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costacctg13_sm_ch12 - CHAPTER 12 PRICING DECISIONS AND COST...

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Unformatted text preview: CHAPTER 12 PRICING DECISIONS AND COST MANAGEMENT 12­1 The three major influences on pricing decisio ns are 1. Customers 2. Compet itors 3. Costs 12­2 Not necessarily. For a one­time­only special order, the relevant costs are only those costs that will change as a result of accept ing the order. In this case, full product costs will rarely be relevant. It is more likely that full product costs will be relevant costs for long­run pricing decisio ns. 12­3 Two examples of pricing decisio ns with a short­run focus: 1. Pricing for a one­time­only special order with no long­term implications. 2. Adjust ing product mix and vo lume in a competit ive market. 12­4 Act ivit y­based costing helps managers in pricing decisio ns in two ways. 1. It gives managers more accurate product­cost informat ion for making pricing decisio ns. 2. It helps managers to manage costs during value engineering by ident ifying the cost impact of eliminat ing, reducing, or changing vario us activit ies. 12­5 Two alternat ive starting points for long­run pricing decisio ns are 1. Market­based pricing, an important form of which is target pricing. The market­based approach asks, “Given what our customers want and how our compet itors will react to what we do, what price should we charge?” 2. Cost­based pricing which asks, “What does it cost us to make this product and, hence, what price should we charge that will recoup our costs and achieve a target return on investment ?” 12­6 A target cost per unit is the estimated lo ng­run cost per unit of a product (or service) that, when so ld at the target price, enables the co mpany to achieve the targeted operating inco me per unit. 12­7 Value engineering is a systemat ic evaluat ion o f all aspects of the value­chain business funct ions, wit h the object ive o f reducing costs while sat isfying customer needs. Value engineering via improvement in product and process designs is a principal technique that companies use to achieve target costs per unit. 12­8 A value­added cost is a cost that customers perceive as adding value, or utilit y, to a product or service. Examples are costs of materials, direct labor, tools, and machinery. A nonvalue­added cost is a cost that customers do not perceive as adding value, or utilit y, to a product or service. Examples of nonvalue­added costs are costs of rework, scrap, expedit ing, and breakdown maintenance. 12­9 No. It is important to dist inguish between when costs are locked in and when costs are incurred, because it is difficult to alter or reduce costs that have already been locked in. 12­1 12­10 Cost­plus pricing is a pricing approach in which managers add a markup to cost in order to determine pr ice. 12­11 Cost­plus pricing methods vary depending on the bases used to calculate prices. Examples are (a) variable manufacturing costs; (b) manufacturing function costs; (c) variable product costs; and (d) full product costs. 12­12 Two examples where the difference in the costs of two products or services is much smaller than the differences in their prices fo llow: 1. The difference in prices charged for a telephone call, hotel room, or car rental during busy versus slack periods is often much greater than the difference in costs to provide these services. 2. The difference in costs for an airplane seat sold to a passenger traveling on business or a passenger traveling for pleasure is roughly the same. However, airline co mpanies price discriminate. They routinely charge business travelers––those who are likely to start and complete their travel during the same week excluding the weekend––a much higher price than pleasure travelers who generally stay at their dest inat ions over at least one weekend. 12­13 Life­cycle budgeting is an est imate of the revenues and costs attributable to each product fro m its init ial R&D to its final customer servicing and support. 12­14 Three benefits of using a product life­cycle reporting format are: 1. The full set of revenues and costs associated with each product becomes more visible. 2. Differences amo ng products in the percentage of total costs committed at early stages in the life cycle are highlighted. 3. Interrelat ionships among business function cost categories are highlighted. 12­15 Predatory pricing occurs when a business deliberately prices below its costs in an effort to drive co mpet itors out of the market and restrict supply, and then raises prices rather than enlarge demand. Under U.S. laws, dumping occurs when a non­U.S. company sells a product in the United States at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the United States. Collusive pricing occurs when co mpanies in an industry conspire in their pricing and production decisio ns to achieve a price above the compet itive pr ice and so restrain trade. 12­2 12­16 (20–30 min.) Relevant­cost approach to pricing decisions, special order. 