CHAPTER12

PRICINGDECISIONSANDCOSTMANAGEMENT
121 Thethreemajorinfluencesonpricingdecisionsare
1. Customers
2. Competitors
3. Costs
122 Notnecessarily.Foraonetimeonlyspecialorder,therelevantcostsareonlythosecosts
thatwillchangeasaresultofacceptingtheorder.Inthiscase,fullproductcostswillrarelybe
relevant. It is more likely that full product costs will be relevant costs for longrun pricing
decisions.
123 Twoexamplesofpricingdecisionswithashortrunfocus:
1.
Pricingforaonetimeonlyspecialorderwithnolongtermimplications.
2.
Adjustingproductmixandvolumeinacompetitivemarket.
124 Activitybasedcostinghelpsmanagersinpricingdecisionsintwoways.
1.
Itgivesmanagersmoreaccurateproductcostinformationformakingpricingdecisions.
2.
It helps managers to manage costs during value engineering by identifying the cost
impactofeliminating,reducing,orchangingvariousactivities.
125 Twoalternativestartingpointsforlongrunpricingdecisionsare
1.
Marketbased pricing, an important form of which is target pricing. The marketbased
approachasks,Givenwhatourcustomerswantandhowourcompetitorswillreacttowhatwe
do,whatpriceshouldwecharge?
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 Atargetcostperunitistheestimatedlongruncostperunitofaproduct(orservice)that,
whensoldatthetargetprice,enablesthecompanytoachievethetargetedoperatingincomeper
unit.
127 Value engineering is a systematic evaluation of all aspects of the valuechain business
functions, with the objective of reducing costs while satisfying customer needs. Value
engineering via improvement in product and process designs is a principal technique that
companiesusetoachievetargetcostsperunit.
128 A valueadded cost is a cost that customers perceive as adding value, or utility, to a
product or service. Examples are costs of materials, direct labor, tools, and machinery. A
nonvalueadded cost is a cost that customers do not perceive as adding value, or utility, to a
productorservice.Examplesofnonvalueaddedcostsarecostsofrework,scrap,expediting,and
breakdownmaintenance.
129 No.Itis importanttodistinguish betweenwhen costsare locked inandwhencostsare
incurred,becauseitisdifficulttoalterorreducecoststhathavealreadybeenlockedin.

121

1210 Costpluspricingisapricingapproachinwhichmanagersaddamarkuptocostinorder
todetermineprice.
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
productcostsand(d)fullproductcosts.
1212 Two examples where the difference in the costs of two products or services is much
smallerthanthedifferencesintheirpricesfollow:
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.
Thedifferenceincostsforanairplaneseatsoldtoapassengertravelingonbusinessora
passenger traveling for pleasure is roughly the same. However, airline companies price
discriminate. They routinely charge business travelersthose who are likely to start and
complete their travel during the same week excluding the weekenda much higher price than
pleasuretravelerswhogenerallystayattheirdestinationsoveratleastoneweekend.
1213 Lifecyclebudgetingisanestimateoftherevenuesandcostsattributabletoeachproduct
fromitsinitialR&Dtoitsfinalcustomerservicingandsupport.
1214 Threebenefitsofusingaproductlifecyclereportingformatare:
1.
Thefullsetofrevenuesandcostsassociatedwitheachproductbecomesmorevisible.
2.
Differencesamongproductsinthepercentageoftotalcostscommittedatearlystagesin
thelifecyclearehighlighted.
3.
Interrelationshipsamongbusinessfunctioncostcategoriesarehighlighted.
1215 Predatorypricingoccurswhenabusinessdeliberatelypricesbelowitscostsinaneffort
to drive competitors out of the market and restrict supply, and then raises prices rather than
enlargedemand.UnderU.S.laws,dumpingoccurswhenanonU.S.companysellsaproductin
theUnitedStatesatapricebelowthemarketvalueinthecountrywhereitisproduced,andthis
lowerprice materially injuresorthreatenstomaterially injurean industry intheUnitedStates.
Collusivepricingoccurswhencompaniesinanindustryconspireintheirpricingandproduction
decisionstoachieveapriceabovethecompetitivepriceandsorestraintrade.

122

1216 (2030min.) Relevantcostapproachtopricingdecisions,specialorder.

1.

Relevantrevenues,$4.00 1,000
Relevantcosts
Directmaterials,$1.60 1,000
Directmanufacturinglabor,$0.90 1,000
Variablemanufacturingoverhead,$0.70 1,000
Variablesellingcosts,0.05 $4,000
Totalrelevantcosts
Increaseinoperatingincome

$4,000
$1,600
900
700
200
3,400
$600

Thiscalculationassumesthat:
a. The monthly fixed manufacturing overhead of $150,000 and $65,000 of monthly
fixedmarketingcostswillbeunchangedbyacceptanceofthe1,000unitorder.
b. The price charged and the volumes sold to other customers are not affected by the
specialorder.
Chapter12usesthephraseonetimeonlyspecialorder todescribethisspecialcase.
2.

Thepresidentsreasoningisdefectiveonatleasttwocounts:
a. The inclusion of irrelevant costsassuming the monthly fixed manufacturing
overheadof$150,000willbeunchangeditisirrelevanttothedecision.
b. The exclusion of relevant costsvariable selling costs(5%of the selling price) are
excluded.

3.

Keyissuesare:
a. Willtheexistingcustomerbasedemandpricereductions?Ifthis1,000tapeorderis
notindependentofothersales,cuttingthepricefrom$5.00to$4.00canhavealarge
negativeeffectontotalrevenues.
b. Is the 1,000tape order a onetimeonly order, or is there the possibility of sales in
subsequent months? The fact that the customer is not in Dill Companys normal
marketing channels does not necessarily mean it is a onetimeonly order. Indeed,
thesalecouldwellopenanewmarketingchannel.DillCompanyshouldbereluctant
toconsideronlyshortrunvariablecostsforpricinglongrunbusiness.

123

1217 (2030min.) Relevantcostapproachtoshortrunpricingdecisions.

1.

