To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 12 PRICING DECISIONS AND COST MANAGEMENT 12-1 The three major influences on pricing decisions are Customers Competitors Costs 12-2 Not necessarily For a one-time-only special order, the relevant costs are only those costs that will change as a result of accepting the order In this case, full product costs will rarely be relevant It is more likely that full product costs will be relevant costs for long-run pricing decisions 12-3 Two examples of pricing decisions with a short-run focus: Pricing for a one-time-only special order with no long-term implications Adjusting product mix and volume in a competitive market 12-4 Activity-based costing helps managers in pricing decisions in two ways It gives managers more accurate product-cost information for making pricing decisions It helps managers to manage costs during value engineering by identifying the cost impact of eliminating, reducing, or changing various activities 12-5 Two alternative starting points for long-run pricing decisions are Market-based pricing, an important form of which is target pricing The market-based approach asks, ―Given what our customers want and how our competitors will react to what we do, what price should we charge?‖ Cost-based 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?‖ 12-6 A target cost per unit is the estimated long-run cost per unit of a product (or service) that, when sold at the target price, enables the company to achieve the targeted operating income per unit 12-7 Value engineering is a systematic evaluation of all aspects of the value-chain 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 companies use to achieve target costs per unit 12-8 A value-added 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 nonvalue-added cost is a cost that customers not perceive as adding value, or utility, to a product or service Examples of nonvalue-added costs are costs of rework, scrap, expediting, and breakdown maintenance 12-9 No It is important to distinguish between when costs are locked in and when costs are incurred, because it is difficult to alter or reduce costs that have already been locked in 12-1 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-10 Cost-plus pricing is a pricing approach in which managers add a markup to cost in order to determine price 12-11 Cost-plus pricing methods vary depending on the bases used to calculate prices Examples are (a) variable manufacturing costs; (b) manufacturing function costs; (c) variable product costs; and (d) full product costs 12-12 Two examples where the difference in the costs of two products or services is much smaller than the differences in their prices follow: 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 The difference in costs for an airplane seat sold to a passenger traveling on business or a passenger traveling for pleasure is roughly the same However, airline companies routinely charge business travelers––those who are likely to start and complete their travel during the same week excluding the weekend––a much higher price than pleasure travelers who generally stay at their destinations over at least one weekend 12-13 Life-cycle budgeting is an estimate of the revenues and costs attributable to each product from its initial R&D to its final customer servicing and support 12-14 Three benefits of using a product life-cycle reporting format are: The full set of revenues and costs associated with each product becomes more visible Differences among products in the percentage of total costs committed at early stages in the life cycle are highlighted Interrelationships among business function cost categories are highlighted 12-15 Predatory pricing occurs when a business deliberately prices below its costs in an effort to drive competitors out of the market and restrict supply, and then raises prices rather than enlarge demand Under U.S laws, dumping occurs when a non-U.S company sells a product in the United States at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the United States Collusive pricing occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade 12-2 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-16 (20–30 min.) Relevant-cost approach to pricing decisions, special order Relevant revenues, $3.80 1,000 Relevant costs Direct materials, $1.50 1,000 Direct manufacturing labor, $0.80 1,000 Variable manufacturing overhead, $0.70 1,000 Variable selling costs, 0.05 $3,800 Total relevant costs Increase in operating income $3,800 $1,500 800 700 190 3,190 $ 610 This calculation assumes that: a The monthly fixed manufacturing overhead of $150,000 and $65,000 of monthly fixed marketing costs will be unchanged by acceptance of the 1,000 unit order b The price charged and the volumes sold to other customers are not affected by the special order Chapter 12 uses the phrase ―one-time-only special order‖ to describe this special case The president’s reasoning is defective on at least two counts: a The inclusion of irrelevant costs––assuming the monthly fixed manufacturing overhead of $150,000 will be unchanged; it is irrelevant to the decision b The exclusion of relevant costs––variable selling costs (5% of the selling price) are excluded Key issues are: a Will the existing customer base demand price reductions? If this 1,000-tape order is not independent of other sales, cutting the price from $5.00 to $3.80 can have a large negative effect on total revenues b Is the 1,000-tape order a one-time-only order, or is there the possibility of sales in subsequent months? The fact that the customer is not in Dill Company’s ―normal marketing channels‖ does not necessarily mean it is a one-time-only order Indeed, the sale could well open a new marketing channel Dill Company should be reluctant to consider only short-run variable costs for pricing long-run business 12-3 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-17 (20–30 min.) Relevant-cost approach to short-run pricing decisions Analysis