1. Relevant revenues, $4.00 ´ 1,000 Relevant costs Direct materials, $1.60 ´ 1,000 Direct manufacturing labor, $0.90 ´ 1,000 Variable manufacturing overhead, $0.70 ´ 1,000 Variable selling costs, 0.05 ´ $4,000 Total relevant costs Increase in operating inco me $4,000 $1,600 900 700 200 3,400 $ 600 This calculat ion assumes that: a. The mo nthly fixed manufacturing overhead o f $150,000 and $65,000 of mo nthly fixed market ing costs will be unchanged by acceptance of the 1,000 unit order. b. The price charged and the volumes so ld to other customers are not affected by the special order. Chapter 12 uses the phrase “one­time­only special order” to describe this special case. 2. The president’s reasoning is defect ive on at least two counts: a. The inclusio n of irrelevant costs––assuming the mo nthly fixed manufacturing overhead of $150,000 will be unchanged; it is irrelevant to the decisio n. b. The exclusio n of relevant costs––variable selling costs (5% of the selling price) are excluded. Key issues are: a. Will the exist ing customer base demand price reductions? If this 1,000­tape order is not independent of other sales, cutting the price from $5.00 to $4.00 can have a large negat ive effect on total revenues. b. Is the 1,000­tape order a one­time­only order, or is there the possibilit y o f sales in subsequent months? The fact that the customer is not in Dill Company’s “norma l market ing channels” does not necessarily mean it is a one­time­only order. Indeed, the sale could well open a new marketing channel. Dill Company should be reluctant to consider only short­run variable costs for pricing long­run business. 3. 12­3 12­17 (20–30 min.) Relevant­cost approach to short­run pricing decisions. 1. Analys is of special order: Sales, 3,000 units ´ $75 Variable costs: Direct materials, 3,000 units ´ $35 Direct manufacturing labor, 3,000 units ´ $10 Variable manufacturing overhead, 3,000 units ´ $6 Other variable costs, 3,000 units ´ $5 Sales commissio n Total variable costs Contribut ion margin $225,000 $105,000 30,000 18,000 15,000 8,000 176,000 $ 49,000 Note that the variable costs, except for commissions, are affected by production vo lume, not sales dollars. If the special order is accepted, operating income would be $1,000,000 + $49,000 = $1,049,000. 2. Whether McMahon’s decisio n to quote full price is correct depends on many factors. He is incorrect if the capacit y would otherwise be idle and if his object ive is to increase operating inco me in the short run. If the offer is rejected, San Carlos, in effect, is willing to invest $49,000 in immediate gains forgone (an opportunit y cost) to preserve the lo ng­run selling­price structure. McMahon is correct if he thinks future compet it ion or future price concessio ns to customers will hurt San Carlos’s operating inco me by more than $49,000. There is also the possibilit y that Abrams could become a lo ng­term customer. In this case, is a price that covers only short­run variable costs adequate? Would Ho ltz be willing to accept a $8,000 sales co mmission (as dist inguished fro m her regular $33,750 = 15% ´ $225,000) for every Abrams order of this size if Abrams becomes a long­term customer? 12­4 12­18 (15­20 min.) Short­run pricing, capacity constraints. 1. Per kilogram o f hard cheese: Milk (10 liters ´ $1.50 per liter) Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing cost allo cated Total manufacturing cost $15 5 3 6 $29 If Vermo nt Hills can get all the Ho lstein milk it needs, and has sufficient production capacit y, 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 o f hard cheese displaces 2.5 kilos of so ft cheese (10 liters o f milk per kilo of hard cheese versus 4 liters o f milk per kilo o f so ft 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 fro m 2.5 kilos of soft cheese, or, $23 + (2.5 ´ $8 per kilo) = $43 per kilo That is, if milk is in short supply, Vermont should not agree to produce any hard cheese unless the buyer is willing to pay at least $43 per kilo. 12­19 (25–30 min.) Value­added, nonvalue­added costs. 1. Category Value­added costs Nonvalue­added costs Examples a. Materials and labor for regular repairs b. Rework costs c. Expedit ing costs caused by work delays g. Breakdown maintenance of equipment Total d. Materials handling costs e. Materials procurement and inspect ion costs f. Prevent ive maintenance of equipment Total $ 800,000 $ 75,000 60,000 55,000 $190,000 $ 50,000 35,000 15,000 $100,000 Gray area Classificat ions of value­added, nonvalue­added, and gray area costs are often not clear­cut. Other classificat ions of so me o f the cost categories are also plausible. For example, so me students may include materials handling, materials procurement, and inspection costs and prevent ive maintenance as value­added costs (costs that customers perceive as adding value and as being necessary for good repair service) rather than as in the gray area. Prevent ive maintenance, for instance, might be regarded as value­added because it helps prevent nonvalue­ adding breakdown maintenance. 12­5 2. Total costs in the gray area are $100,000. Of this, we assume 65%, or $65,000, are value­added and 35%, or $35,000, are nonvalue­added. Total value­added costs: $800,000 + $65,000 $ 865,000 Total nonvalue­added costs: $190,000 + $35,000 225,000 Total costs $1,090,000 Nonvalue­added costs are $225,000 ÷ $1,090,000 = 20.64% of total costs. Value­added costs are $865,000 ÷ $1,090,000 = 79.36% of total costs. 