Analysisofspecialorder:
Sales,3,000units $75
Variablecosts:
Directmaterials,3,000units $35
Directmanufacturinglabor,3,000units $10
Variablemanufacturingoverhead,3,000units $6
Othervariablecosts,3,000units $5
Salescommission
Totalvariablecosts
Contributionmargin

$225,000
$105,000
30,000
18,000
15,000
8,000
176,000
$ 49,000

Notethatthe variable costs, except for commissions, are affected by production volume,
notsalesdollars.
If the special order is accepted, operating income would be $1,000,000 + $49,000 =
$1,049,000.
2. WhetherMcMahonsdecisiontoquotefullpriceiscorrectdependsonmanyfactors.Heis
incorrect if the capacity would otherwise be idle and if his objective is to increase operating
incomeintheshortrun.Iftheofferisrejected,SanCarlos,ineffect,iswillingtoinvest$49,000
inimmediategainsforgone(anopportunitycost)topreservethelongrunsellingpricestructure.
McMahoniscorrectifhethinksfuturecompetitionorfuturepriceconcessionstocustomerswill
hurtSanCarlossoperatingincomebymorethan$49,000.
ThereisalsothepossibilitythatAbramscouldbecomealongtermcustomer.Inthiscase,
isapricethatcoversonlyshortrunvariablecostsadequate?WouldHoltzbewillingtoaccepta
$8,000 sales commission (as distinguished from her regular $33,750 = 15% $225,000) for
everyAbramsorderofthissizeifAbramsbecomesalongtermcustomer?

124

1218 (1520min.) Shortrunpricing,capacityconstraints.

1.Perkilogramofhardcheese:
Milk(10liters $1.50perliter)
Directmanufacturinglabor
Variablemanufacturingoverhead
Fixedmanufacturingcostallocated
Totalmanufacturingcost

$15
5
3
6
$29

IfVermontHillscangetalltheHolstein milk it needs,and has sufficientproductioncapacity,

then,theminimumpriceperkiloitshouldchargeforthehardcheeseisthevariablecostperkilo
=$15+5+3=$23perkilo.
2.
Ifmilkisinshortsupply,theneachkiloofhardcheesedisplaces2.5kilosofsoftcheese
(10litersofmilkperkiloofhardcheeseversus4litersofmilkperkiloofsoftcheese).Then,for
thehardcheese,theminimumpriceVermontshouldchargeisthevariablecostperkiloofhard
cheeseplusthecontributionmarginfrom2.5kilosofsoftcheese,or,
$23+(2.5 $8perkilo)=$43perkilo
Thatis,ifmilkisinshortsupply,Vermontshouldnotagreetoproduceanyhardcheeseunless
thebuyeriswillingtopay atleast$43perkilo.

1219 (2530min.) Valueadded,nonvalueaddedcosts.

1.
Category
Valueaddedcosts
Nonvalueaddedcosts

Grayarea

Examples
a. Materialsandlaborforregularrepairs
b. Reworkcosts
c. Expeditingcostscausedbyworkdelays
g. Breakdownmaintenanceofequipment
Total
d. Materialshandlingcosts
e. Materialsprocurementandinspectioncosts
f. Preventivemaintenanceofequipment
Total

$800,000
$75,000
60,000
55,000
$190,000
$50,000
35,000
15,000
$100,000

Classifications of valueadded, nonvalueadded, and gray area costs are often not clearcut.
Other classifications of some of the cost categories are also plausible. For example, some
students may include materials handling, materials procurement, and inspection costs and
preventivemaintenanceasvalueaddedcosts(coststhatcustomersperceiveasaddingvalueand
as being necessary for good repair service) rather than as in the gray area. Preventive
maintenance,forinstance,mightberegardedasvalueaddedbecauseithelpspreventnonvalue
addingbreakdownmaintenance.

125

2.
Total costs in the gray area are $100,000. Of this, we assume 65%, or $65,000, are
valueaddedand35%,or$35,000,arenonvalueadded.
Totalvalueaddedcosts:$800,000+$65,000
$865,000
Totalnonvalueaddedcosts:$190,000+$35,000
225,000
Totalcosts
$1,090,000
Nonvalueaddedcostsare$225,000$1,090,000=20.64%oftotalcosts.
Valueaddedcostsare$865,000$1,090,000=79.36%oftotalcosts.
3.
Program
(a) Qualityimprovementprogramsto
reducereworkcostsby75%(0.75 $75,000)
reduceexpeditingcostsby75%
(0.75 $60,000)
reducematerialsandlaborcostsby5%
(0.05 $800,000)
Totaleffect

EffectonCostsClassifiedas
Value
Nonvalue
Gray
Added
Added
Area
$56,250
45,000
$40,000
$40,000

(b) Workingwithsuppliersto
reducematerialsprocurementandinspectioncostsby
20%(0.20 $35,000)
reducematerialshandlingcostsby25%
(0.25 $50,000)
Totaleffect
Transferring65%ofgrayareacosts(0.65
$19,500=$12,675)asvalueaddedand35%
$12,675
(0.35 $19,500=$6,825)asnonvalueadded
$12,675
Effectonvalueaddedandnonvalueaddedcosts
(c) Maintenanceprogramsto
increasepreventivemaintenancecostsby50%
(0.50 $15,000)
decreasebreakdownmaintenancecostsby40%
(0.40 $55,000)
Totaleffect
Transferring 65% of gray area costs (0.65 $7,500 =
$4,875) as valueadded and 35% (0.35 $7,500 =
+$4,875
$2,625)asnonvalueadded
+$ 4,875
Effectonvalueaddedandnonvalueaddedcosts
Totaleffectofallprograms
$47,800
Valueaddedandnonvalueaddedcostscalculatedin
requirement2
865,000
Expectedvalueaddedandnonvalueaddedcostsasaresultof
implementingtheseprograms
$817,200

$101,250

$7,000
12,500
19,500

$6,825
$6,825

+19,500
$0

+$7,500
$22,000
22,000

+2,625
$19,375
$127,450

+$7,500

7,500
$0

225,000
$97,550

If these programs are implemented in 2007, total costs would decrease from $1,090,000
(requirement2)to$817,200+$97,550=$914,750,andthepercentageofnonvalueaddedcosts
would decrease from 20.64% (requirement 2) to $97,550 914,750 = 10.66%. These are
significantimprovementsinMarinosperformance.

126

1220 (25-30min.) Targetoperatingincome,valueaddedcosts,servicecompany.