of special order: Sales, 3,000 units $80 Variable costs: Direct materials, 3,000 units $35 Direct manufacturing labor, 3,000 units $10 Variable manufacturing overhead, 3,000 units Other variable costs, 3,000 units $5 Sales commission Total variable costs Contribution margin $240,000 $5 $105,000 30,000 15,000 15,000 6,000 171,000 $ 69,000 Note that the variable costs, except for commissions, are affected by production volume, not sales dollars If the special order is accepted, operating income would be $1,000,000 + $69,000 = $1,069,000 Whether McMahon’s decision to quote full price is correct depends on many factors He is incorrect if the capacity would otherwise be idle and if his objective is to increase operating income in the short run If the offer is rejected, San Carlos, in effect, is willing to invest $69,000 in immediate gains forgone (an opportunity cost) to preserve the long-run selling-price structure McMahon is correct if he thinks future competition or future price concessions to customers will hurt San Carlos’s operating income by more than $69,000 There is also the possibility that Abrams could become a long-term customer In this case, is a price that covers only short-run variable costs adequate? Would Holtz be willing to accept a $6,000 sales commission (as distinguished from her regular $36,000 = 15% $240,000) for every Abrams order of this size if Abrams becomes a long-term customer? 12-4 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-18 (15-20 min.) Short-run pricing, capacity constraints Per kilogram of hard cheese: Milk (10 liters $1.50 per liter) Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing cost allocated Total manufacturing cost $15 $29 If Vermont Hills can get all the Holstein milk it needs, and has sufficient production capacity, then, the minimum price per kilo it should charge for the hard cheese is the variable cost per kilo = $15+5+3 = $23 per kilo If milk is in short supply, then each kilo of hard cheese displaces 2.5 kilos of soft cheese (10 liters of milk per kilo of hard cheese versus liters of milk per kilo of soft cheese) Then, for the hard cheese, the minimum price Vermont should charge is the variable cost per kilo of hard cheese plus the contribution margin from 2.5 kilos of soft cheese, or, $23 + (2.5 $8 per kilo) = $43 per kilo That is, if milk is in short supply, Vermont should not agree to produce any hard cheese unless the buyer is willing to pay at least $43 per kilo 12-19 (25–30 min.) Value-added, nonvalue-added costs Category Value-added costs Nonvalue-added costs Gray area Examples a Materials and labor for regular repairs b Rework costs c Expediting costs caused by work delays g Breakdown maintenance of equipment Total d Materials handling costs e Materials procurement and inspection costs f Preventive maintenance of equipment Total $ 800,000 $ 75,000 60,000 55,000 $190,000 $ 50,000 35,000 15,000 $100,000 Classifications of value-added, nonvalue-added, and gray area costs are often not clear-cut Other classifications of some of the cost categories are also plausible For example, some students may include materials handling, materials procurement, and inspection costs and preventive maintenance as value-added costs (costs that customers perceive as adding value and as being necessary for good repair service) rather than as in the gray area Preventive maintenance, for instance, might be regarded as value-added because it helps prevent nonvalueadding breakdown maintenance 12-5 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Total costs in the gray area are $100,000 Of this, we assume 65%, or $65,000, are value-added and 35%, or $35,000, are nonvalue-added Total value-added costs: $800,000 + $65,000 $ 865,000 Total nonvalue-added costs: $190,000 + $35,000 225,000 Total costs $1,090,000 Nonvalue-added costs are $225,000 ÷ $1,090,000 = 20.64% of total costs Value-added costs are $865,000 ÷ $1,090,000 = 79.36% of total costs Program (a) Quality improvement programs to • reduce rework costs by 75% (0.75 $75,000) • reduce expediting costs by 75% (0.75 $60,000) • reduce materials and labor costs by 5% (0.05 $800,000) Total effect (b) Working with suppliers to • reduce materials procurement and inspection costs by 20% (0.20 $35,000) • reduce materials handling costs by 25% (0.25 $50,000) Total effect Transferring 65% of gray area costs (0.65 $19,500 = $12,675) as value-added and 35% (0.35 $19,500 = $6,825) as nonvalue-added Effect on value-added and nonvalue-added costs (c) Maintenance programs to • increase preventive maintenance costs by 50% (0.50 $15,000) • decrease breakdown maintenance costs by 40% (0.40 $55,000) Total effect Transferring 65% of gray area costs (0.65 $7,500 = $4,875) as value-added and 35% (0.35 $7,500 = $2,625) as nonvalue-added Effect on value-added and nonvalue-added costs Total effect of all programs Value-added and nonvalue-added costs calculated in requirement Expected value-added and nonvalue-added costs as a result of implementing these programs Effect on Costs Classified as ValueNonvalueGray Added Added Area –$56,250 – 45,000 –$ 40,000 –$ 40,000 –$101,250 –$7,000 –12,500 –19,500 –$ 12,675 –$ 12,675 – $ 6,825 – $6,825 + 19,500 $ +$7,500 – $22,000 – 22,000 +$ 4,875 +$ 4,875 – $ 47,800 + 2,625 – $19,375 –$127,450 865,000 225,000 $817,200 $ 97,550 + $7,500 $ – 7,500 If these programs are implemented in 2007, total costs would decrease from $1,090,000 (requirement 2) to $817,200 + $97,550 = $914,750, and the percentage of nonvalue-added costs would decrease from 20.64% (requirement 2) to $97,550 ÷ 914,750 = 10.66% These are significant improvements in Marino’s performance 12-6 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-20 (25 30 min.) Target operating income, value-added costs, service company The classification of total costs in 2007 into value-added, nonvalue-added, or in the gray area in between follows: Value Gray NonvalueTotal Added Area added (4) = (1) (2) (3) (1)+(2)+(3) Doing calculations and preparing