CHAPTER 12

CHAPTER 12

PRICING DECISIONS AND COST MANAGEMENT

12-16(2030 min.) Relevant-cost 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 ( 1,000900

Variable manufacturing overhead, $0.70 ( 1,000700

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 one-time-only special order to describe this special case.

2.The presidents reasoning is defective on at least two counts:

a.The inclusion of irrelevant costsassuming the monthly fixed manufacturing overhead of $150,000 will be unchanged; it is irrelevant to the decision.

b.The exclusion of relevant costsvariable selling costs (5% of the selling price) are excluded.

3.Key issues are:

a.Will the existing customer base demand price reductions? If this 1,000-tape 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 1,000-tape order a one-time-only order, or is there the possibility of sales in subsequent months? The fact that the customer is not in Dill Companys normal marketing channels does not necessarily mean it is a one-time-only order. Indeed, the sale could well open a new marketing channel. Dill Company should be reluctant to consider only short-run variable costs for pricing long-run business.

12-17(2030 min.)Relevant-cost approach to short-run 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 ( $1030,000

Variable manufacturing overhead, 3,000 units ( $618,000

Other variable costs, 3,000 units ( $515,000

Sales commission 8,000

Total variable costs

176,000Contribution 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 McMahons 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 long-run selling-price structure. McMahon is correct if he thinks future competition or future price concessions to customers will hurt San Carloss operating income by more than $49,000.

There is also the possibility that Abrams could become a long-term customer. In this case, is a price that covers only short-run 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 long-term customer?

12-18(15-20 min.) Short-run 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 kiloThat 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.

12-19 (2530 min.) Value-added, nonvalue-added costs.

1.

CategoryExamples

Value-added costsa.Materials and labor for regular repairs$ 800,000

Nonvalue-added costsb.Rework costs

c.Expediting costs caused by work delays

g.Breakdown maintenance of equipment

Total$ 75,000

60,000 55,000$190,000

Gray aread.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 value-added, nonvalue-added, and gray area costs are often not clear-cut. 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 value-added 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 value-added because it helps prevent nonvalue-adding breakdown maintenance.

2.Total costs in the gray area are $100,000. Of this, we assume 65%, or $65,000, are value-added and 35%, or $35,000, are nonvalue-added.

Total value-added costs: $800,000 + $65,000

$ 865,000

Total nonvalue-added costs: $190,000 + $35,000

225,000Total costs$1,090,000Nonvalue-added costs are $225,000 $1,090,000 = 20.64% of total costs.

Value-added costs are $865,000 $1,090,000 = 79.36% of total costs.

3.Effect on Costs Classified as

ProgramValue-Added Nonvalue-AddedGray

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 value-added and 35% (0.35 ( $19,500 = $6,825) as nonvalue-added

Effect on value-added and nonvalue-added costs $ 12,675$ 12,675 $ 6,825 $6,825$7,000

12,50019,500

+ 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 value-added and 35% (0.35 ( $7,500 = $2,625) as nonvalue-added

Effect on value-added and nonvalue-added 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

Value-added and nonvalue-added costs calculated in requirement 2

Expected value-added and nonvalue-added 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 nonvalue-added costs would decrease from 20.64% (requirement 2) to $97,550 914,750 = 10.66%. These are significant improvements in Marinos performance.

12-20(25(30 min.) Target operating income, value-added costs, service company.

1. The classification of total costs in 2009 into value-added, nonvalue-added, or in the gray area in between follows:

Value

GrayNonvalue-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

$28,00028,000

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 32,000Total 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 18,000Total

$471,600$22,400$84,000$578,000

Doing calculations and responding to client requests for changes are value-added 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 nonvalue-added 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 well-informed 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 labor-hours 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

3.Currently 85% 8,000 hours = 6,800 hours are billed to clients generating revenues of $680,000. The remaining 15% of professional labor-hours (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 labor-hour. If the 1,200 professional labor-hours currently not being billed to clients were billed to clients, Carascos 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

$578,000Carascos operating income would be

Revenues

$800,000

Total costs

578,000

Operating income

$222,000

12-21(2530 min.) Target prices, target costs, activity-based costing.

1.Snappys 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$1,000,000750,000

25,000

120,000

60,000 955,000$ 45,000$4.003.00

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.