1.
Theclassificationoftotalcostsin2009intovalueadded,nonvalueadded,orinthegray
areainbetweenfollows:
Value
Gray
Nonvalue Total
Added
Area
added
(4)=
(1)
(2)
(3)(1)+(2)+(3)
Doingcalculationsandpreparingdrawings
75%$400,000
$300,000
$300,000
Checkingcalculationsanddrawings
4%$400,000
$16,000
16,000
Correctingerrorsfoundindrawings
7%$400,000
$28,000
28,000
Makingchangesinresponsetoclient
requests6%$400,000
24,000
24,000
Correctingerrorstomeetgovernment
buildingcode,8%$400,000
32,000
32,000
Totalprofessionallaborcosts
324,000 16,000
60,000
400,000
Administrativeandsupportcostsat40%
($160,000$400,000)ofprofessional
laborcosts
129,600
6,400
24,000
160,000
Travel
18,000

18,000
Total
$471,600 $22,400
$84,000 $578,000
Doingcalculationsandrespondingtoclientrequestsforchangesarevalueaddedcostsbecause
customersperceivethesecostsasnecessary fortheserviceofpreparingarchitecturaldrawings.
Costs incurred on correcting errors in drawings and making changes because they were
inconsistent with building codes are nonvalueadded costs. Customers do not perceive these
costs as necessary and would be unwilling to pay for them. Carasco should seek to eliminate
these costs by making sure that all associates are wellinformed regarding building code
requirements and by training associates to improve the quality of their drawings. Checking
calculationsanddrawingsisinthegrayarea(some,butnotall,checkingmaybeneeded).There
is room for disagreement on these classifications. For example, checking calculations may be
regardedasvalueadded.
2.

Reductioninprofessionallaborhoursby
a.Correctingerrorsindrawings(7%8,000)
b.Correctingerrorstoconformtobuildingcode(8%8,000)
Total
Costsavingsinprofessionallaborcosts(1,200hours$50)
Costsavingsinvariableadministrativeandsupport
costs(40%$60,000)
Totalcostsavings
Currentoperatingincomein 2009
Addcostsavingsfromeliminatingerrors
Operatingincomein 2009iferrorseliminated

127

560hours
640hours
1,200hours
$60,000
24,000
$84,000
$102,000
84,000
$186,000

3.
Currently 85% 8,000 hours = 6,800 hours arebilled to clients generating revenues of
$680,000.Theremaining15%ofprofessionallaborhours(15%8,000=1,200hours)islostin
makingcorrections.Carascobillsclientsattherateof$680,0006,800=$100perprofessional
laborhour.Ifthe1,200professionallaborhourscurrentlynotbeingbilledtoclientswerebilled
toclients,Carascosrevenueswouldincreaseby1,200hours$100=$120,000from$680,000
to$800,000.
Costsremainunchanged
Professionallaborcosts
Administrativeandsupport(40%$400,000)
Travel
Totalcosts
Carascosoperatingincomewouldbe
Revenues
Totalcosts
Operatingincome

128

$400,000
160,000
18,000
$578,000
$800,000
578,000
$222,000

1221 (2530min.) Targetprices,targetcosts,activitybasedcosting.

1.

Snappysoperatingincomein 2008isasfollows:
Totalfor
250,000Tiles
(1)
$1,000,000
750,000
25,000
120,000
60,000
955,000
$45,000

Revenues($4 250,000)
Purchasecostoftiles($3 250,000)
Orderingcosts($50 500)
Receivingandstorage($30 4,000)
Shipping($40 1,500)
Totalcosts
Operatingincome

PerUnit
(2)=(1)250,000
$4.00
3.00
0.10
0.48
0.24
3.82
$0.18

2.
Pricetoretailersin 2009is95%of2008price=0.95 $4=$3.80costpertilein 2009is
96%of2008cost=0.96 $3=$2.88.
Snappysoperatingincomein 2009isasfollows:
Totalfor
250,000Tiles
(1)
$950,000
720,000
25,000
120,000
60,000
925,000
$25,000

Revenues($3.80 250,000)
Purchasecostoftiles($2.88 250,000)
Orderingcosts($50 500)
Receivingandstorage ($30 4,000)
Shipping($40 1,500)
Totalcosts
Operatingincome

PerUnit
(2)=(1)250,000
$3.80
2.88
0.10
0.48
0.24
3.70
$0.10

3. Snappysoperatingincomein2009,ifitmakeschangesinorderingandmaterialhandling,
willbeasfollows:
Totalfor
250,000Tiles
PerUnit
(1)
(2)=(1)250,000
$950,000
$3.80
Revenues($3.80 250,000)
720,000
2.88
Purchasecostoftiles($2.88 250,000)
5,000
0.02
Orderingcosts($25 200)
87,500
0.35
Receivingandstorage($28 3,125)
60,000
0.24
Shipping($40 1,500)
872,500
3.49
Totalcosts
$77,500
$0.31
Operatingincome
Throughbettercostmanagement,Snappywillbeabletoachieveitstargetoperatingincomeof
$0.30 pertile despite the factthat its revenue per tile has decreased by $0.20 ($4.00 $3.80),
whileitspurchasecostpertilehasdecreasedbyonly$0.12($3.00 $2.88).

129

1222 (20min.) Targetcosts,effectofproductdesignchangesonproductcosts.

1.and2. ManufacturingcostsofHJ6in 2008and2009areasfollows:
2008
PerUnit
Total
(2)=
(1)
(1)3,500
Directmaterials,$1,2003,500$1,1004,000 $4,200,000
$1,200
Batchlevelcosts,$8,00070$7,50080
560,000
160
Manuf.operationscosts,$5521,000
$5022,000
1,155,000
330
Engineeringchangecosts,$12,00014
$10,00010
168,000
48
Total
$6,083,000
$1,738

3.