drawings 75% × $400,000 $300,000 $300,000 Checking calculations and drawings 4% × $400,000 $16,000 16,000 Correcting errors found in drawings 7% × $400,000 $28,000 28,000 Making changes in response to client requests 6% × $400,000 24,000 24,000 Correcting errors to meet government building code, 8% × $400,000 32,000 32,000 Total professional labor costs 324,000 16,000 60,000 400,000 Administrative and support costs at 40% ($160,000 ÷ $400,000) of professional labor costs 129,600 6,400 24,000 160,000 Travel 18,000 — 18,000 Total $471,600 $22,400 $84,000 $578,000 Doing calculations and responding to client requests for changes are value-added costs because customers perceive these costs as necessary for the service of preparing architectural drawings Costs incurred on correcting errors in drawings and making changes because they were inconsistent with building codes are nonvalue-added costs Customers not perceive these costs as necessary and would be unwilling to pay for them Carasco should seek to eliminate these costs by making sure that all associates are well-informed regarding building code requirements and by training associates to improve the quality of their drawings Checking calculations and drawings is in the gray area (some, but not all, checking may be needed) There is room for disagreement on these classifications For example, checking calculations may be regarded as value added Reduction in professional labor-hours by a Correcting errors in drawings (7% × 8,000) b Correcting errors to conform to building code (8% × 8,000) Total Cost savings in professional labor costs (1,200 hours × $50) Cost savings in variable administrative and support costs (40% × $60,000) Total cost savings Current operating income in 2007 Add cost savings from eliminating errors Operating income in 2007 if errors eliminated 12-7 560 hours 640 hours 1,200 hours $ 60,000 24,000 $ 84,000 $102,000 84,000 $186,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Currently 85% × 8,000 hours = 6,800 hours are billed to clients generating revenues of $680,000 The remaining 15% of professional labor-hours (15% × 8,000 = 1,200 hours) is lost in making corrections Carasco bills clients at the rate of $680,000 ÷ 6,800 = $100 per professional labor-hour If the 1,200 professional labor-hours currently not being billed to clients were billed to clients, Carasco’s revenues would increase by 1,200 hours × $100 = $120,000 from $680,000 to $800,000 Costs remain unchanged Professional labor costs Administrative and support (40% × $400,000) Travel Total costs Carasco’s operating income would be Revenues Total costs Operating income 12-8 $400,000 160,000 18,000 $578,000 $800,000 578,000 $222,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-21 (25–30 min.) Target prices, target costs, activity-based costing Snappy’s operating income in 2006 is as follows: Total for 250,000 Tiles Per Unit (1) (2) = (1) ÷ 250,000 $1,000,000 $4.00 750,000 3.00 25,000 0.10 120,000 0.48 60,000 0.24 955,000 3.82 $ 45,000 $0.18 Revenues ($4 250,000) Purchase cost of tiles ($3 250,000) Ordering costs ($50 500) Receiving and storage ($30 4,000) Shipping ($40 1,500) Total costs Operating income Price to retailers in 2007 is 95% of 2006 price = 0.95 96% of 2006 cost = 0.96 $3 = $2.88 $4 = $3.80; cost per tile in 2007 is Snappy’s operating income in 2007 is as follows: Total for 250,000 Tiles (1) $ 950,000 720,000 25,000 120,000 60,000 925,000 $ 25,000 Revenues ($3.80 250,000) Purchase cost of tiles ($2.88 250,000) Ordering costs ($50 500) Receiving and storage ($30 4,000) Shipping ($40 1,500) Total costs Operating income Per Unit (2) = (1) ÷ 250,000 $3.80 2.88 0.10 0.48 0.24 3.70 $0.10 Snappy’s operating income in 2007, if it makes changes in ordering and material handling, will be as follows: Total for 250,000 Tiles Per Unit (1) (2) = (1) ÷ 250,000 $950,000 $3.80 Revenues ($3.80 250,000) 720,000 2.88 Purchase cost of tiles ($2.88 250,000) 5,000 0.02 Ordering costs ($25 200) 87,500 0.35 Receiving and storage ($28 3,125) 60,000 0.24 Shipping ($40 1,500) 872,500 3.49 Total costs $ 77,500 $0.31 Operating income Through better cost management, Snappy will be able to achieve its target operating income of $0.30 per tile despite the fact that its revenue per tile has decreased by $0.20 ($4.00 – $3.80), while its purchase cost per tile has decreased by only $0.12 ($3.00 – $2.88) 12-9 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-22 (20 min.) Target costs, effect of product-design changes on product costs and Manufacturing costs of HJ6 in 2006 and 2007 are as follows: 2006 Total (1) Direct materials, $1,200 × 3,500; $1,100 × 4,000 $4,200,000 Batch-level costs, $8,000 × 70; $7,500 × 80 560,000 Manuf operations costs, $55 × 21,000; $50 × 22,000 1,155,000 Engineering change costs, $12,000 × 14; $10,000 × 10 168,000 Total $6,083,000 Per Unit (2) = (1) ÷ 3,500 $1,200 160 2007 Per Unit Total (4) = (3) (3) ÷ 4,000 $4,400,000 $1,100 600,000 150 330 1,100,000 275 48 $1,738 100,000 $6,200,000 25 $1,550 Target manufacturing cost Manufacturing cost per unit of HJ6 in 2007 = per unit in 2006 × 90% = $1,738 × 0.90 = $1,564.20 Actual manufacturing cost per unit of HJ6 in 2007 was $1,550 Hence, Medical Instruments did achieve its target manufacturing cost per unit of $1,564.20 To reduce the manufacturing cost per unit in 2007, Medical Instruments reduced the cost per unit in each of the four cost categories—direct materials costs, batch-level costs, manufacturing operations costs, and engineering change costs It also reduced machine-hours and number of engineering changes made—the quantities of the cost drivers In 2006, Medical Instruments used machine-hours per unit of HJ6 (21,000 machine-hours 3,500 units) In 2007, Medical Instruments used 5.5 machine-hours per unit of HJ6 (22,000 machine-hours 4,000 units) Medical Instruments reduced engineering changes from 14 in 2006 to 10 in 2007 Medical Instruments achieved these gains through value engineering activities that retained only those