3. Program (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 Effect on Costs Classified as Value­ Nonvalue­ Gray Added Added Area –$56,250 – 45,000 –$ 40,000 –$ 40,000 –$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 = $12,675) as value­a dded and 35% –$ 12,675 (0.35 ´ $19,500 = $6,825) as nonvalue­added –$ 12,675 Effect on value­added and nonvalue­added costs (c) Maintenance programs to • incr ease 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 value­a dded and 35% (0.35 ´ $7,500 = +$ 4,875 $2,625) as nonvalue­added +$ 4,875 Effect on value­added and nonvalue­added costs Total effect of all programs – $ 47,800 Value­added and nonvalue­a dded costs calculated in requir ement 2 865,000 Expected value­a dded and nonvalue­added costs as a result of implementing these programs $817,200 –$7,000 –12,500 –19,500 – $ 6,825 – $6,825 + 19,500 $ 0 +$7,500 – $22,000 – 22,000 + $7,500 + 2,625 – $19,375 –$127,450 225,000 $ 97,550 – 7,500 $ 0 If these programs are implemented in 2007, total costs would decrease fro m $1,090,000 (requirement 2) to $817,200 + $97,550 = $914,750, and the percentage of nonvalue­added costs would decrease fro m 20.64% (requirement 2) to $97,550 ÷ 914,750 = 10.66%. These are significant improvements in Marino’s performance. 12­6 12­20 (25-30 min.) Target operating income, value­added costs, service company. 1. The classificat ion o f total costs in 2009 into value­added, nonvalue­added, or in the gra y area in between fo llows: Value Gray Nonvalue­ Total Added Area added (4) = (1) (2) (3) (1)+(2)+(3) Doing calculat ions and preparing drawings 75% × $400,000 $300,000 $300,000 Checking calculations and drawings 4% × $400,000 $16,000 16,000 Correcting errors found in drawings 7% × $400,000 $28,000 28,000 Making changes in response to client requests 6% × $400,000 24,000 24,000 Correcting errors to meet government building code, 8% × $400,000 32,000 32,000 Total professio nal labor costs 324,000 16,000 60,000 400,000 Administrative and support costs at 40% ($160,000 ÷ $400,000) of professio nal labor costs 129,600 6,400 24,000 160,000 Travel 18,000 — 18,000 Total $471,600 $22,400 $84,000 $578,000 Doing calculat ions and responding to client requests for changes are value­added costs because customers perceive these costs as necessary for the service o f preparing architectural drawings. Costs incurred on correcting errors in drawings and making changes because they were inconsistent with building codes are nonvalue­added costs. Customers do not perceive these costs as necessary and would be unwilling to pay for them. Carasco should seek to eliminate these costs by making sure that all associates are well­informed regarding building code requirements and by training associates to improve the qualit y o f their drawings. Checking calculat ions and drawings is in the gray area (so me, but not all, checking ma y be needed). There is room for disagreement on these classificat ions. For example, checking calculations may be regarded as value added. 2. Reduction in pro fessio nal labor­hours by a. Correcting errors in drawings (7% × 8,000) b. Correcting errors to conform to building code (8% × 8,000) Total Cost savings in professio nal labor costs (1,200 hours × $50) Cost savings in variable administrative and support costs (40% × $60,000) Total cost savings Current operating inco me in 2009 Add cost savings from eliminat ing errors Operating inco me in 2009 if errors eliminated 560 hours 640 hours 1,200 hours $ 60,000 24,000 $ 84,000 $102,000 84,000 $186,000 12­7 3. Current ly 85% × 8,000 hours = 6,800 hours are billed to clients generat ing revenues o f $680,000. The remaining 15% of professio nal labor­hours (15% × 8,000 = 1,200 hours) is lost in making corrections. Carasco bills clients at the rate of $680,000 ÷ 6,800 = $100 per professio na l labor­hour. If the 1,200 professio nal labor­hours currently not being billed to clients were billed to clients, Carasco’s revenues would increase by 1,200 hours × $100 = $120,000 from $680,000 to $800,000. Costs remain unchanged Professio nal labor costs Administrative and support (40% × $400,000) Travel Total costs Carasco’s operating inco me would be Revenues Total costs Operating inco me $400,000 160,000 18,000 $578,000 $800,000 578,000 $222,000 12­8 12­21 (25–30 min.) Target prices, target costs, activity­based costing. 1. Snappy’s operating inco me in 2008 is as fo llows: Total for 250,000 Tiles (1) $1,000,000 750,000 25,000 120,000 60,000 955,000 $ 45,000 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 inco me Per Unit (2) = (1) ÷ 250,000 $4.00 3.00 0.10 0.48 0.24 3.82 $0.18 2. Price to retailers in 2009 is 95% of 2008 price = 0.95 ´ $4 = $3.80; cost per tile in 2009 is 96% of 2008 cost = 0.96 ´ $3 = $2.88. Snappy’s operating inco me in 2009 is as fo llows: Total for 250,000 Tiles (1) $ 950,000 720,000 25,000 120,000 60,000 925,000 $ 25,000 Per Unit (2) = (1) ÷ 250,000 $3.80 2.88 0.10 0.48 0.24 3.70 $0.10 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 inco me 3. Snappy’s operating inco me in 2009, if it makes changes in ordering and material handling, will be as fo llows: Total for 250,000 Tiles Per Unit (1) (2) = (1) ÷ 250,000 $950,000 $3.80 Revenues ($3.80 ´ 250,000) 720,000 2.88 Purchase cost of tiles ($2.88 ´ 250,000) 5,000 0.02 Ordering costs ($25 ´ 200) 87,500 0.35 Receiving and storage ($28 ´ 3,125) 60,000 0.24 Shipping ($40 ´ 1,500) 872,500 3.49 Total costs $ 77,500 $0.31 Operating inco me Through better cost management, Snappy will be able to achieve it s target operating inco me o f $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). 