-cost coverage, marking up material cost, marking up full factory cost, and marking up conversion cost.

According to the article, marking up material costs to price products will tend to encourage jobs using low-priced materials and penalize products requiring higher-priced materials.


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