2009
PerUnit
Total
(4)=
(3)
(3)4,000
$4,400,000 $1,100
600,000
150
1,100,000

275

100,000
$6,200,000

25
$1,550

Targetmanufacturingcost= Manufacturingcost 90%

perunitofHJ6in2009
perunitin2008
=$1,7380.90=$1,564.20

ActualmanufacturingcostperunitofHJ6in2009was$1,550.Hence,MedicalInstrumentsdid
achieveitstargetmanufacturingcostperunitof$1,564.20
4.
Toreducethemanufacturingcostperunitin2009,MedicalInstrumentsreducedthecost
per unit in each of the four cost categoriesdirect materials costs, batchlevel costs,
manufacturing operations costs, and engineering change costs. It also reduced machinehours
and numberofengineeringchanges madethequantitiesofthecostdrivers.In2008,Medical
Instrumentsused6machinehoursperunitofHJ6(21,000machinehours 3,500units).In2009,
Medical Instruments used 5.5 machinehours per unit of HJ6 (22,000 machinehours 4,000
units). Medical Instruments reduced engineering changes from 14 in 2008 to 10 in 2009.
MedicalInstrumentsachievedthesegainsthroughvalueengineeringactivitiesthatretainedonly
those product features that customers wanted while eliminating nonvalueadded activities and
costs.

1210

1223 (20min.) Costplustargetreturnoninvestmentpricing.

1.

Targetoperatingincome=targetreturnoninvestment investedcapital
Targetoperatingincome(25%of$1,000,000)
$250,000
Totalfixedcosts
358,000
Targetcontributionmargin
$608,000
Targetcontributionperroomnight,($608,00016,000)
Addvariablecostsperroomnight
Pricetobechargedperroomnight
Proof
Totalroomrevenues($42 16,000roomnights)
Totalcosts:
Variablecosts($4 16,000)
Fixedcosts
Totalcosts
Operatingincome

$38
4
$42

$672,000
$ 64,000
358,000
422,000
$250,000

Thefullcostofaroom = variablecostperroom+fixedcostperroom
Thefullcostofaroom = $4+($358,00016,000)=$4 +$22.375=$26.375
Markupperroom

=Rentalpriceperroom Fullcostofaroom
=$42 $26.375=$15.625
Markuppercentageasafractionoffullcost= $15.625$26.375 =59.24%
2.

Ifpriceisreducedby10%,thenumberofroomsBeckcouldrentwouldincreaseby10%.
Thenewpriceperroomwouldbe90%of$42
$37.80
ThenumberofroomsBeckexpectstorentis110%of 16,000
17,600
Thecontributionmarginperroomwouldbe$37.80$4
$33.80
Contributionmargin($33.80 17,600)
$594,880

Becausethecontributionmarginof$594,880atthereducedpriceof$37.80islessthanthe
contributionmarginof$608,000atapriceof$42,Beckshouldnotreducethepriceoftherooms.
Note that the fixed costs of $358,000 will be the same under the $42 and the $37.80 price
alternativesandhence,areirrelevanttotheanalysis.

1211

1224 (20-25min.) Costplus,targetpricing,workingbackwards.

1.

Investment
Returnoninvestment
Operatingincome(20% $2,400,000)
OperatingincomeperunitofRF17($480,000 20,000)
FullcostperunitofRF17
Sellingprice($300+$24)
Markuppercentageonfullcost($24 $300)

$2,400,000
20%
$480,000
$24
$300
$324
8%

Witha50%markuponvariablecosts,
SellingpriceofRF17=VariablecostperunitofRF17 1.50,so:
VariablecostsperunitofRF17 =
2.

SellingpriceofRF17 $324
=
=$216
1.50
1.50

Fixedcostperunit=$300 $216=
Totalfixedcosts= $84perunit 20,000units=
Atapriceof$348,sales=20,000units 0.90
Revenues($348 18,000)
Variablecosts($216 18,000)
Contributionmargin($132 18,000)
Fixedcosts
Operatingincome

$84
$1,680,000
18,000
$6,264,000
3,888,000
2,376,000
1,680,000
$ 696,000

IfWaterbuyincreasesthesellingpriceofRF17to$348,itsoperatingincomewillbe$696,000.
Thiswouldbemorethanthe$480,000operatingincomeWaterbury earnsbyselling20,000units
at a price of $324, so, if its forecast is accurate, and based on financial considerations alone,
Waterburyshouldincreasethesellingpriceto$348.
3.

Targetinvestmentin2009
Targetreturnoninvestment
Targetoperatingincomein2009,20% $2,100,000

$2,100,000
20%
$420,000

Anticipated revenuesin2009,$315 20,000

Lesstargetoperatingincomein2009
Targetfull costsin2009
Less:totaltargetfixedcosts
Totaltargetvariablecostsin2009

$6,300,000
420,000
5,880,000
1,680,000
$4,200,000

Targetvariablecostperunitin2009,$4,200,000 20,000 =$210

1212

1225 Lifecycleproductcosting.
1. Variablecostperunit=Productioncostperunit+Mktganddistribn.costperunit
=$50 +$10=$60
TotalfixedcostsoverlifeofYew=$6,590,000 + $1, 450,000 + $19,560,000 + 5, 242,000 +$2,900,000
=$35,742,000
Fixedcosts
$35,742,000
=
BEPinunits=
=714,840units
Sellingprice - Variablecostperunit
$110 -$60

2a.
Revenues($110 1,500,000units)
Variablecosts($60 1,500,000units)
Fixedcosts
Operatingincome

$165,000,000
90,000,000
35,742,000
$39,258,000

Revenues
Year2($240 100,000units)
Years3&4($110 1,200,000units)
Totalrevenues
Variablecosts($60 1,300,000units)
Fixedcosts
Operatingincome

$ 24,000,000
132,000,000
156,000,000
78,000,000
35,742,000
$42,258,000

2b.

Overtheproductslifecycle,OptionBresultsinanoverallhigheroperatingincomeof
$3,000,000.
3. Before selecting its pricing strategy, Intentical managers should evaluate whether the same
pricing policy will be adopted globally. Different markets may need different pricing. For
example, special taxes on imports may mean higher prices in foreign markets. Intenticals
pricingstrategymustbesensitivetochangingcustomerpreferencesandreactionsofcompetitors.

1213

1226 (30min.)
1.

Relevantcostapproachtopricingdecisions.