Snappys 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$ 950,000720,000

25,000

120,000

60,000 925,000$ 25,000$3.802.88

0.10

0.48

0.24 3.70$0.10

3.Snappys 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$950,000720,000

5,000

87,500

60,000 872,500$ 77,500$3.802.88

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).

12-22 (20 min.) Target costs, effect of product-design changes on product costs. 1. and 2. Manufacturing costs of HJ6 in 2008 and 2009 are as follows:

2008

2009

Per UnitPer 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

Batch-level 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 25Total

$6,083,000$1,738$6,200,000$1,5503.

= 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 categoriesdirect materials costs, batch-level costs, manufacturing operations costs, and engineering change costs. It also reduced machine-hours and number of engineering changes madethe quantities of the cost drivers. In 2008, Medical Instruments used 6 machine-hours per unit of HJ6 (21,000 machine-hours (3,500 units). In 2009, Medical Instruments used 5.5 machine-hours per unit of HJ6 (22,000 machine-hours ( 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 nonvalue-added activities and costs.

12-23(20 min.)Cost-plus 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 room-night, ($608,000 16,000) $38

Add variable costs per room-night

4

Price to be charged per room-night

$42

Proof

Total room revenues ($42 ( 16,000 room-nights)$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.

12-24(20(25 min.)Cost-plus, target pricing, working backwards.1.Investment$2,400,000

Return on investment20%

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 = = = $2162.Fixed cost per unit = $300 $216 = $84

Total fixed costs = $84 per unit ( 20,000 units =$1,680,000At a price of $348, sales = 20,000 units ( 0.9018,000Revenues ($348 ( 18,000)$6,264,000

Variable costs ($216 ( 18,000) 3,888,000Contribution margin ($132 ( 18,000)2,376,000

Fixed costs 1,680,000Operating income$ 696,000If 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 investment20%

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 420,000Target full costs in 20095,880,000Less: total target fixed costs 1,680,000Total target variable costs in 2009$4,200,000Target variable cost per unit in 2009, $4,200,000 ( 20,000 = $21012-25Life-cycle product costing.

1.

= $35,742,000

BEP in units = = 714,840 units

2a.

Revenues ($1101,500,000 units)$165,000,000

Variable costs ($601,500,000 units)90,000,000

Fixed costs 35,742,000

Operating income$ 39,258,000

2b.Revenues

Year 2 ($240100,000 units)$ 24,000,000

Years 3 & 4 ($1101,200,000 units)132,000,000

Total revenues156,000,000

Variable costs ($601,300,000 units)78,000,000

Fixed costs 35,742,000

Operating income$ 42,258,000

Over the products life-cycle, 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. Intenticals pricing strategy must be sensitive to changing customer preferences and reactions of competitors.12-26(30 min.)Relevant-cost 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 margin46,000

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

Variable manufacturing cost per unit

$40 ( 200 crates$ 8,000

Special packaging 2,000Relevant 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 200-crate 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 cost-volume-profit 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 short-run focus is appropriate. For example, what is the likelihood of demand from other customers increasing over time? If Stardom accepts the 200-crate 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 Stardoms 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.

12-27(2530 min.)Target rate of return on investment, activity-based 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 margin84,000

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 EAs 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 margin72,000

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 EAs 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%.

12-28 (25 min.) Cost-plus, target pricing, working backward.1. In the following table, work backwards from operating income to calculate the selling priceSelling 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 = $9.45500,000 units = $4,725,000

b) Selling price = $9.45 (from above)

Alternatively,

Operating income$ 225,000

Add fixed costs 3,250,000

Contribution margin3,475,000

Add variable costs ($2.50 500,000 units) 1,250,000

Sales revenue$4,725,000

c) Rate of return on investment = = 9%

d) Markup % on full cost

Total cost = ($2.50500,000 units) + $3,250,000 = $4,500,000

Unit cost = = $9

Markup % = = 5%

Or = 5%

2.New fixed costs= $3,250,000 $250,000 = $3,000,000

New variable costs= $2.50 $0.50 = $2

New total costs= ($2500,000 units) + $3,000,000 = $4,000,000

New total sales (5% markup)= $4,000,0001.05 = $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= $81.05 = $8.40

3.New units sold = $500,000 90% = $450,000 units

Budgeted Operating Income

For the year ending December 31, 20xx

Revenues ($8.40450,000 units)$3,780,000

Variable costs ($2.00450,000 units) 900,000

Contribution margin2,880,000

Fixed costs 3,000,000

Operating income (loss)$ (120,000)

12-29(4045 min.) Target prices, target costs, value engineering, cost incurrence, locked-in cost, activity-based costing.1.