12­9 12­22 (20 min.) Target costs, effect of product­design changes on product costs. 1. and 2. Manufacturing costs of HJ6 in 2008 and 2009 are as fo llows: 2008 Per Unit Total (2) = (1) (1) ÷ 3,500 Direct materials, $1,200 × 3,500; $1,100 × 4,000 $4,200,000 $1,200 Batch­level costs, $8,000 × 70; $7,500 × 80 560,000 160 Manuf. operations costs, $55 × 21,000; $50 × 22,000 1,155,000 330 Engineering change costs, $12,000 × 14; $10,000 × 10 168,000 48 Total $6,083,000 $1,738 2009 Per Unit Total (4) = (3) (3) ÷ 4,000 $4,400,000 $1,100 600,000 150 1,100,000 100,000 $6,200,000 275 25 $1,550 3. Target manufacturing cost = Manufacturing cost × 90% per unit of HJ6 in 2009 per unit in 2008 = $1,738 × 0.90 = $1,564.20 Actual manufacturing cost per unit of HJ6 in 2009 was $1,550. Hence, Medical Instruments did achieve its target manufacturing cost per unit of $1,564.20 4. To reduce the manufacturing cost per unit in 2009, Medical Instruments reduced the cost per unit in each of the four cost categories—direct materials costs, batch­level costs, manufacturing operations costs, and engineering change costs. It also reduced machine­hours and number of engineering changes made—the quant it ies o f the cost drivers. In 2008, Medica l Instruments used 6 machine­hours per unit of HJ6 (21,000 machine­hours ¸3,500 units). In 2009, Medical Instruments used 5.5 machine­hours per unit o f HJ6 (22,000 machine­hours ¸ 4,000 units). Medical Instruments reduced engineering changes fro m 14 in 2008 to 10 in 2009. Medical Instruments achieved these gains through value engineering act ivit ies that retained only those product features that customers wanted while eliminat ing nonvalue­added act ivit ies and costs. 12­10 12­23 (20 min.) Cost­plus target return on investment pricing. 1. Target operating inco me = target return on investment ´ invested capital Target operating inco me (25% of $1,000,000) $250,000 Total fixed costs 358,000 Target contribution margin $608,000 Target contribution per room­night, ($608,000 ÷ 16,000) Add variable costs per room­night Price to be charged per room­night Proof Total room revenues ($42 ´ 16,000 room­nights) Total costs: Variable costs ($4 ´ 16,000) Fixed costs Total costs Operating inco me $38 4 $42 $672,000 $ 64,000 358,000 422,000 $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 fract ion 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 contribut ion margin per room would be $37.80 – $4 $33.80 Contribut ion margin ($33.80 ´17,600) $594,880 Because the contribution margin o f $594,880 at the reduced price of $37.80 is less than the contribution margin o f $608,000 at a price o f $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 alternat ives and hence, are irrelevant to the analysis. 12­11 12­24 (20-25 min.) Cost­plus, target pricing, working backwards. 1. Invest ment Return on investment Operating inco me (20% ´ $2,400,000) Operating inco me per unit of RF17 ($480,000 ¸ 20,000) Full cost per unit of RF17 Selling price ($300 + $24) Markup percentage on full cost ($24 ¸ $300) 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 = 2. S elling price of RF17 $324 = = $216 1. 50 1. 0 5 $2,400,000 20% $480,000 $24 $300 $324 8% Fixed cost per unit = $300 – $216 = Total fixed costs = $84 per unit ´ 20,000 units = At a price of $348, sales = 20,000 units ´ 0.90 Revenues ($348 ´ 18,000) Variable costs ($216 ´ 18,000) Contribut ion margin ($132 ´ 18,000) Fixed costs Operating inco me $84 $1,680,000 18,000 $6,264,000 3,888,000 2,376,000 1,680,000 $ 696,000 If Waterbuy increases the selling price of RF17 to $348, its operating inco me will be $696,000. This would be more than the $480,000 operating inco me Waterbury earns by selling 20,000 units at a price of $324, so, if its forecast is accurate, and based on financial considerat ions alo ne, Waterbury should increase the selling price to $348. 3. Target invest ment in 2009 Target return on invest ment Target operating inco me in 2009, 20% ´ $2,100,000 Ant icipated revenues in 2009, $315 ´ 20,000 Less target operating inco me in 2009 Target full costs in 2009 Less: total target fixed costs Total target variable costs in 2009 Target variable cost per unit in 2009, $4,200,000 ¸ 20,000 = $210 $2,100,000 20% $420,000 $6,300,000 420,000 5,880,000 1,680,000 $4,200,000 12­12 12­25 Life­cycle product costing. 1. Variable cost per unit = Production cost per unit + Mktg and distribn. cost per unit = $50 + $10 = $60 Total fixed costs over life of Yew = $6, 590, 000 + $1, 450, 000 + $19, 560, 000 + 5, 242, 000 + $2, 900, 000 = $35,742,000 Fixed costs $35, 742, 000 = BEP in units = = 714,840 units Selling price - Variable cost per unit $110 - $60 2a. Revenues ($110 ´ 1,500,000 units) Variable costs ($60 ´ 1,500,000 units) Fixed costs Operating inco me 2b. Revenues Year 2 ($240 ´ 100,000 units) Years 3 & 4 ($110 ´ 1,200,000 units) Total revenues Variable costs ($60 ´ 1,300,000 units) Fixed costs Operating inco me $ 24,000,000 132,000,000 156,000,000 78,000,000 35,742,000 $ 42,258,000 $165,000,000 90,000,000 35,742,000 $ 39,258,000 Over the product’s life­cycle, Option B results in an overall higher operating inco me o f $3,000,000. 