chap 015

CHAPTER 15Target Costing and Cost Analysis for Pricing Decisions

ANSWERS TO REVIEW QUESTIONS

15-1 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.

15-2 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 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.

15-4 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 2009 The McGraw-Hill Companies, Inc.Managerial Accounting, 8/e 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 information for better decisions.

McGraw-Hill/Irwin 2009 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 pricing 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 EXERCISES

EXERCISE 15-28 (25 MINUTES)



Dollars per unit

p*Marginal cost

Demand (average revenue)

Marginal revenue

Quantity soldper monthq*

Dollars

Total cost

Total revenue

Total profit at profit-maximizing quantity and price

Quantity sold per monthq*


1. Tabulated price, quantity, and revenue data:

(1)

QuantitySold perMonth

(2)

UnitSalesPrice

(3)Total

Revenueper

Month*

(4)

Changesin Total

Revenue

20 .......................................$500 .....................................................................................$10,000}}}}

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

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

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

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

$9,000 8,000 7,000

6,000

40 ....................................... 475 ..................................................................................... 19,000 60 ....................................... 450 ..................................................................................... 27,000 80 ....................................... 425 ..................................................................................... 34,000100 ....................................... 400 ..................................................................................... 40,000

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



EXERCISE 15-29 (CONTINUED)

2. Total revenue curve:


Quantity sold per month

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

Dollars

$40,000

$35,000

$30,000

$25,000

$20,000

$15,000

$10,000

$ 5,000

20 40 60 80 100

Total revenue


1. Tabulated cost and quantity data:

(1)QuantityProduced

and Sold per Month

(2)

AverageCost per

Unit

(3)

TotalCost perMonth*

(4)

Changesin TotalCost†

20 .......................................$450 .....................................................................................$ 9,000}}}}

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

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

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

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

$ 8,000 7,600 9,800 10,100

40 ....................................... 425 ..................................................................................... 17,000 60 ....................................... 410 ..................................................................................... 24,600 80 ....................................... 430 ..................................................................................... 34,400100 ....................................... 445 ..................................................................................... 44,500

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



EXERCISE 15-30 (CONTINUED)2. Total cost curve:



Total cost increases at an increasing rate

Dollars

$45,000

$40,000

$35,000

$30,000

$25,000

$20,000

$15,000

$10,000

$ 5,000

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 .......................................$500 .....................................................................................$10,000 $ 9,000 ..............................................................................................................................$1,000 40 .......................................475 .....................................................................................19,000 17,000 ..............................................................................................................................2,000 60 .......................................450 .....................................................................................27,000 24,600 ..............................................................................................................................2,400 80 .......................................425 .....................................................................................34,000 34,400 ..............................................................................................................................(400)100 .......................................400 .....................................................................................40,000 44,500 ..............................................................................................................................(4,500)

*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, $450 is the optimal price. This price produces a monthly profit of $2,400, which is greater than the profit at the other four candidate prices.



2. Total revenue and cost curves:



Total revenue


Total profit at the profit-maximizing quantity and

price.

Dollars

$45,000

$40,000

$35,000

$30,000

$25,000

$20,000

$15,000

$10,000

$ 5,000

20 40 60 80 100

Total cost


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

$495 = total unit cost + (12.5% total unit cost)

$495 = total unit cost 1.125

Total unit cost = = $440

Allocated fixedselling and

administrative cost=

totalunitcost

–all

manufacturingcosts

–variable

selling andadministrative cost

= $440 – ($275 + $55) – $66

= $44

Cost-Plus Pricing Formula2. a. Variable manufacturing cost ...................................................$275 $495 = $275 + (80% $275)*

Applied fixed manufacturing cost .......................................... 55

b. Absorption manufacturing cost .............................................$330 $495 = $330 + (50% $330)†

Variable manufacturing cost ...................................................$275Variable selling and administrative cost .......................................................................................... 66

c. Total variable cost ...................................................................$341 $495 = $341 + (45.16% $341)**

*($495 – $275) ÷ $275 = 80% †($495 – $330) ÷ $330 = 50%**($495 – $341) ÷ $341 = 45.16% (rounded)



1. Profit on sales of 60,000 units:

Sales revenue (60,000 9.00p) .............................................. 540,000pLess: Variable costs:

Manufacturing and administrative (60,000 4.50p) ...... 270,000pSales commissions (60,000 9.00p 10%) .................. 54,000 p 324,000 p