product features that customers wanted while eliminating nonvalue-added activities and costs 12-10 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com The following table presents the manufacturing cost per unit for different cost categories for P-81 REV and P-63 REV Cost Categories Direct manufacturing product costs: Direct materials Indirect manufacturing product costs: Materials handling (75 $0.80; 42 $0.80) Assembly management (2.0 $48; 1.5 $48) Machine insertion of parts (59 $0.75; 29 $0.75) Manual insertion of parts (16 $1.90; 13 $1.90) Quality testing (1.2 $35; 0.9 $35) Total indirect manufacturing costs Total manufacturing costs Target cost P-81 REV P-63 REV $385.00 $260.00 60.00 96.00 44.25 30.40 42.00 272.65 $657.65 $675.00 33.60 72.00 21.75 24.70 31.50 183.55 $443.55 $435.00 P-81 REV is $17.35 below its target cost However, P-63 REV is $8.55 above its target cost The $8 reduction in cost per hour of assembly time and the increased testing-hours per unit result in the following product costs: Cost Categories Direct manufacturing product costs: Direct materials Indirect manufacturing product costs: Materials handling (75 $0.80; 42 $0.80) Assembly management (2.0 $40; 1.5 $40) Machine insertion of parts (59 $0.75; 29 $0.75) Manual insertion of parts (16 $1.90; 13 $1.90) Quality testing (1.6 $35; 0.95 $35) Total indirect manufacturing costs Total manufacturing costs Target cost P-81 REV P-63 REV $385.00 $260.00 60.00 80.00 44.25 30.40 56.00 270.65 $655.65 $675.00 33.60 60.00 21.75 24.70 33.25 173.30 $433.30 $435.00 The reduction in the assembly management activity rate, despite the increase in testing time, further reduces the cost of P-81 REV below the target cost It also makes it more likely that P-63 REV will achieve its target cost Farnham should reduce the supervisory staff (In general, testing time is more of a value-added activity than is supervision – another reason to implement the change) 12-19 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-30 (40–45 min.) Target prices, target costs, value engineering, cost incurrence, lockedin cost, activity-based costing Direct materials costs Direct manufacturing labor costs Machining costs Testing costs Rework costs Ordering costs Engineering costs Total manufacturing costs Old CE100 $182,000 28,000 31,500 35,000 14,000 3,360 21,140 $315,000 Cost Change $2.20 7,000 = $15,400 less $0.50 7,000 = $3,500 less Unchanged because capacity same (20% 2.5 7,000) $2 = $7,000 (See Note 1) (See Note 2) Unchanged because capacity same New CE100 $166,600 24,500 31,500 28,000 5,600 2,100 21,140 $279,440 Note 1: 10% of old CE100s are reworked That is, 700 (10% of 7,000) CE100s made are reworked Rework costs = $20 per unit reworked 700 = $14,000 If rework falls to 4% of New CE100s manufactured, 280 (4% of 7,000) New CE100s manufactured will require rework Rework costs = $20 per unit 280 = $5,600 Note : Ordering costs for New CE100 = orders/month = $2,100 50 components $21/order Unit manufacturing costs of New CE100 = $279,440 ÷ 7,000 = $39.92 Total manufacturing cost reductions based on new design = $315,000 – $279,440 = $35,560 Reduction in unit manufacturing costs based on new design = $35,560 ÷ 7,000 = $5.08 per unit The reduction in unit manufacturing costs based on the new design can also be calculated as Unit cost of old design, $45 ($315,000 ÷ 7,000 units) – Unit cost of new design, $39.92 = $5.08 Therefore, the target cost reduction of $6 per unit is not achieved by the redesign Changes in design have a considerably larger impact on costs per unit relative to improvements in manufacturing efficiency ($5.08 versus $1.50) One explanation is that many costs are locked in once the design of the radio-cassette is completed Improvements in manufacturing efficiency cannot reduce many of these costs Design choices can influence many direct and overhead cost categories, for example, by reducing direct materials requirements, by reducing defects requiring rework, and by designing in fewer components that translate into fewer orders placed and lower ordering costs 12-20 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-31 (10 min.) Cost-plus pricing In bidding for Galliano’s order, Bryant should only consider incremental costs caused by the order These are the variable direct manufacturing labor cost, the variable overhead cost and the incremental administrative costs associated with the order Bryant should ask for a minimum of $22 per violin in order to recoup its incremental costs, as shown below: Variable dir mfg labor cost = 1,250a DMLH $60 per DMLH Variable overhead cost = 1,250 DMLH $20 per DMLH Incremental administrative costs Total incremental costs Minimum price per violin Bryant should bid = $110,000 a 5,000 violins $75,000 25,000 10,000 $110,000 5,000 = $22 violins per DMLH = 1,250 DMLH The $110,000 calculated in requirement includes the incremental administrative costs of Galliano’s order We only need to add the allocated fixed costs to arrive at full costs and use that to estimate Bryant’s bid price per violin: Total incremental costs (from requirement 1) Allocated fixed overhead = $50 per DMLH 1,250 DMLH Full cost of 5,000 violins Markup (20% of full cost) Total bid on Galliano’s order Bid price per violin = $207,000 5,000 violins $110,000 62,500 $172,500 34,500 $207,000 $41.40 Since a bid of $33 per violin will cover the incremental cost per violin of $22 and even provide a $11 contribution towards fixed costs, Bryant should consider putting in a bid at $33 But, if other orders are more profitable, then Bryant should not displace them—it should suggest to Galliano’s that it will assemble violins for them only up to the available excess capacity, and only if there is no opportunity cost of doing so Other factors to consider is whether producing the violins for Galliano’s at $33 apiece will cause other customers to be unwilling to pay more than $33, and put downward pressure on prices in general, and whether bidding on and winning this order from