3. Before select ing its pricing strategy, Intent ical 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. Intent ical’s pricing strategy must be sensit ive to changing customer preferences and react ions of co mpet itors. 12­13 12­26 (30 min.) 1. Relevant­cost approach to pricing decisions. $100,000 $40,000 14,000 54,000 46,000 $20,000 16,000 36,000 $ 10,000 Revenues (1,000 crates at $100 per crate) Variable costs: Manufacturing Marketing Total variable costs Contribut ion margin Fixed costs: Manufacturing Marketing Total fixed costs Operating inco me Normal markup percentage: $46,000 ÷ $54,000 = 85.19% of total variable costs. 2. Only the manufacturing­cost category is relevant to considering this special order; no addit ional market ing costs will be incurred. The relevant manufacturing costs for the 200­crate special order are: Variable manufacturing cost per unit $40 ´ 200 crates Special packaging Relevant manufacturing costs $ 8,000 2,000 $10,000 Any price above $50 per crate ($10,000 ÷ 200) will make a posit ive contribution to operating inco me. Therefore, based on financial considerations, Stardom should accept the 200­crate special order at $55 per crate that will generate revenues o f $11,000 ($55 ´ 200) and relevant (incremental) costs of $10,000. The reasoning based on a co mparison o f $55 per crate price wit h the $60 per crate absorption cost ignores monthly cost­volume­profit relat ionships. 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 fro m 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 strict ly short­run focus is appropriate. For example, what is the likelihood of demand fro m other customers increasing over t ime? If Stardom accepts the 200­crate special o ffer for more than one mo nth, it may preclude accepting other customers at prices exceeding $55 per crate. Moreover, the exist ing customers may learn about Stardom’s willingness to set a price based on variable cost plus a small contribut ion margin. The lo nger the time frame over which Stardom keeps selling 200 crates of canned peaches at $55 a crate, the more likely it is that exist ing customers will approach Stardom for their own special price reduct ions. If the new customer wants the contract to extend over a longer time period, Stardom should negotiate a higher price. 12­14 12­27 (25–30 min.) Target rate of return on investment, activity­based costing. 1. Operating Income Statement, April 2009 Revenues (12,000 disks ´ $22 per disk) Materials (12,000 disks ´ $15 per disk) Gross margin Ordering (40 vendors ´ $250 per vendor) Cataloging (20 new t itles ´ $100 per title) Delivery and support (400 deliveries ´ $15 per delivery) Billing and collect ion (300 customers ´ $50 per customer) Operating Inco me Rate of return on invest ment ($51,000 ¸ $300,000 ) $264,000 180,000 84,000 10,000 2,000 6,000 15,000 $ 51,000 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 invest ment of 13%, which is below EA’s target rate of return on invest ment of 15%. EA will have to cut costs to earn its target rate of return on invest ment. Operating Income Statement, May 2009 Revenues (12,000 disks ´ $18 per disk) Materials (12,000 disks ´ $12 per disk) Gross margin Ordering (40 vendors ´ $250 per vendor) Cataloging (20 new t itles ´ $100 per title) Delivery and support (400 deliveries ´ $15 per delivery) Billing and collect ion (300 customers ´ $50 per customer) Operating Inco me Rate of return on invest ment ($39,000 ¸ $300,000 ) $216,000 144,000 72,000 10,000 2,000 6,000 15,000 $ 39,000 13.00% 3. After EA’s workforce has implemented process improvements, its monthly support costs are $31,500, as shown below. Monthly support costs after process improvements, May 2009 Ordering (30 vendors ´ $200 per vendor) $ 6,000 Cataloging (15 new t itles ´ $100 per title) 1,500 Delivery and support (450 deliveries ´ $20 per delivery) 9,000 Billing and collect ion (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 suc h 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%. 12­15 12­28 (25 min.) Cost­plus, target pricing, working backward. 1. In the fo llowing table, work backwards fro m operating inco me to calculate the selling price Selling price $ 9.45 (plug) Less: Variable cost per unit 2.50 Unit contribut ion margin $ 6.95 Number of unit s produced and sold ×500,000 units Contribut ion margin $3,475,000 Less: Fixed costs 3,250,000 Operating inco me $ 225,000 a) Total sales revenue = $9.45 ´ 500,000 units = $4,725,000 b) Selling price = $9.45 (from above) Alternat ively, Operating inco me $ 225,000 Add fixed costs 3,250,000 Contribut ion margin 3,475,000 Add variable costs ($2.50 × 500,000 units) 1,250,000 Sales revenue $4,725,000 Sales revenue $4, 725, 000 Selling price = = = $9.45 Units sold 500, 000 Operating income $225,000 = c) Rate of return on invest ment = = 9% Total investment in assets 2, 500, 000 d) Markup % on full cost Total cost = ($2.50 ´ 500,000 units) + $3,250,000 = $4,500,000 $4,500,000 Unit cost = = $9 500,000 units $9.45 - $9 Markup % = = 5% $9 $4, 725, 000 - $4, 500, 000 Or = 5% $4, 500, 000 2. New fixed costs New variable costs New total costs New total sales (5% markup) New selling price Alternat ively, New unit cost New selling price = $3,250,000 ─ $250,000 = $3,000,000 = $2.50 ─ $0.50 = $2 = ($2 ´ 500,000 units) + $3,000,000 = $4,000,000 = $4,000,000 ´ 1.05 = $4,200,000 = $4,200,000 ÷ 500,000 units = $8.40 = $4,000,000 ÷ 500,000 units = $8 = $8 ´ 1.05 = $8.40 3. New units so ld = $500,000 × 90% = $450,000 units Budgeted Operating Income For the year ending December 31, 20xx Revenues ($8.40 ´ 450,000 units) Variable costs ($2.00 ´ 450,000 units) Contribut ion margin Fixed costs Operating inco me ( loss) 12­16 $3,780,000 900,000 2,880,000 3,000,000 $ (120,000) 12­29 (40–45 min.) Target prices, target costs, value engineering, cost incurrence, locked­ in cost, activity­based costing. 