Contribution margin ................................................................ 216,000pLess: Fixed costs (90,000p + 7,500p) ..................................... 97,500 p Profit .......................................................................................... 118,500 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

= 4.50p + 3.00p = 7.50p per unit

As an alternative approach, let X denote the price required in order to earn additional profit of 30,000p on the special order:

10,000X– 10,000(4.50p) = 30,000p

10,000X = 75,000p

X = 7.50p per unit




Cost-Plus Pricing Formula(1) Variable manufacturing cost ...................................................$300 $600 = $300 + (100% $300)a

Applied fixed manufacturing cost .......................................... 105

(2) Absorption manufacturing cost .............................................$405 $600 = $405 + (48.15% $405)b

Variable selling and administrative cost ............................... 45Allocated fixed selling and administrative cost ................................................................ 75

(3) Total cost $525 $600 = $525 + (14.29% $525)c

Variable manufacturing cost ...................................................$300Variable selling and administrative cost ............................... 45

(4) Total variable cost ...................................................................$345 $600 = $345 + (73.91% $345)d

Explanatory Notes:

a($600 – $300) ÷ $300 = 100%b($600 – $405) ÷ $405 = 48.15% (rounded)c($600 – $525) ÷ $525 = 14.29% (rounded)d($600 – $345) ÷ $345 = 73.91% (rounded)


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. 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).


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.



SOLUTIONS TO PROBLEMS

PROBLEM 15-38 (45 MINUTES)

1. The order will boost Heartland’s net income by $13,950, as the following calculations show.

Sales revenue...................................................... $82,500Less: Sales commissions (10%)........................ 8,250 $74,250Less manufacturing costs:

Direct material................................................ $14,600Direct labor..................................................... 28,000Variable manufacturing overhead*.......................... 8,400 Total manufacturing costs 51,000

Income before taxes............................................ $ 23,250Income taxes (40%)............................................. 9,300 Net income ...................................................... $ 13,950

*Based on an analysis of the year just ended, variable overhead is 30 percent of direct labor ($1,125 ¸ $3,750). For Premier’s Foods’ order:

Direct-labor cost x .30 = $28,000 x .30 = $8,400.

2. Yes. Although this amount is below the $82,500 full-cost price, the order is still profitable. Heartland can afford to pick up some additional business, because the company is operating at 75 percent of practical capacity.

Sales revenue............................................................. $63,500Less: Sales commissions (10%).............................. 6,350 $57,150Less manufacturing costs:

Direct material...................................................... $14,600Direct labor........................................................... 28,000Variable manufacturing overhead...................... 8,400 Total manufacturing costs…………………… 51,000

Income before taxes.................................................. $ 6,150Income taxes (40%)................................................... 2,460 Net income ............................................................. $ 3,690

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 Heartland’s management decides about the order.


PROBLEM 15-38 (CONTINUED)

3. The break-even price is $56,667, computed as follows:

Let P = break-even bid price

P – 0.1P - $51,000 = 0

0.9P = $51,000

P = $56,667 (rounded)

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

4. Profits will probably decline. Heartland originally used a full-cost pricing formula to derive a $82,500 bid price. A drop in the selling price to $63,500 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 were able to generate additional volume. This situation will not occur here, because the problem states that Heartland has operated, and will continue to operate, at 75 percent of practical capacity.

5. The electronic version of the Solutions Manual “BUILD A SPREADSHEET SOLUTIONS” is available on your Instructors CD and on the Hilton, 8e website: WWW.MHHE.COM/HILTON8E.



http://www.mhhe.com/hilton8e


1. (a) Time charges:

Hourly labor cost + +

= $20.00 + + $5.00

= $36.25 per labor hour

(b) Material charges:

=

2. PRICE QUOTATION

Time charges: Labor time .....................................................................................................400 hours Rate ........................................................................................................... $36.25 per hourTotal ..............................................................................................................$14,500

Material changes: Cost of materials for job .............................................................................$75,000+ Charge for material handling and storage ............................................. 7,500*Total ..............................................................................................................$82,500

Total price of job: Time ...............................................................................................................$14,500Material ......................................................................................................... 82,500Total ..............................................................................................................$97,000

*Charge for material handling and storage):10% = $31,250 ÷ $312,500; 10% $75,000 = $7,500