Galliano’s can lead to larger, more profitable orders from them 12-21 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-32 (20 min.) Cost-plus, time and materials The different markup rates used by Mazzoli for direct materials and direct labor may represent the approximate overheads (plus a profit margin) associated with each: for example, direct materials would incur ordering and handling overhead, and direct labor would incur overheads such as benefits, insurance, etc., and these may be approximately 50% and 100% of costs These markups could also be driven by industry practice and competitive factors As shown in the table below, Bariess will tell White that she will have to pay $270 get the clutch plate repaired and $390 to get it replaced COST Repair option (3.5 hrs $30 per hr.; $40) Replace option(1.5 hrs $30 per hr.; $200) Labor Materials Total cost $105 $40 $145 45 200 245 PRICE (100% markup on labor cost; 50% markup on materials) Repair option ($105 2; $40 1.5) Replace option ($45 2; $200 1.5) Labor Materials Total Price $210 $60 $270 90 300 390 If the repair and replace options are equally safe and effective, White will choose to get the clutch plate repaired for $270 (rather than spend $390 on a replacement plate) Mazzoli Brothers will earn a greater contribution toward overhead in the replace option ($145 = $390 – $245) than in the repair option ($125 = $270 – $145) If we assume that Mazzoli Brothers earns a constant profit margin on each job, it will earn a larger profit by replacing the clutch plate on Johanna White’s car for $390 than by repairing it for $270 Therefore, Bariess will recommend the replace option to White, which is not the one she would prefer Recognizing this conflict, Bariess may even present only the replace option to Johanna White, or suggest that the repair option will result in a less-than-safe car Of course, he runs the risk of White walking away and thinking of other options (at which point, he could present the repair option as a compromise) The problem is that Bariess has superior information about the repairs needed but his incentives may cause him to not reveal his information an instead use it to his advantage It is only the seller’s desire to build a reputation, to have a long-term relationship with the customer, and to have the customer recommend the seller to other potential buyers of the service that encourages an honest discussion of the options 12-22 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-33 (25 min.) Cost-plus and market-based pricing California Temps’ full cost per hour of supplying contract labor is Variable costs Fixed costs ($240,000 ÷ 80,000 hours) Full cost per hour Price per hour at full cost plus 20% = $15 $12 $15 1.20 = $18 per hour Contribution margins for different prices and demand realizations are as follows: Price per Hour (1) $16 17 18 19 20 Variable Cost per Hour (2) $12 12 12 12 12 Contribution Margin per Hour (3) = (1) – (2) $4 Demand in Hours (4) 120,000 100,000 80,000 70,000 60,000 Total Contribution (5) = (3) × (4) $480,000 500,000 480,000 490,000 480,000 Fixed costs will remain the same regardless of the demand realizations Fixed costs are, therefore, irrelevant since they not differ among the alternatives The table above indicates that California Temps can maximize contribution margin ($500,000) and operating income by charging a price of $17 per hour The cost-plus approach to pricing in requirement does not explicitly consider the effect of prices on demand The approach in requirement models the interaction between price and demand and determines the optimal level of profitability using concepts of relevant costs The two different approaches lead to two different prices in requirements and As the chapter describes, pricing decisions should consider both demand or market considerations and supply or cost factors The approach in requirement is the more balanced approach In most cases, of course, managers use the cost-plus method of requirement as only a starting point They then modify the cost-plus price on the basis of market considerations—anticipated customer reaction to alternative price levels and the prices charged by competitors for similar products 12-23 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-34 (60 min.) Cost-plus and market-based pricing Single pool: $1,262,460 106,000 hours = $11.91 per hour = Hourly billing rate = $11.91 per hour × 1.45 = $17.27 per billing hour See Solution Exhibit 12-34 SOLUTION EXHIBIT 12-34 HTT Test pool labor (.3, 2, 2, 1, 2) Supervision (.40, 15, 15, 15, 15) Equip depreciation Heat (.50, 05, 05, 30, 10) Electricity (.30, 10, 10, 40, 10) Water (.00, 00, 20, 20, 60) Set-up (.20, 15, 30, 15, 20) Indirect materials (.15, 15, 30, 20, 20) Operating supplies (.10, 10, 25, 20, 35) Total costs Total test-hours Hourly test-cost Hourly billing rate (hourly test-cost × 1.45) ATT SST ACT AQT Total $126,000 $ 84,000 $ 84,000 $ 42,000 $ 84,000 $ 420,000 28,800 48,230 10,800 22,000 10,800 39,230 10,800 32,000 10,800 37,000 72,000 178,460 85,000 8,500 8,500 51,000 17,000 170,000 37,200 12,400 12,400 49,600 12,400 124,000 0 14,800 14,800 44,400 74,000 11,600 8,700 17,400 8,700 11,600 58,000 15,600 15,600 31,200 20,800 20,800 104,000 6,200 6,200 15,500 12,400 21,700 62,000 $358,630 $168,200 $233,830 $242,100 29,680 $12.08 12,720 $13.22 27,560 $8.48 22,260 $10.88 13,780 $18.85 $17.52 $19.17 $12.30 $15.78 $27.33 12-24 $259,700 $1,262,460 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com The new costing method will have the following effects on the pricing structure for each of the five test types given the competitors’ hourly billing rates HTT ATT SST ACT AQT New hourly billing rate (hourly test-cost × 1.45) Competitor rate New rate over/(under) market Percent over/(under) market $17.52 $17.50 $ 02 0.1% $19.17 $19.00 $ 17 0.9% $12.30 $15.50 $(3.20) (20.6)% $15.78 $16.00 $ (.22) (1.4)% $27.33 $20.00 $ 7.33 36.7% Common pool rate New rate over/(under) old rate Percent over/(under) old rate $17.27 $0.25 1.4% $17.27 $1.90 11.0% $17.27 $(4.97) (28.8)% $17.27 $(1.49) (8.6)% $17.27 $10.06 58.3% Best Test will now be pricing all its lab tests more competitively in the market For Heat Testing (HTT), there is minimal variance between the common pool rate, the new separate rate, and the competitors’ rates The HTT rate could either be left at the old rate, or nominally raised to the competitors’ rates or new pool rate without much impact, depending upon how Best Test wanted to position the test compared to the competition For Air Turbulence Testing (ATT), the new separate computed billing rate is significantly different than the common pool rate as well as close to the competitors’ rates The same is true of Arctic Condition Testing (ACT) In both cases, Best Test would probably want to adjust billing rates (raise ATT rate and lower ACT rate) to the newly computed rates or competitors’ rates to better reflect resources consumed by the tests For Stress Testing (SST), the newly computed rate is dramatically less than both the common pool rate and the competitors’ rates Best Test would want to significantly reduce the price to at least meet the competitors’ price or reduce it further to the newly computed price, depending upon how aggressively it wanted to market this test For Aquatic Testing (AQT), the newly computed rate is significantly higher than both the common pool rate and the competitors’ rates Best Test would want to raise the billing rate at least to the competitors’ rates to recover its cost plus some contribution towards administrative costs Its current common billing rate of $17.27 is below the $18.85 cost to perform the AQT test Because the newly computed billing prices for both SST and AQT are significantly different than competitors’ prices, the cost assumptions should be further analyzed to verify accuracy and identify opportunities 12-25 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com In general, at least three other internal or external determinants of pricing structure include the number and nature of competitors for additional tests and their quality and timeliness of service company’s overall capacity and its ability to react to volume and mix changes for tests if the demand changes due to the new pricing structure number of potential customers, overall demand for the tests, and price elasticity of demand for the tests strategic focus, such as desire to gain or defend market share, long-term support for entry into or exit from a market, or stage in the test’s product life cycle (introduction, growth, mature, or dying) 12-35 (25–30 min.) Life-cycle costing The predicted total life-cycle costs and life-cycle operating incomes for GL1 and GL2 are shown in the last two rows of the table below Based on forecasted life-cycle operating incomes alone, Insight would choose GL1 Life-Cycle Costs and Operating Incomes for GL1 and GL2 GL1 $480 4,000 Selling price Sales quantity (over 4-year life-cycle) Lifecycle revenues ($480 per pkg 4,000 pkgs.) Lifecycle costs R&D Design Production ($100,000 + ($25/pkg 4,000 pkgs.)) Marketing ($70,000 + ($24/pkg 4,000 pkgs.); $90,000 + ($40/pkg 4,000 pkgs.)) Distribution ($50,000 + ($16/pkg 4,000 pkgs.); $80,000 + ($25/pkg 4,000 pkgs.)) Customer service ($80,000 + ($30/pkg 4,000 pkgs.); $100,000 + ($50/pkg 4,000 pkgs.)) Total life-cycle costs Life-cycle operating income 12-26 GL2 $480 4,000 $1,920,000 $1,920,000 240,000 160,000 200,000 150,000 75,000 200,000 166,000 250,000 114,000 180,000 200,000 300,000 1,080,000 1,155,000 $ 840,000 $ 765,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com R&D Design Production Marketing Distribution Customer service Total life-cycle costs Lifecycle Costs GL1 GL2 $240,000 $150,000 160,000 75,000 200,000 200,000 166,000 250,000 114,000 180,000 200,000 300,000 $1,080,000 $1,155,000 Percentage of Total Lifecycle Costs GL1 GL2 22% 13% 15 18 17 15 22 11 16 19 26 100% 100% The table above shows the life-cycle cost in each cost category, both in absolute terms and as a percentage of total life-cycle costs for each product We can see that GL1, with its emphasis on a robust implementation for many applications, incurs 22% of its life-cycle costs for R&D, and 56% (22% + 15% + 19%) of its life-cycle costs through the production phase For GL2, the lifecycle costs are more concentrated in the later stages of the value chain—customer supports costs are 26% of all costs and marketing, distribution and customer support together account for 64% (22% + 16% +26%) of life-cycle costs Insight would view GL1 as more risky—more of its life-cycle costs are incurred up-front, during years and 2, before a penny of revenue has been earned With GL2, Insight can have lower R&D and design costs, and can adjust its down-stream costs depending on market feedback With Jori Yellin’s short time horizon of 1-2 years, she is going to recommend that Insight produce GL2 which has lower R&D and design costs But if Insight’s sales and costs forecasts are accurate, we have seen from Requirement that producing and selling GL1 is in the best financial interests of the company Insight’s management should consider mitigating potential conflicts of interest such as these by possibly not ―charging‖ divisions for R&D and design Of course, then there would be potential for division managers to overspend on R&D, design and set-up; this would have to be addressed with a very tight budgeting system and a detailed understanding of all product development proposals from divisions Alternatively, Insight could charge divisions for R&D and design but evaluate these investments on a long-run basis rather than as part of the short-run income statements 12-27 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-36 (30 min.) Airline pricing, considerations other than cost in pricing If the fare is $500, a Air Americo would expect to have 200 business and 100 pleasure travelers b Variable costs per passenger would be $80 c Contribution margin per passenger = $500 – $80 = $420 