Revenues(1,000cratesat$100percrate)
Variablecosts:
Manufacturing
Marketing
Totalvariablecosts
Contributionmargin
Fixedcosts:
Manufacturing
Marketing
Totalfixedcosts
Operatingincome

$100,000
$40,000
14,000
54,000
46,000
$20,000
16,000
36,000
$10,000

Normalmarkuppercentage:$46,000$54,000=85.19%oftotalvariablecosts.
2.
Only the manufacturingcost category is relevant to considering this special order no
additional marketingcostswill be incurred.Therelevant manufacturingcosts forthe200crate
specialorderare:
Variablemanufacturingcostperunit
$40 200crates
Specialpackaging
Relevantmanufacturingcosts

$8,000
2,000
$10,000

Any price above $50 per crate ($10,000 200)will make a positive contribution tooperating
income. Therefore, based on financial considerations, Stardom should accept the 200crate
special order at $55 per cratethat will generate revenues of $11,000 ($55 200) and relevant
(incremental)costsof$10,000.
The reasoning based on a comparison of $55 per crate price with the $60 per crate
absorption cost ignores monthly costvolumeprofit relationships. The $60 per crate absorption
costincludesa$20percratecostcomponentthatisirrelevanttothespecialorder.Therelevant
rangeforthefixedmanufacturingcostsisfrom500to1,500cratespermonththespecialorder
will increase production from 1,000 to 1,200 crates per month. Furthermore, the special order
requiresnoincrementalmarketingcosts.
3.
Ifthe newcustomer is likelytoremain in business,Stardomshouldconsiderwhethera
strictlyshortrunfocusisappropriate.Forexample,whatisthelikelihoodofdemandfromother
customersincreasingovertime?IfStardomacceptsthe200cratespecialofferformorethanone
month,itmayprecludeacceptingothercustomersatpricesexceeding$55percrate.Moreover,
the existing customers may learn about Stardoms willingness to set a price based on variable
cost plus a small contribution margin. The longer the time frame over which Stardom keeps
selling200cratesofcannedpeachesat$55acrate,themorelikelyitisthatexistingcustomers
will approach Stardom for their own special price reductions. If the new customer wants the
contracttoextendoveralongertimeperiod,Stardomshouldnegotiateahigherprice.

1214

1227 (2530min.) Targetrateofreturnoninvestment,activitybasedcosting.

1.
OperatingIncomeStatement,April2009
Revenues(12,000disks $22perdisk)
Materials(12,000disks $15perdisk)
Grossmargin
Ordering(40vendors $250pervendor)
Cataloging(20newtitles $100pertitle)
Deliveryandsupport(400deliveries $15perdelivery)
Billingandcollection(300customers $50percustomer)
OperatingIncome
Rateofreturnoninvestment($51,000 $300,000)

$264,000
180,000
84,000
10,000
2,000
6,000
15,000
$ 51,000
17.00%

2.
Thetablebelowshowsthatifthesellingpriceofgamedisksfallsto$18andthecostof
eachdisk fallsto$12,monthlygross margin fallsto$72,000(from$84,000 in April),andthis
resultsinareturnoninvestmentof13%,whichisbelowEAstargetrateofreturn oninvestment
of15%. EAwillhavetocutcoststoearnitstargetrate ofreturnoninvestment.
OperatingIncomeStatement, May2009
Revenues(12,000disks $18perdisk)
Materials(12,000disks $12perdisk)
Grossmargin
Ordering(40vendors $250pervendor)
Cataloging(20newtitles $100pertitle)
Deliveryandsupport(400deliveries $15perdelivery)
Billingandcollection(300customers $50percustomer)
OperatingIncome
Rateofreturnoninvestment($39,000 $300,000)

$216,000
144,000
72,000
10,000
2,000
6,000
15,000
$ 39,000
13.00%

3.
AfterEAsworkforcehasimplementedprocessimprovements,itsmonthlysupportcosts
are$31,500,asshownbelow.
Monthlysupportcostsafterprocessimprovements,May2009
Ordering(30vendors $200pervendor)
$ 6,000
Cataloging(15newtitles $100pertitle)
1,500
Deliveryandsupport(450deliveries $20perdelivery)
9,000
Billingandcollection(300customers $50percustomer)
15,000
Totalmonthlysupportcosts
$31,500
EA nowearns$6($18$12)gross marginperdisk.Suppose itneedstosellXgamedisksto
earnat least its15%targetrateofreturnon investmentof$300,000.ThenX needstobesuch
that:
$6X$31,500 >= $300,000 15%=$45,000
$6X >= $76,500
X >= $76,500 $6=12,750gamedisks
i.e.,EAmustnowsellatleast12,750gamediskspermonthtoearnitstargetrateofreturn on
investmentof15%.

1215

1228 (25min.) Costplus,targetpricing,workingbackward.

1. Inthefollowingtable,workbackwardsfromoperatingincometocalculatethesellingprice
Sellingprice
$
9.45 (plug)
Less:Variablecostperunit
2.50
Unitcontributionmargin
$
6.95
Numberofunitsproducedandsold 500,000units
Contributionmargin
$3,475,000
Less:Fixedcosts
3,250,000
Operatingincome
$ 225,000
a)Totalsalesrevenue=$9.45 500,000units=$4,725,000
b)Sellingprice=$9.45(fromabove)
Alternatively,
Operatingincome
$225,000
Addfixedcosts
3,250,000
Contributionmargin
3,475,000
Addvariablecosts($2.50500,000units)
1,250,000
Salesrevenue
$4,725,000
Salesrevenue $4, 725,000
Sellingprice=
=
=$9.45
Unitssold
500,000
Operatingincome
$225,000
=
c)Rateofreturnoninvestment=
=9%
Totalinvestmentinassets 2,500,000
d)Markup%onfullcost
Totalcost=($2.50 500,000units)+$3,250,000 = $4,500,000
$4,500,000
Unitcost =
=$9
500,000units
$9.45 -$9
Markup%=
=5%
$9
$4, 725,000 -$4,500,000
Or
=5%
$4,500,000
2.

3.