Old CE100Cost ChangeNew 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 radio-cassette 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.

12-30(25 min.)Cost-plus, target return on investment pricing.1. Target operating income = Return on capital in dollars = $13,000,00010% = $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 revenuesSelling price = $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 = 27.66%3.

Budgeted Operating Income

For the year ending December 31, 20xx

Revenues ($14475,000 cases*)$6,650,000

Variable costs ($5475,000 cases) 2,375,000

Contribution margin4,275,000

Fixed costs 2,200,000

Operating income $2,075,000

* New units = 500,000 cases95% = 475,000 cases

Return on investment = 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.

12-31(20 min.)Cost-plus, 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.

COSTLaborMaterialsTotal 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)LaborMaterialsTotal 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 Whites 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 less-than-safe 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 sellers desire to build a reputation, to have a long-term 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.12-32(25 min.)Cost-plus and market-based pricing.

1.California Temps full cost per hour of supplying contract labor isVariable costs$12

Fixed costs ($240,000 80,000 hours) 3Full 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)

$16

17$12

12$4

5120,000

100,000$480,000

500,000

18

19

2012

12

126

7

880,000

70,000

60,000480,000

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 cost-plus 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 cost-plus method of requirement 1 as only a starting point. They then modify the cost-plus price on the basis of market considerationsanticipated customer reaction to alternative price levels and the prices charged by competitors for similar products.12-33Cost-plus and market-based pricing. 1. Single rate = $11.91 per testing hour

Billing rate = $11.911.45 = $17.27

2. Labor and supervision = = $4.64 per test-hour

Setup and facility costs = = $503.275 per setup hourUtilities = = $36.80 per MH

3. HTT ACTTotal

Labor and supervision (60%, 40%)$295,104$196,736 $ 491,840

Setup and facility cost (25%, 75%)100,655301,965402,620

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

1106,000 testing hours60% = 63,600 TH; 106,000 testing hours40% = 42,400 THThe billing rates based on the activity-based cost structure make more sense. These billing rates reflect the ways the testing procedures consume the firms resources.

4. To stay competitive, Best Test needs to be more efficient in arctic testing. Roughly 44% of arctic testings total cost () occurs in setups and facility costs. Perhaps the setup activity can be redesigned to achieve cost savings.

12-34(2530 min.)Life-cycle 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 [($2016,000) + ($224,800)] 425,600

Contribution margin 5,294,400

Fixed costs:

Design costs700,000

Production ($9,00048 mos.)432,000

Marketing [($3,00032 mos.) + ($1,00016 mos.)]112,000

Distribution [($2,00032 mos.) + ($1,00016 mos.)] 80,000

Life cycle operating income$ 3,970,400

Average profit per desk = $190.882. Projected Life Cycle Income Statement

Revenues ($40016,000)$6,400,000

Variable costs:

Production ($22516,000)3,600,000

Distribution ($2016,000) 320,000

Contribution margin2,480,000

Fixed costs:

Design costs700,000

Production ($9,00032 mos.)288,000

Marketing ($3,00032 mos.)96,000

Distribution ($2,00032 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

3. Life cycle operating income (requirement 2)$1,332,000

Additional fixed production costs ($9,00016 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 () operating income per desk.

12-35(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.

12-36(25 min.) Ethics and pricing.

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 ball-bearings order as a long-term business relationship rather than a special order. For long-run 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 long-run 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 accountants 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 Lazaruss 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. Lazaruss 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 Lazaruss and Deckers behavior (if Decker agrees to reduce the cost of the order) could be viewed as unethical.

CredibilityThe 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 accountants 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 Lazaruss 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 mark-up 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 Lazaruss 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.

12-37 (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

7.00

Testing ($12 per hr.0.25 hr.) 3.00

Full cost per unit of TX40$32.48

2. Markup % = = 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 ($22.4860,000 units)$1,348,800

Engineering ($1425,000 hrs.)350,000

Testing ($360,000 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

12-

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