3. Price of job without markup on material costs (from requirement 2) .... $ 97,000Markup on total material costs ($82,500 10%) ...................................... 8,250 Total price of job .......................................................................................... $105,250


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

= 500 DLH

Traceable out-of-pocket costs:

Direct labor ($16.00 500) ..................................................................... $ 8,000 Variable overhead ($12.00 500) ......................................................... 6,000 Administrative cost ................................................................................. 2,000 Total traceable out-of-pocket costs................................................... $16,000

Minimum price per dose =

= = $.016

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

Direct labor ($16.00 500) ......................................................................... $ 8,000Variable overhead ($12.00 500) .............................................................. 6,000Fixed overhead ($20.00 500) .................................................................. 10,000Administrative cost ..................................................................................... 2,000 Total cost .................................................................................................. $26,000Maximum allowable return (15%) ............................................................... 3,900 Total bid price .......................................................................................... $29,900

Bid price per dose = = = $.0299 per dose




3. Under the supposition that the price computed by Manhattan Pharmaceuticals, Inc. using Wyant’s criterion is greater than $0.03, the factors that Manhattan’s management should consider before deciding whether or not to submit a bid at the maximum allowable price include whether Manhattan Pharmaceuticals has excess capacity, whether there are available jobs on which earnings might be greater, and whether the maximum bid of $0.03 contributes toward covering fixed costs.


1. The manufacturing overhead rate is $27.00 per direct-labor hour, and the product cost includes $13.50 of manufacturing overhead per pressure valve. Accordingly, the direct-labor hours per finished valve is 1/2 hour ($13.50 ÷ $27.00). 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 ................................................................ $28 .50 $3,420,000

Incremental costs: Variable costs: Direct material ................................................................. $ 7.50 $ 900,000 Direct labor ...................................................................... 9.00 1,080,000 Variable overhead ........................................................... 4 .50 540,000 Total variable costs .................................................... $21 .00 $2,520,000

Fixed overhead: Supervisory and clerical costs (4 months @ $18,000) ........................................................ 72,000Total incremental costs ........................................................... $2,592,000Total incremental profit ........................................................... $ 828,000

The following costs are irrelevant to the analysis:

Shipping

Sales commission

Fixed manufacturing overhead (both traceable and allocated)



3. The minimum unit price that Wolverine 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 ...................................................................... $ 7.50 Direct labor ........................................................................... 9.00 Variable overhead ................................................................ 4 .50 $21.00Additional fixed cost ($72,000 ÷ 120,000) .............................. .60 Minimum unit price .................................................................. $21.60

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

The effect of the special order on Wolverine’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.






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 $675:

Direct material……………………………... $ 90Direct labor………………………………… 225Manufacturing overhead………………… 150Selling and administrative expenses…. 75

Total cost………………………………. $540Markup ($540 x 25%)……………………... 135 Selling price………………………………... $675

3. Lehigh’s markup is $135, which is 20% of the current $675 selling price ($135 ÷ $675). To achieve a 20% markup on a $585 selling price, the company must reduce its costs by $72.

Selling price……………………………….. $585Less: 20% markup ($585 x 20%)………. 117 Target cost………………………………… $468

Current cost……………………………….. $540Less: Target cost…………………………. 468 Required cost reduction………………… $ 72



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 $540, Lehigh will have to reduce its markup to remain competitive. Assuming a desire to achieve the going market price of $585, the markup must equal $45 ($585 - $540), or 8.33% of cost ($45 ÷ $540). 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. The minimum price per blanket that Detroit Synthetic Fibers, Inc. could bid without reducing the company’s net income is $48 calculated as follows:

Raw material (6 lbs. @ $3.00 per lb.) .......................................................... $18.00Direct labor (.25 hrs. @ $14.00 per hr.) ...................................................... 3.50Machine time ($20.00 per blanket) ............................................................. 20.00Variable overhead (.25 hrs. @ $6.00 per hr.) ............................................. 1.50Administrative costs ($5,000 ÷ 1,000) ........................................................ 5 .00 Minimum bid price ................................................................................... $48 .00

2. Using the full cost criteria and the maximum allowable return specified, Detroit Synthetic Fibers, Inc.’s bid price per blanket would be $59.80 calculated as follows:

Relevant costs from requirement (1) ......................................................... $48.00Fixed overhead (.25 hrs. @ $16.00 per hr.) ................................................ 4 .00 Subtotal .................................................................................................... $52.00Allowable return (.15 $52.00) .................................................................. 7 .80 Bid price ................................................................................................... $59 .80

3. Factors that management should consider before deciding whether to submit a bid at the maximum acceptable price of $50 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 $50 per blanket, there will be a $2 contribution per blanket to cover 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. Target costing is more appropriate. MSC 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 = $27,000,000 x 12% = $3,240,000

3. Revenue = target profit + variable cost + fixed cost= $3,240,000 + (25,000 hours x $33) + $2,850,000= $6,915,000

Since total revenue must equal $6,915,000, the revenue per hour must be $276.60 ($6,915,000 ÷ 25,000 hours).