1. Old CE100 Direct materials costs $182,000 Direct manufacturing labor costs 28,000 Machining costs 31,500 Testing costs 35,000 Rework costs 14,000 Ordering costs 3,360 Engineering costs 21,140 Total manufacturing costs $315,000 Cost Change $2.20 ´ 7,000 = $15,400 less $0.50 ´ 7,000 = $3,500 less Unchanged because capacit y same (20% ´ 2.5 ´ 7,000) $2 = $7,000 (See Note 1) (See Note 2) Unchanged because capacit y same New CE100 $166,600 24,500 31,500 28,000 5,600 2,100 21,140 $279,440 Note 1: 10% of o ld 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 = $35,560 ÷ 7,000 = $5.08 per unit. Reduction in unit manufacturing costs based on new design 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 relat ive to improvements in manufacturing efficiency ($5.08 versus $1.50). One explanat ion is that many costs are locked in once the design of the radio­cassette is co mpleted. Improvements in manufacturing efficiency cannot reduce many o f these costs. Design cho ices 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. 12­17 12­30 (25 min.) Cost­plus, target return on investment pricing. 1. Target operating inco me = Return on capital in dollars = $13,000,000 ´ 10% = $1,300,000 2. Revenues* Variable costs [($3.50 + $1.50) ´ 500,000 cases Contribut ion margin Fixed costs ($1,000,000 + $700,000 + $500,000) Operating inco me (fro m requirement 1) * solve backwards for revenues $6, 000, 000 = $12 per case. 500, 000 cases 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 $12 ­ $9.40 Markup % on full cost = = 27.66% $9. 40 Selling price = 3. Budgeted Operating Income For the year ending December 31, 20xx Revenues ($14 ´ 475,000 cases*) $6,650,000 Variable costs ($5 ´ 475,000 cases) 2,375,000 Contribut ion margin 4,275,000 Fixed costs 2,200,000 Operating inco me $2,075,000 * New units = 500,000 cases ´ 95% = 475,000 cases Return on investment = $2, 075, 000 = 15.96% $13, 000, 000 $6,000,000 2,500,000 3,500,000 2,200,000 $1,300,000 Yes, increasing the selling price is a good idea because operating inco me increases wit hout increasing invested capital, which results in a higher return on invest ment. The new return on investment exceeds the 10% target return on investment. 12­18 12­31 (20 min.) Cost­plus, time and materials. 1. The different markup rates used by Mazzo li for direct materials and direct labor may represent the approximate overheads (plus a profit margin) associated wit h 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% o f costs. These markups could also be driven by industry practice and co mpet it ive factors. 2. As shown in the table below, Bariess will tell White that she will have to pay $270 get the clutch plate repaired and $390 to get it replaced. COST Repair option (3.5 hrs. ´ $30 per hr.; $40) Replace option(1.5 hrs. ´ $30 per hr.; $200) PRICE (100% markup on labor cost; 50% markup on materials) Repair option ($105 ´ 2; $40 ´ 1.5) Replace option ($45 ´ 2; $200 ´ 1.5) Labor Materials Total Cost $105 $ 40 $145 45 200 245 Labor Materials Total Price $210 $ 60 $270 90 300 390 3. If the repair and replace options are equally safe and effect ive, White will choose to get the clutch plate repaired for $270 (rather than spend $390 on a replacement plate). 4. Mazzo li Brothers will earn a greater contribution toward overhead in the replace option ($145 = $390 – $245) than in t he repair option ($125 = $270 – $145). If we assume that Mazzoli Brothers earns a constant profit margin on each job, it will earn a larger profit by replacing the clutch plate on Johanna White’s car for $390 than by repairing it for $270. Therefore, Bariess will reco mmend the replace option to White, which is not the one she would prefer. Recognizing this conflict, Bariess ma y even present only the replace option to Johanna White, or suggest that the repair option will result in a less­than­safe car. Of course, he runs the risk o f White walking away and thinking o f other options (at which point, he could present the repair option as a compro mise). The problem is that Bariess has superior information about the repairs needed but his incent ives may cause him to not reveal his information and instead use it to his advantage. It is only the seller’s desire to build a reputation, to have a lo ng­term relat ionship wit h the customer, and to have the customer recommend the seller to other potential buyers of the service that encourages an honest discussio n of the options. 12­19 12­32 (25 min.) Cost­plus and market­based pricing. 