Newfixedcosts
Newvariablecosts
Newtotalcosts
Newtotalsales(5%markup)
Newsellingprice
Alternatively,
Newunitcost
Newsellingprice

= $3,250,000$250,000=$3,000,000
=$2.50$0.50=$2
=($2 500,000units)+$3,000,000=$4,000,000
=$4,000,000 1.05=$4,200,000
=$4,200,000500,000units=$8.40
=$4,000,000500,000units=$8
=$8 1.05=$8.40

Newunitssold=$500,00090%=$450,000units
Budgeted OperatingIncome
FortheyearendingDecember31,20xx
Revenues($8.40 450,000units)
Variablecosts($2.00 450,000units)
Contributionmargin
Fixedcosts
Operatingincome(loss)
1216

$3,780,000
900,000
2,880,000
3,000,000
$(120,000)

1229 (4045min.) Targetprices,targetcosts,valueengineering,costincurrence,locked

incost,activitybasedcosting.
1.
Old
CE100
Directmaterialscosts
$182,000
Directmanufacturinglaborcosts
28,000
Machiningcosts
31,500
Testingcosts
35,000
Reworkcosts
14,000
Orderingcosts
3,360
Engineeringcosts
21,140
Totalmanufacturingcosts
$315,000

CostChange
$2.20 7,000=$15,400less
$0.50 7,000=$3,500less
Unchangedbecausecapacitysame
(20% 2.5 7,000)$2=$7,000
(SeeNote1)
(SeeNote2)
Unchangedbecausecapacitysame

New
CE100
$166,600
24,500
31,500
28,000
5,600
2,100
21,140
$279,440

Note1:
10% of old CE100s are reworked. That is, 700 (10% of 7,000) CE100s made are reworked.
Reworkcosts=$20perunitreworked 700=$14,000.Ifreworkfallsto4%ofNewCE100s
manufactured,280(4%of7,000)NewCE100smanufacturedwill requirerework.Reworkcosts
=$20perunit 280=$5,600.
Note2:
OrderingcostsforNewCE100=2orders/month 50components $21/order
=$2,100
UnitmanufacturingcostsofNewCE100=$279,4407,000=$39.92
2.

Totalmanufacturingcostreductionsbasedonnewdesign

=$315,000 $279,440
=$35,560

Reductioninunitmanufacturingcostsbasedonnewdesign

=$35,5607,000
=$5.08perunit.

Thereductioninunitmanufacturingcostsbasedonthenewdesigncanalsobecalculatedas
Unitcostofolddesign,$45($315,0007,000units) Unitcostofnewdesign,$39.92=$5.08
Therefore,thetargetcostreductionof$6perunitisnotachievedbytheredesign.
3.
Changes in design have a considerably larger impact on costs per unit relative to
improvements in manufacturing efficiency ($5.08 versus $1.50). One explanation is that many
costs are locked in once the design of the radiocassette is completed. Improvements in
manufacturingefficiencycannotreducemanyofthesecosts.Designchoicescaninfluencemany
directandoverheadcostcategories, forexample,byreducingdirectmaterialsrequirements,by
reducing defects requiring rework, and by designing in fewer components that translate into
fewerordersplacedandlowerorderingcosts.

1217

1230 (25min.) Costplus,targetreturnoninvestmentpricing.

1. Targetoperatingincome=Returnoncapitalindollars=$13,000,000 10%=$1,300,000
2.
Revenues*
Variablecosts[($3.50+$1.50) 500,000cases
Contributionmargin
Fixedcosts($1,000,000+$700,000+$500,000)
Operatingincome(fromrequirement1)
*solvebackwardsforrevenues

$6,000,000
2,500,000
3,500,000
2,200,000
$1,300,000

$6,000, 000
= $12percase.
500, 000cases
Markup%onfullcost
Fullcost=$2,500,000+$2,200,000=$4,700,000
Unitcost=$4,700,000500,000cases=$9.40percase
$12$9.40
Markup%onfullcost=
= 27.66%
$9.40
Sellingprice=

3.
BudgetedOperatingIncome
For theyearendingDecember31,20xx
Revenues($14 475,000cases*)
$6,650,000
Variablecosts($5 475,000cases)
2,375,000
Contributionmargin
4,275,000
Fixedcosts
2,200,000
Operatingincome
$2,075,000
*Newunits=500,000cases 95%=475,000cases
Returnoninvestment=

$2,075, 000
= 15.96%
$13,000, 000

Yes, increasing the selling price is a good idea because operating income increases without
increasing investedcapital,whichresults ina higherreturnon investment.The newreturnon
investmentexceedsthe10%targetreturnoninvestment.

1218

1231 (20min.) Costplus,timeandmaterials.

1.
The different markup rates used by Mazzoli for direct materials and direct labor may
represent the approximate overheads (plus a profit margin) associated with each: for example,
direct materials would incur ordering and handling overhead, and direct labor would incur
overheadssuchas benefits, insurance,etc.,andthese maybeapproximately50%and100%of
costs.Thesemarkupscouldalsobedrivenbyindustrypracticeandcompetitivefactors.
2.
Asshown inthetable below,Bariesswilltell Whitethatshewill havetopay$270get
theclutchplaterepairedand$390togetitreplaced.
COST
Repairoption(3.5hrs. $30perhr.$40)
Replaceoption(1.5hrs. $30perhr.$200)

Labor Materials Total Cost

$105
$ 40
$145
45
200
245

PRICE(100%markuponlaborcost50%
markuponmaterials)
Repairoption($105 2$40 1.5)
Replaceoption($45 2$200 1.5)

Labor Materials TotalPrice

$210
$ 60
$270
90
300
390

3.
Iftherepairandreplaceoptionsareequallysafeandeffective,Whitewillchoosetoget
theclutchplaterepairedfor$270(ratherthanspend$390onareplacementplate).
4.
MazzoliBrotherswillearnagreatercontribution towardoverhead inthereplaceoption
($145=$390$245)thanintherepairoption($125=$270$145).IfweassumethatMazzoli
Brothersearnsaconstantprofitmarginoneachjob,itwillearnalargerprofitbyreplacingthe
clutch plate on Johanna Whites car for $390than by repairing it for $270.Therefore, Bariess
willrecommendthereplaceoptiontoWhite,whichisnottheoneshewouldprefer.Recognizing
thisconflict,BariessmayevenpresentonlythereplaceoptiontoJohannaWhite,orsuggestthat
therepairoptionwillresultinalessthansafecar.Ofcourse,herunstheriskofWhitewalking
away and thinking of other options (at which point, he could present the repair option as a
compromise).TheproblemisthatBariesshassuperiorinformationabouttherepairsneededbut
hisincentivesmaycausehimtonotrevealhisinformationandinsteaduseittohisadvantage.It
is only the sellers desire to build a reputation, to have a longterm relationship with the
customer,andtohavethecustomerrecommendthesellertootherpotentialbuyersoftheservice
thatencouragesanhonestdiscussionoftheoptions.