4. Target profit = asset investment x rate of return = $27,000,000 x 14% = $3,780,000

Revenue = target profit + variable cost + fixed cost= $3,780,000 + (25,000 hours x $33) + $2,850,000= $7,455,000

No. A 14% return requires that MSC generate revenue per service hour of $298.20 ($7,455,000 ÷ 25,000 hours), which is clearly in excess of the $265 market price.

5. To achieve a 14% return and a $265 revenue-per-hour figure, the company must trim its costs. MSC 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. 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. Portland Electronics' current profit on sales is 10 percent [($700-$630)/$700]. Therefore, the target cost for the new product must be $600 less 10 percent, or $540 [$600 – ($600 10%)].

4. The proposed changes to the just-in-time cell manufacturing process at Portland Electronics will bring costs down to $532 per unit, which is below the $540 target cost limit. Revised costs under the JIT cell manufacturing process are calculated as follows:

CurrentIncrease/

(Decrease) Revised

Material:Purchased components................................... $215 $215All other............................................................. 85 85

Labor:Manufacturing, direct....................................... 130 $ 30 160Setups................................................................ 18 (18) 0Material handling.............................................. 36 (36) 0Inspection.......................................................... 46 (46) 0

Machining:All....................................................................... 70 (10) 60

Other:Finished-goods warehousing.......................... 10 (10) 0Warranty*........................................................... 20 (8) 12

Total cost................................................................. $630 $(98) $532

*40% reduction




1. Budgeted overhead costs:

Department I Department IIVariable overhead Department I: 37,500 $12 ...................................................................$450,000 Department II: 37,500 $6 ..................................................................... $ 225,000Fixed overhead ............................................................................................ 225,000 225,000 Total overhead .............................................................................................$675,000 $ 450,000Total budgeted overhead for both departments ($675,000 + $450,000) ......................................................... $1,125,000Total expected direct-labor hours for both departments (37,500 + 37,500) ......................................................... 75,000

Predetermined overhead rate =

=

= $15.00 per direct-labor hour

2. Standard DeluxeTotal cost ......................................................................................................$600.00 $750.00Markup (15% of cost) Standard: $600 .15 ............................................................................. 90.00 Deluxe: $750 .15 ..................................................................................______ 112.50Price ..............................................................................................................$690.00 $862.50

3. Department I Department IIBudgeted overhead (from requirement 1)..................................................$675,000 $450,000Budgeted direct-labor hours ...................................................................... 37,500 37,500

Calculation of predetermined overhead rate ............................................

Predetermined overhead rate .....................................................................$18.00 $12.00



4. Standard DeluxeDirect material ..............................................................................................$240 $390Direct labor ...................................................................................................210 210Manufacturing overhead: Department I: Standard: 2 $18 ...............................................................................36 Deluxe: 8 $18 ................................................................................... 144 Department II: Standard: 8 $12 ...............................................................................96 Deluxe: 2 $12 ................................................................................... 24 Total cost ......................................................................................................$582 $768

5. Standard DeluxeTotal cost (from requirement 4)...................................................................$582.00 $768.00Markup (15% of cost) Standard: $582 .15 ..............................................................................87.30 Deluxe: $768 .15 ..................................................................................______ 115 .20 Price ..............................................................................................................$669 .30 $883 .20

6. The management of Super Sounds, 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 Standard speakers were overcosted and the Deluxe speakers were undercosted. This in turn resulted in the Standard model being overpriced and the Deluxe model being underpriced. The cost and price distortion resulted from the following facts: (1) the Standard speakers spend most of their production time in Department II, which is the least costly of the two departments; and (2) the Deluxe speakers spend most of their production time in Department I, which is more costly than Department II.