1. California Temps’ full cost per hour of supplying contract labor is Variable costs Fixed costs ($240,000 ÷ 80,000 hours) Full cost per hour $12 3 $15 Price per hour at full cost plus 20% = $15 ´ 1.20 = $18 per hour. 2. Contribut ion margins for different prices and demand realizations are as fo llows: Contribution Margin per Hour (3) = (1) – (2) $4 5 6 7 8 Price per Hour (1) $16 17 18 19 20 Variable Cost per Hour (2) $12 12 12 12 12 Demand in Hours (4) 120,000 100,000 80,000 70,000 60,000 Total Contribution (5) = (3) × (4) $480,000 500,000 480,000 490,000 480,000 Fixed costs will remain the same regardless of the demand realizations. Fixed costs are, therefore, irrelevant since they do not differ amo ng the alternat ives. The table above indicates that California Temps can maximize contribut ion margin ($500,000) and operating inco me by charging a pr ice of $17 per hour. 3. The cost­plus approach to pricing in requirement 1 does not explicit ly consider the effect of prices on demand. The approach in requirement 2 models the interact ion between price and demand and determines the optimal level o f profitabilit y using concepts of relevant costs. The two different approaches lead to two different prices in requirements 1 and 2. As the chapter describes, pricing decisio ns should consider both demand or market considerations and supply or cost factors. The approach in requirement 2 is the more balanced approach. In most cases, of course, managers use the cost­plus method of requirement 1 as only a starting po int. They then modify t he cost­plus price on the basis o f market considerations—ant icipated customer react io n to alternat ive pr ice levels and the prices charged by co mpet itors for similar products. 12­20 12­33 Cost­plus and market­based pricing. 1. Single rate = $1, 262, 460 = $11.91 per testing hour 106, 000 testing hours Billing rate = $11.91 ´ 1.45 = $17.27 2. Labor and supervis io n = $ 491,840 = $4.64 per test­hour 106,000 test­hours $402,620 = $503.275 per setup hour 800 setup hours Setup and facilit y costs = Utilit ies = 3. $368,000 = $36.80 per MH 10,000 MH Labor and supervisio n (60%, 40%) Setup and facilit y cost (25%, 75%) Utilit ies (50%, 50%) Total cost 1 Number of testing hours (TH) Cost per testing hour Markup Billing rate per testing hour 1 HTT $295,104 100,655 184,000 $579,759 ÷63,600 TH $ 9.12 per TH ×1.45 $ 13.22 per TH ACT $196,736 301,965 184,000 $682,701 ÷42,400 TH $ 16.10 per TH ×1.45 $ 23.35 per TH Total $ 491,840 402,620 368,000 $1,262,460 106,000 testing hours ´ 60% = 63,600 TH; 106,000 testing hours ´ 40% = 42,400 TH The billing rates based on the act ivit y­based cost structure make more sense. These billing rates reflect the ways the testing procedures consume the firm’s resources. 4. To stay co mpet itive, Best Test needs to be more efficient in arctic testing. Roughly 44% of 301, 965 = 44% ) occurs in setups and facilit y costs. Perhaps the setup arctic testing’s total cost ( 682, 701 activit y can be redesigned to achieve cost savings. 12­21 12­34 (25–30 min.) Life­cycle costing. 1. Projected Life Cycle Income Statement Revenues [$500 ´ (16,000 + 4,800)] Variable costs: Production [$225 ´ (16,000 + 4,800)] Distribut ion [($20 ´ 16,000) + ($22 ´ 4,800)] Contribut ion margin Fixed costs: Design costs Production ($9,000 ´ 48 mos.) Marketing [($3,000 ´ 32 mos.) + ($1,000 ´ 16 mos.)] Distribut ion [($2,000 ´ 32 mos.) + ($1,000 ´ 16 mos.)] Life cycle operating inco me Average profit per desk = 2. Projected Life Cycle Income Statement Revenues ($400 ´ 16,000) Variable costs: Production ($225 ´ 16,000) Distribut ion ($20 ´ 16,000) Contribut ion margin Fixed costs: Design costs Production ($9,000 ´ 32 mos.) Marketing ($3,000 ´ 32 mos.) Distribut ion ($2,000 ´ 32 mos.) Life cycle operating inco me $6,400,000 3,600,000 320,000 2,480,000 700,000 288,000 96,000 64,000 $1,332,000 $3, 970, 400 = $190.88 (16, 000 + 4, 800) $10,400,000 4,680,000 425,600 5,294,400 700,000 432,000 112,000 80,000 $ 3,970,400 The new desk design is still profitable even if FFM drops the product after only 32 mo nths of $1, 332, 000 production. However, the operating income per unit falls to only $83.25 ( ) per desk. 16, 000 desks 3. Life cycle operating inco me (requirement 2) Addit io nal fixed production costs ($9,000 ´ 16 mos.) Revised life cycle operating inco me $1,332,000 144,000 $1,188,000 No, the answer does not change even if FFM cont inues to incur the fixed production costs for the full 48 months. The revised operating income for the new execut ive desk beco mes $1,188,000, $1,188, 000 which translates into $74.25 ( ) operating inco me per desk. 16, 000 desks 12­22 12­35 (30 min.) Airline pricing, considerations other than cost in pricing. 1. If the fare is $500, a. Air Americo would expect to have 200 business and 100 pleasure travelers. b. Variable costs per passenger would be $80. c. Contribut ion 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. Contribut ion margin per passenger = $2,000 – $180 = $1,820. Contribut ion margin fro m business travelers at prices o f $500 and $2,000, respect ively, fo llo w: 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 contribut ion margin and operating inco me by charging business travelers a fare of $2,000. Contribut ion margin from pleasure travelers at prices of $500 and $2,000, respectively, fo llo w: 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 contribut ion margin and operating inco me by charging pleasure travelers a fare o f $500. Air Americo would maximize contribution margin and operating income by a price different iat ion strategy, where business travelers are charged $2,000 and pleasure travelers $500. In deciding between the alternat ive 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 elast icit y of demand o f the two classes of passengers drives the different demands o f the travelers. Business travelers are relatively price insensit ive because they must get to their destination during the week (exclusive o f weekends) and their fares are paid by their co mpanies. A 300% increase in fares fro m $500 to $2,000 will deter only 5% of the business passengers fro m 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 vacat ion plans they could pursue instead. 