1219

1232 (25min.) Costplusandmarketbasedpricing.

1.

CaliforniaTempsfullcostperhour ofsupplyingcontractlaboris
Variablecosts
Fixedcosts($240,00080,000hours)
Fullcostperhour

$12
3
$15

Priceperhouratfullcostplus20%=$15 1.20=$18perhour.
2.

Contributionmarginsfordifferentpricesanddemandrealizationsareasfollows:

PriceperHour
(1)
$16
17
18
19
20

VariableCost
perHour
(2)
$12
12
12
12
12

Contribution
Marginper
Hour
(3)= (1) (2)
$4
5
6
7
8

Demandin
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,irrelevantsincetheydonotdifferamongthealternatives.
The table above indicates that California Temps can maximize contribution margin
($500,000) andoperatingincomebychargingapriceof$17perhour.
3.
Thecostplusapproachtopricinginrequirement1doesnotexplicitlyconsidertheeffect
ofpricesondemand.Theapproach inrequirement2 modelsthe interaction betweenprice and
demand and determines the optimal level of profitability using concepts of relevant costs. The
two different approaches lead to two different prices in requirements 1 and 2. As the chapter
describes,pricingdecisionsshouldconsiderbothdemandormarketconsiderationsandsupplyor
cost factors. The approach in requirement 2 is the more balanced approach. In most cases, of
course,managersusethecostplusmethodofrequirement1asonlyastartingpoint.Theythen
modifythecostpluspriceonthebasisofmarketconsiderationsanticipatedcustomerreaction
toalternativepricelevelsandthepriceschargedbycompetitorsforsimilarproducts.

1220

1233 Costplusandmarketbasedpricing.
1. Singlerate=

$1, 262, 460

= $11.91pertestinghour
106,000testinghours

Billingrate=$11.91 1.45=$17.27
2. Laborandsupervision=

$491,840
=$4.64pertesthour
106,000testhours

Setupandfacilitycosts=

Utilities=

$402,620
=$503.275persetuphour
800setuphours

$368,000
=$36.80per MH
10,000MH

3.

Laborandsupervision(60%,40%)
Setupandfacilitycost(25%,75%)
Utilities(50%,50%)
Totalcost
Numberoftestinghours(TH)1
Costpertestinghour
Markup
Billingratepertestinghour

HTT
$295,104
100,655
184,000
$579,759
63,600TH
$ 9.12perTH
1.45
$ 13.22perTH

ACT
$196,736
301,965
184,000
$682,701
42,400TH
$ 16.10perTH
1.45
$ 23.35perTH

Total
$ 491,840
402,620
368,000
$1,262,460

106,000testinghours 60%=63,600TH106,000testinghours 40%=42,400TH

Thebillingratesbasedontheactivitybasedcoststructuremakemoresense.Thesebillingrates
reflectthewaysthetestingproceduresconsumethefirmsresources.
4. Tostaycompetitive,BestTestneedstobemoreefficientinarctictesting.Roughly44%of
301,965
=44%)occursinsetupsandfacilitycosts.Perhapsthesetup
arctictestingstotalcost(
682,701
activitycanberedesignedtoachievecostsavings.

1221

1234 (2530min.) Lifecyclecosting.

1.
ProjectedLifeCycleIncomeStatement
Revenues[$500 (16,000+4,800)]
Variablecosts:
Production[$225 (16,000+4,800)]
Distribution[($20 16,000)+($22 4,800)]
Contributionmargin
Fixedcosts:
Designcosts
Production ($9,000 48mos.)
Marketing[($3,000 32mos.)+($1,000 16mos.)]
Distribution[($2,000 32mos.)+($1,000 16mos.)]
Lifecycleoperatingincome
Averageprofitperdesk=

$10,400,000
4,680,000
425,600
5,294,400
700,000
432,000
112,000
80,000
$ 3,970,400

$3,970, 400
= $190.88
(16,000 +4,800)

2.
ProjectedLifeCycleIncomeStatement
Revenues($400 16,000)
Variablecosts:
Production ($225 16,000)
Distribution ($20 16,000)
Contributionmargin
Fixedcosts:
Designcosts
Production ($9,000 32mos.)
Marketing($3,000 32mos.)
Distribution ($2,000 32mos.)
Lifecycleoperatingincome

$6,400,000
3,600,000
320,000
2,480,000
700,000
288,000
96,000
64,000
$1,332,000

ThenewdeskdesignisstillprofitableevenifFFMdropstheproductafteronly32monthsof
$1,332,000
production.However, theoperatingincomeperunitfallstoonly$83.25 (
)perdesk.
16,000desks
3.
Lifecycleoperatingincome(requirement2)
Additionalfixedproductioncosts($9,000 16mos.)
Revisedlifecycleoperatingincome

$1,332,000
144,000
$1,188,000

No,theanswerdoesnotchangeevenifFFMcontinuestoincurthefixedproductioncostsforthe
full48months.Therevisedoperatingincomeforthenewexecutivedeskbecomes$1,188,000,
$1,188,000
whichtranslatesinto$74.25(
)operatingincomeperdesk.
16,000desks
1222

1235 (30min.) Airlinepricing,considerationsotherthancostinpricing.

1.

Ifthefareis$500,
a. AirAmericowouldexpecttohave200businessand100pleasuretravelers.
b. Variablecostsperpassengerwouldbe$80.
c. Contributionmarginperpassenger=$500$80=$420.
Ifthefareis$2,000,
a. AirAmericowouldexpecttohave190businessand20pleasuretravelers.
b. Variablecostsperpassengerwouldbe$180.
c. Contributionmarginperpassenger=$2,000 $180=$1,820.