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) Danish Interiors currently earns a $48 profit on each table sold ($240 - $192), which translates into a 20% markup on sales ($48 ÷ $240). The current competitive market price is $285, which means that if the company maintains the 20% markup, it will earn $57 ($285 x 20%) per unit. The maximum allowable cost is therefore $228 ($285 - $57).

(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 Danish Interiors 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, management could also add a lock to the storage area. Supporting calculations follow.

Maximum allowable cost…………... $228.00Less: Current cost…………………... 192.00 Cost of additional features………… $ 36.00

1—Add cabinet doors………………. $ 18.002—New appearance for table top… 12.75

Subtotal…………………………… $ 30.754—Add security lock……………….. __ 4.95

Total……………………………….. $ 35.70

4. An expanded storage area would be the most logical additional feature in view of its no. 3 ranking. Danish Interiors 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.



SOLUTIONS TO CASES

CASE 15-48 (40 MINUTES)

1. Bid based on standard pricing policy:

Direct material ............................................................................................ $307,200Direct labor (11,000 DLH @ $18.00) .......................................................... 198,000Manufacturing overhead (11,000 DLH @ $10.80) .................................... 118,800 Full manufacturing costs ...................................................................... $624,000Markup (50% of full cost) ........................................................................... 312,000 Standard pricing policy bid ....................................................................... $936,000

2. Minimum bid acceptable to Bair Company:

Direct material ............................................................................................ $307,200Direct labor (11,000 DLH @ $18.00) .......................................................... 198,000Variable manufacturing overhead (11,000 @ $6.48a) .............................. 71,280Opportunity cost of lost salesb .................................................................. 42,240 Minimum bid ............................................................................................... $618,720

aProportion of variable overhead =

=

= 60%

Variable overhead rate =

= ($10.80) (.6)

= $6.48


CASE 15-48 (Continued)

bSelling price per unit of standard product................................................ $14,400 Variable costs per unit Direct material .....................................................................................$3,000 Direct labor (250 DLH @ $18.00) ........................................................4,500 Variable overhead (250 DLH @ $6.48) ............................................... 1,620 9,120Net contribution per unit ............................................................................. $ 5,280Standard 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 ......................................................................................... $42,240

3. Lyan Company’s assistant purchasing manager is not acting ethically. The details of the bid submitted by Bair Company are confidential between Bair Company and Lyan Company. It is unfair and unethical to give this information to Bair’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.



CASE 15-49 (50 MINUTES)

1. Handy Household Products, Inc. should price the standard compound at $44 per case and the commercial compound at $60 per case. The contribution margin is the highest at these prices as shown in the following calculations:

Standard CompoundSelling price per case ..................................................................................$ 38 $ 40 $ 42 $ 44 $ 46Variable cost per case ................................................................................. 32 32 32 32 32 Contribution margin per case .....................................................................$ 6 $ 8 $ 10 $ 12 $ 14Volume in cases (in thousands) ................................................................. 120 100 90 80 50 Total contribution margin (in thousands) .................................................$ 720 $ 800 $ 900 $ 960 $ 700

Commercial CompoundSelling price per case ..................................................................................$ 52 $ 54 $ 60 $ 64 $ 70Variable cost per case ................................................................................. 42 42 42 42 42 Contribution margin per case .....................................................................$ 10 $ 12 $ 18 $ 22 $ 28Volume in cases (in thousands) ................................................................. 175 140 100 55 35 Total contribution margin (in thousands) .................................................$1,750 $1,680 $1,800 $1,210 $ 980


CASE 15-49 (CONTINUED)

2. a. Management 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.

HANDY HOUSEHOLD PRODUCTS, INC.SHREVEPORT PLANT

PROJECTED CONTRIBUTION MARGIN

FOR THE SIX-MONTH PERIOD ENDING DECEMBER 31(IN THOUSANDS)

Standard Commercial TotalSales ..............................................................................................................$2,300 $2,450 $4,750 Variable costs: Selling and administrative ......................................................................$ 400 $ 490 $ 890 Manufacturing .......................................................................................... 1,200 980 2,180 Total variable costs ............................................................................$1,600 $1,470 $3,070 Contribution margin ....................................................................................$ 700 $ 980 $1,680

b. Management should consider the following qualitative factors when making the decision about the Shreveport 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.



chap 015

Documents

detroit synthetic

expanded storage

solutions

wave darters

standard deluxetotal

variable manufacturing

total variable

absorption