Select solutions to Chapter 15
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.
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.
PROBLEM 15-38 (45 MINUTES)
1. The order will boost Heartland’s net income by $13,950, as the following calculations show.
Sales revenue... $82,500
Less: Sales commissions (10%)... 8,250 $74,250 Less manufacturing costs:
Direct material... $14,600 Direct labor... 28,000 Variable manufacturing overhead*... 8,400
Total manufacturing costs 51,000
Income before taxes... $ 23,250 Income 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... $63,500
Less: Sales commissions (10%)... 6,350 $57,150 Less manufacturing costs:
Direct material $14,600
Direct labor 28,000
Variable manufacturing overhead 8,400
Total manufacturing costs……… 51,000
Income before taxes... $ 6,150 Income 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.
PROBLEM 15-39 (30 MINUTES) 1. (a) Time charges:
Hourly labor cost +
hours labor annual storage) and handling material (excluding overhead annual
+ coverhourlyprofitchargemagin to
= $20.00 + $135,00012,000 + $5.00 = $36.25 per labor hour (b) Material charges:
used
materials
of
cost
annual
costs
storage
and
handling
l
materia
job
on
incurred
cost
material
job
on
incurred
cost
Material
= $312,500 $31,250 job on incurred cost material job on incurred cost Material 2. PRICE QUOTATIONTime charges: Labor time ...400 hours
Rate ... $36.25 per hour Total ...$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 ...$14,500 Material ... 82,500 Total ...$97,000
*Charge for material handling and storage):
PROBLEM 15-39 (CONTINUED)
3. Price of job without markup on material costs (from requirement 2) .... $ 97,000 Markup on total material costs ($82,500 10%) ... 8,250 Total price of job ... $105,250
PROBLEM 15-40 (25 MINUTES)
1. Direct-labor hours (DLH) required for job = 1,000,0002,000dosesdoses/DLH to be packaged = 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 = total traceabl1,000,000eout-dosesof-pocketcosts
= 1,000,000$16,000 = $.016
2. As in requirement (1), 500 direct-labor hours are required for the job.
Direct labor ($16.00 500) ... $ 8,000 Variable overhead ($12.00 500) ... 6,000 Fixed overhead ($20.00 500) ... 10,000 Administrative cost ... 2,000 Total cost ... $26,000 Maximum allowable return (15%) ... 3,900 Total bid price ... $29,900
PROBLEM 15-40 (CONTINUED)
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.
PROBLEM 15-43 (30 MINUTES)
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.) ... $18.00 Direct labor (.25 hrs. @ $14.00 per hr.) ... 3.50 Machine time ($20.00 per blanket) ... 20.00 Variable overhead (.25 hrs. @ $6.00 per hr.) ... 1.50 Administrative costs ($5,000 ÷ 1,000) ... 5 .00 Minimum bid price ... .00$48
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) ... $48.00 Fixed overhead (.25 hrs. @ $16.00 per hr.) ... 4 .00 Subtotal ... $52.00 Allowable return (.15 $52.00) ... 7 .80 Bid price ... .80$59
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.
PROBLEM 15-44 (25 MINUTES)
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.
PROBLEM 15-46 (50 MINUTES) 1. Budgeted overhead costs:
Department I Department II Variable overhead Department I: 37,500 $12 ...$450,000 Department II: 37,500 $6 ... $ 225,000 Fixed overhead ... 225,000 225,000 Total overhead ...$675,000 $ 450,000
Total budgeted overhead for both departments ($675,000 + $450,000)
... $1,125,000 Total expected direct-labor hours for
both departments (37,500 + 37,500)
... 75,000
Predetermined overhead rate = budgetedbudgeteddirectoverhead-laborhours
= $1,125,00075,000
= $15.00 per direct-labor hour
2. Standard Deluxe Total cost ...$600.00 $750.00 Markup (15% of cost) Standard: $600 .15 ... 90.00 Deluxe: $750 .15 ...______ 112.50 Price ...$690.00 $862.50 3. Department I Department II
Budgeted overhead (from requirement 1)...$675,000 $450,000 Budgeted direct-labor hours ... 37,500 37,500
Calculation of predetermined overhead rate ...$37675,500,000 $37450,500,000
PROBLEM 15-46 (CONTINUED) 4. Standard Deluxe Direct material ...$240 $390 Direct labor ...210 210 Manufacturing 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 Deluxe
Total cost (from requirement 4)...$582.00 $768.00 Markup (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.
PROBLEM 15-47 (35 MINUTES)
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
PROBLEM 15-47 (CONTINUED)
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…………... $228.00
Less: Current
cost………...
192.00 Cost of additional features………… $ 36.00 1—Add cabinet
doors………. $ 18.00
2—New appearance for table top… 12.75 Subtotal……… … $ 30.75 4—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.