If the fare is $2,000, a Air Americo would expect to have 190 business and 20 pleasure travelers b Variable costs per passenger would be $180 c Contribution margin per passenger = $2,000 – $180 = $1,820 Contribution margin from business travelers at prices of $500 and $2,000, respectively, follow: At a price of $500: $420 × 200 passengers At a price of $2,000: $1,820 × 190 passengers = $ 84,000 = $345,800 Air Americo would maximize contribution margin and operating income by charging business travelers a fare of $2,000 Contribution margin from pleasure travelers at prices of $500 and $2,000, respectively, follow: At a price of $500: $420 × 100 passengers At a price of $2,000: $1,820 × 20 passengers = $42,000 = $36,400 Air Americo would maximize contribution margin and operating income by charging pleasure travelers a fare of $500 Air Americo would maximize contribution margin and operating income by a price differentiation strategy, where business travelers are charged $2,000 and pleasure travelers $500 In deciding between the alternative prices, all other costs such as fuel costs, allocated annual lease costs, allocated ground services costs, and allocated flight crew salaries are irrelevant Why? Because these costs will not change whatever price Air Americo chooses to charge The elasticity of demand of the two classes of passengers drives the different demands of the travelers Business travelers are relatively price insensitive because they must get to their destination during the week (exclusive of weekends) and their fares are paid by their companies A 300% increase in fares from $500 to $2,000 will deter only 5% of the business passengers from flying with Air Americo In contrast, a similar fare increase will lead to an 80% drop in pleasure travelers who are paying for their own travels, unlike business travelers, and who may have alternative vacation plans they could pursue instead Since business travelers often want to return within the same week, while pleasure travelers often stay over weekends, a requirement that a Saturday night stay is needed to qualify for the $500 discount fare would discriminate between the passenger categories This price discrimination is legal because airlines are service companies rather than manufacturing companies and because these practices not, nor are they intended to, destroy competition 12-28 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12-37 (25 min.) Ethics and pricing Baker prices at full product costs plus a mark-up of 10% = $80,000 + 10% of $80,000 = $80,000 + $8,000 = $88,000 The incremental costs of the order are as follows: Direct materials $40,000 Direct manufacturing labor 10,000 30% of overhead costs (30% × $30,000) 9,000 Incremental costs $59,000 Any bid above $59,000 will generate a positive contribution margin for Baker Baker may prefer to use full product costs because it regards the new ball-bearings order as a long-term business relationship rather than a special order For long-run pricing decisions, managers prefer to use full product costs because it indicates the bare minimum costs they need to recover to continue in business rather than shut down For a business to be profitable in the long run, it needs to recover both its variable and its fixed product costs Using only variable costs may tempt the manager to engage in excessive long-run price cutting as long as prices give a positive contribution margin Using full product costs for pricing thereby prompts price stability Not using full product costs (including an allocation of fixed overhead) to price the order, particularly if it is in direct contradiction of company policy, may be unethical In assessing the situation, the specific ―Standards of Ethical Conduct for Management Accountants,‖ described in Chapter (p 16), that the management accountant should consider are listed below Competence Clear reports using relevant and reliable information should be prepared Reports prepared on the basis of excluding certain fixed costs that should be included would violate the management accountant’s responsibility for competence It is unethical for Lazarus to suggest that Decker change the cost numbers that were prepared for the bearings order and for Decker to change the numbers in order to make Lazarus’s performance look good Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict Lazarus’s motivation for wanting Decker to reduce costs was precisely to earn a larger bonus This action could be viewed as violating the standard for integrity The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information In this regard, both Lazarus’s and Decker’s behavior (if Decker agrees to reduce the cost of the order) could be viewed as unethical 12-29 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Objectivity The Standards of Ethical Conduct for Management Accountants require that information should be fairly and objectively communicated and that all relevant information should be disclosed From a management accountant’s standpoint, reducing fixed overhead costs in deciding on the price to bid are clearly violating both of these precepts For the reasons cited above, the behavior described by Lazarus and Decker (if he goes along with Lazarus’s wishes) is unethical Decker should indicate to Lazarus that the costs were correctly computed and that determining prices on the basis of full product costs plus a mark-up of 10% are required by company policy If Lazarus still insists on making the changes and reducing the costs of the order, Decker should raise the matter with Lazarus’s superior If, after taking all these steps, there is continued pressure to understate the costs, Decker should consider resigning from the company, rather than engaging in unethical behavior 12-38 (40 min.) Target prices, target costs, value engineering TX-40-1 50,000 output units Cost Category (1) Direct materials Direct manufacturing labor (DML) Direct machining (fixed) Setup Cost Driver (2) Number of kits DML hours Details of