3. Since business travelers o ften want to return wit hin 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 discriminat ion is legal because airlines are service companies rather than manufacturing companies and because these pract ices do not, nor are they intended to, destroy competit ion. 12­23 12­36 (25 min.) Ethics and pricing. 1. Baker prices at full product costs plus a mark­up of 10% = $80,000 + 10% of $80,000 = $80,000 + $8,000 = $88,000. 2. The incremental costs of the order are as fo llows: 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 contribut ion margin for Baker. Baker may prefer to use full product costs because it regards the new ball­bearings order as a long­term business relationship rather than a special order. For long­run pricing decisio ns, 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 lo ng 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 lo ng­run price cutting as lo ng as prices give a posit ive contribution margin. Using full product costs for pricing thereby prompts price stabilit y. 3. Not using full product costs (including an allo cation of fixed overhead) to price the order, particularly if it is in direct contradiction o f co mpany po licy, may be unethical. In assessing the situation, the specific “Standards o f 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 informat ion should be prepared. Reports prepared on the basis o f excluding certain fixed costs that should be included would vio late the management accountant’s responsibilit y for competence. It is unethical for Lazarus to suggest that Decker change the cost numbers that were prepared for the bearings order and for Decker to change the numbers in order to make Lazarus’s performance look good. Integrity The management accountant has a responsibilit y to avo id actual or apparent conflicts o f interest and advise all appropriate parties o f any potential conflict. Lazarus’s mot ivat ion for want ing Decker to reduce costs was precisely to earn a larger bonus. This action could be viewed as vio lat ing the standard for integrit y. The Standards o f Ethical Conduct require the management accountant to communicate favorable as well as unfavorable informat ion. In this regard, both Lazarus’s and Decker’s behavio r (if Decker agrees to reduce the cost of the order) could be viewed as unethical. Credibility The Standards of Ethical Conduct for Management Accountants require that information should be fairly and object ively co mmunicated and that all relevant informat ion should be disclosed. From a management accountant’s standpo int, reducing fixed overhead costs in deciding on the price to bid are clearly vio lating both of these precepts. For the reasons cited above, the behavior described by Lazarus and Decker (if he goes along wit h Lazarus’s wishes) is unethical. Decker should indicate to Lazarus that the costs were correctly co mputed and that determining prices on the basis of full product costs plus a mark­up of 10% are required by co mpany po licy. I f Lazarus st ill insists on making the changes and reducing the costs of the order, Decker should raise the matter with Lazarus’s superior. If, after taking all these steps, there is cont inued pressure to understate the costs, Decker should consider resigning from the company, rather than engaging in unethical behavio r. 12­24 12­37 (30 min.) Target prices, target costs, value engineering. 1. Direct materials Direct manufacturing labor ($15 per hr. ´ 0.5 hr.) $14 ´ 25,000 hrs. ) Engineering ( 50,000 units Testing ($12 per hr. ´ 0.25 hr.) Full cost per unit of TX40 2. Markup % = $40.60 - $32.48 = 25% $32. 48 $14.98 7.50 7.00 3.00 $32.48 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 Direct costs ($14.98 + $7.50) Testing costs Contribut ion margin Increase in unit s sold Increased contribution margin Less : Advertising costs Operating inco me ( loss) $40.60 22.48 3.00 $15.12 ×10,000 units $151,200 (200,000) $ (48,800) No, the increase in unit s sold are insufficient to cover the extra advertising costs and incremental costs of production. Avery will incur an operating loss on these extra units and should not pursue this strategy. 4. Direct costs ($22.48 ´ 60,000 units) Engineering ($14 ´ 25,000 hrs.) Testing ($3 ´ 60,000 units) Advert ising Full cost of TX40 Divide by number of unit s Full cost per unit of TX40 Markup New selling price $1,348,800 350,000 180,000 200,000 $2,078,800 ÷60,000 units $34.65 ×1.25 $43.31 12­25 ...
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This note was uploaded on 10/11/2010 for the course ACCT 321 taught by Professor Cole during the Spring '10 term at University of Miami.

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