Contribution margin from businesstravelers atpricesof$500 and$2,000,respectively,

follow:
Atapriceof$500:$420200passengers
=$84,000
Atapriceof$2,000:$1,820190passengers
=$345,800
Air Americo would maximize contribution margin and operating income by charging
businesstravelersafareof$2,000.
Contribution margin from pleasure travelers at prices of $500 and $2,000, respectively,
follow:
Atapriceof$500:$420100passengers
=$42,000
Atapriceof$2,000:$1,82020passengers
=$36,400
Air Americo would maximize contribution margin and operating income by charging
pleasure travelers a fare of $500. Air Americo would maximize contribution margin and
operatingincomebyapricedifferentiationstrategy,wherebusinesstravelersarecharged$2,000
andpleasuretravelers$500.
In deciding between the alternative prices, all other costs such as fuel costs, allocated
annual lease costs, allocated ground services costs, and allocated flight crew salaries are
irrelevant. Why? Because these costs will not change whatever price Air Americo chooses to
charge.
2.
Theelasticityofdemandofthetwoclassesofpassengersdrivesthedifferentdemandsof
the travelers. Business travelers are relatively price insensitive because they must get to their
destinationduringtheweek(exclusiveofweekends)andtheirfaresarepaidbytheircompanies.
A 300% increase in fares from $500 to $2,000 will deter only 5% of the business passengers
fromflyingwithAirAmerico.
Incontrast,asimilarfareincreasewillleadtoan80%dropinpleasuretravelerswhoare
paying for their own travels, unlike business travelers, and who may have alternative vacation
planstheycouldpursueinstead.
3.
Since business travelers often want to return within the same week, while pleasure
travelersoftenstayoverweekends,arequirementthataSaturdaynightstayisneededtoqualify
for the $500 discount fare would discriminate between the passenger categories. This price
discrimination is legal because airlines are service companies rather than manufacturing
companiesandbecausethesepracticesdonot,noraretheyintendedto,destroycompetition.
1223

1236 (25min.) Ethicsandpricing.

1.Bakerpricesatfullproductcostsplusamarkupof10%=$80,000+10%of $80,000=$80,000+$8,000=$88,000.

2.

Theincrementalcostsoftheorderareasfollows:
Directmaterials
$40,000
Directmanufacturinglabor
10,000
30%ofoverheadcosts(30%$30,000) 9,000
Incrementalcosts
$59,000

Anybidabove$59,000willgenerateapositivecontributionmarginforBaker.Bakermayprefertouse
full product costs because it regards the new ballbearings order as a longterm business relationship
rather than a special order. For longrun pricing decisions, managers prefer to use full product costs
becauseitindicatesthebareminimumcoststheyneedtorecovertocontinueinbusinessratherthanshut
down.Forabusinesstobeprofitable inthe longrun, it needstorecoverboth itsvariable and its fixed
product costs. Using only variable costs may tempt the manager to engage in excessive longrun price
cuttingaslongaspricesgiveapositivecontributionmargin.Usingfullproductcostsforpricingthereby
promptspricestability.
3.
Not using full product costs (including an allocation of fixed overhead) to price the order,
particularlyifitisindirectcontradictionofcompanypolicy,maybeunethical.Inassessingthesituation,
thespecificStandardsofEthicalConductforManagementAccountants,describedinChapter1(p.16),
that themanagementaccountantshouldconsiderarelistedbelow.
Competence
Clearreportsusingrelevantandreliableinformationshouldbeprepared.Reportspreparedonthebasisof
excluding certain fixed costs that should be included would violate the management accountants
responsibilityforcompetence.ItisunethicalforLazarustosuggestthatDeckerchangethecostnumbers
that were prepared for the bearings order and for Decker to change the numbers in order to make
Lazarussperformancelookgood.
Integrity
The management accountant has a responsibility to avoid actual or apparent conflicts of interest and
adviseallappropriatepartiesofanypotentialconflict.LazarussmotivationforwantingDeckertoreduce
costs was precisely to earn a larger bonus. This action could be viewed as violating the standard for
integrity. The Standards of Ethical Conduct require the management accountant to communicate
favorable as well as unfavorable information. In this regard, both Lazaruss and Deckers behavior (if
Deckeragreestoreducethecostoftheorder)couldbeviewedasunethical.
Credibility
TheStandardsofEthicalConductforManagementAccountantsrequirethatinformationshouldbefairly
andobjectivelycommunicatedandthatallrelevantinformationshouldbedisclosed.Fromamanagement
accountantsstandpoint,reducingfixedoverheadcostsindecidingonthepricetobidareclearlyviolating
bothoftheseprecepts.Forthereasonscitedabove,thebehaviordescribedbyLazarusandDecker(ifhe
goesalongwithLazarusswishes)isunethical.
Decker should indicate to Lazarus that the costs were correctly computed and that determining
prices on the basis of full product costs plus a markup of 10% are required by company policy. If
Lazarusstill insistson makingthechangesandreducingthecostsoftheorder,Deckershouldraisethe
matterwithLazarusssuperior.If,aftertakingallthesesteps,thereiscontinuedpressuretounderstatethe
costs,Deckershouldconsiderresigningfromthecompany,ratherthanengaginginunethicalbehavior.
1224

1237 (30min.) Targetprices,targetcosts,valueengineering.

1.
Directmaterials
Directmanufacturinglabor($15perhr. 0.5hr.)
$14 25,000hrs.
)
Engineering (
50,000units
Testing($12perhr. 0.25hr.)
FullcostperunitofTX40
2.Markup%=

$14.98
7.50
7.00
3.00
$32.48

$40.60 -$32.48
=25%
$32.48

3. Thesenewunitswillrequiredirectcostsandtesting,butnoadditional engineeringsince
therewillbenoincrementalR&Danddesign coststoproduce10,000moreunits.
Incrementalrevenues
Directcosts($14.98+$7.50)
Testingcosts
Contributionmargin
Increaseinunitssold
Increasedcontributionmargin
Less:Advertisingcosts
Operatingincome(loss)

$40.60
22.48
3.00
$15.12
10,000 units
$151,200
(200,000)
$ (48,800)

No, theincreasein unitssoldareinsufficienttocovertheextraadvertisingcostsand

incrementalcostsofproduction.Averywillincuranoperatinglossontheseextraunitsand
shouldnotpursuethisstrategy.
4.
Directcosts($22.48 60,000units)
Engineering($14 25,000hrs.)
Testing($3 60,000units)
Advertising
FullcostofTX40
Dividebynumberofunits
FullcostperunitofTX40
Markup
Newsellingprice

$1,348,800
350,000
180,000
200,000
$2,078,800
60,000units
$34.65
1.25
$43.31

1225