Cost Driver Quantities (3) (4) kit per output 50,000 output unit units 0.25 DML hours per output unit 50,000 output units Machinehours Setup-hours 12 setup-hours per batch Testing Testing-hours 2.5 testing-hours per output unit Engineering Engineeringhours a kit per output unit 50,000 output units 0.25 DMLH per output unit 50,000 output units c 12 setup hours per batch 100 batches d 2.5 testing-hours per output unit 50,000 output units b 12-30 100 batches 50,000 output units Total Quantity of Cost Driver (5) 50,000a Cost per Unit of Cost Driver (6) $ 17 12,500b $ 24 50,000 $ 1,200c $ 25 125,000d $ 1,700 $100 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Costs of TX-40-1 Cost Category Direct materials (50,000 kits $17 per kit) Direct manufacturing labor (12,500 DMLH $24 per DMLH) Direct machining (fixed) (50,000 mach hrs $3 per mach hr.) Setup (1,200 setup hrs $25 per setup hr.) Testing (125,000 testing hrs $2 per testing hr.) Engineering (1,700 engg hrs $100 per engg hr.) Total Full cost per unit = $1,750,000 50,000 = Mark-up on full product cost per unit of TX-40-1 = = The target price for TX-40-2 is $34.80 Suppose the target cost per unit of TX-40-2 is $X Then $X (1.16) = $34.80 That is $X = $34.80 = $30 1.16 Avery’s target cost per unit of TX-40-2 is $30 12-31 $ 850,000 300,000 150,000 30,000 250,000 170,000 $1,750,000 $35.00 Selling price Full product cost Full product cost $40.60 $35 $35 $5.60 16% $35 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com TX-40-2 50,000 output units Cost Category Cost Driver (1) Direct Materials (2) Number of kits (7) kit per output unit (8) 50,000 output units Direct manufacturing labor (DML) DML hours 0.25 DML hours per output unit 50,000 output units Direct machining (fixed) Setup Testing Engineering Details of Cost Driver Quantities Machinehours Setup-hours setup-hours per batch Testinghours testing-hours per output unit 100 batches 50,000 output units Engineeringhours Total Quantity of Cost Driver (9) 50,000a Cost per Unit of Cost Driver (10) $ 14 12,500b $ 21 50,000 $ 600c 100,000d 1,700 $ 25 $ $100 a kit per output unit 50,000 output units 0.25 DMLH per output unit 50,000 output units c set-up hours per batch 100 batches d testing-hours per output unit 50,000 output units b Costs of TX-40-2 Cost Category Direct materials (50,000 kits $14 per kit) Direct manufacturing labor (12,500 DMLH $21 per DMLH) Direct machining (fixed) (50,000 mach hrs $3 per mach hr.) Setup (600 setup hrs $25 per setup hr.) Testing (100,000 testing hrs $2 per testing hr.) Engineering (1,700 engg hrs $100 per engg hr.) Total Full cost per unit = $1,497,500 50,000 = $ 700,000 262,500 150,000 15,000 200,000 170,000 $1,497,500 $ 29.95 The TX-40-2 design will reduce the manufacturing costs per unit of TX-40-2 to $29.95, which is just less than the target cost of $30 Therefore, TX-40-2 will achieve the targeted cost reductions The price of TX-40-2 using a 16% mark-up (on full product costs of $29.95) = $29.95 × 1.16 = $34.74 12-32 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 12 Video Case The video case can be discussed using only the case writeup in the chapter Alternatively, instructors can have students view the videotape of the company that is the subject of the case The videotape can be obtained by contacting your Prentice Hall representative The case questions challenge students to apply the concepts learned in the chapter to a specific business situation GRAND CANYON RAILWAY: Pricing Grand Canyon Railway has high fixed costs (depreciation, insurance, interest expense, salaries) and low variable costs per passenger (food and beverages, fuel, passenger-service labor) The proportion of variable costs is likely to be higher for the higher classes of service (Club Car and Chief Car) since it is customer service that distinguishes these classes from Coach class In addition, demand for all travel in general, and rail travel in particular, is usually lower in winter These factors would likely give rise to the following pricing implications: Fewer discounts in Club Car and Chief Car classes of service due to their higher proportion of variable of costs relative to Coach service, and lower elasticity of demand for these classes of service Peak-load pricing in the summer (few discounts offered; the company attempts to recover fixed costs) versus discounted pricing in the winter (to stimulate demand so that the company covers variable costs and earns a contribution towards fixed costs) The Club and Chief cars have the highest levels of service, which can result in high passenger-driven unit costs for food and beverages If, on the day of departure, the managers can fill empty seats in the Club and Chief cars at discounted prices that at least cover the marginal or variable cost of each such passenger, they should certainly try to so—otherwise, once a train leaves the station, the unsold seats will remain unoccupied and the additional revenues from them will be lost However, such a pricing policy may, over time, result in a permanent decline in revenues from the Club and Chief classes of service as more people wait to book seats that have been discounted on the day of departure Fewer discounts meant that Grand Canyon Railway earned higher revenues per passenger and higher contribution margin per passenger Thus, although the number of passengers declined, this decrease was more than made up by the higher contribution per passenger 12-33 ... lockedin cost, activity-based costing Direct materials costs Direct manufacturing labor costs Machining costs Testing costs Rework costs Ordering costs Engineering costs Total manufacturing costs... 440,000 watches 550 watches per batch = 800 batches 176 watches per batch = 2,500 batches 12- 14 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 12- 26... materials costs, batch-level costs, manufacturing operations costs, and engineering change costs It also reduced machine-hours and number of engineering changes made—the quantities of the cost drivers