Target Costing and Cost Analysis for Pricing Decisions: Answers To Review Questions

CHAPTER 15

Target Costing and Cost Analysis for Pricing Decisions ANSWERS TO REVIEW QUESTIONS 15.1 15.1

In the long long run, run, every every organ organiza izatio tion n must price price its its product product or servi service ce above above the total total cost of production. While the market for the product also is critically important, costs cannot be ignored.

15.2 15.2

The The stat statem emen entt that that prices prices are determ determin ined ed by prod produc ucti tion on costs costs is too simp simpli list stic ic.. Although firms must price their products and services above their total costs in the long run, management cannot ignore demand issues and the economic environment. Setting prices generally is a balance between cost-related issues and economic market forces.

15.3 15.3

Four Four major major influe influence ncess on pric pricing ing deci decisio sions ns are are as as follo follows: ws: (1) Custom Customer er demand demand:: Manage Managemen mentt must must consid consider er custom customers ers’’ demand demand for their their produc product, t, which which reflec reflects ts the price price that that custom customers ers are willing willing to pay for the product. (2) Actions Actions of competitors: competitors: When pricing pricing its product, product, management management must consider consider the likely pricing decisions and product design decisions of competing firms. (3) Costs: Costs: No organizat organization ion or industry can price its product product below total production production costs indefinitely. (4) Political, legal, and image-related image-related issues: Management Management must consider the way the public perceives the firm and must adhere to certain laws when setting prices.

15.4 5.4

It is cruci ruciaal to defin efinee the the fir firm’s m’s prod produc uctt whe when consi onsid derin ering g the the react eactio ion n of competitors, so that the competitors can be identified. For example, is a firm that produces produces glass bottles bottles competing competing only with other firms firms that produce glass bottles, or is the firm competing with all companies that produce containers? Defining the product as glass bottles or containers is an important step in identifying who the firm’s competitors are.

McGraw-Hill/Irwin Inc. Managerial Accounting, 8/e

© 2009

The McGraw-Hill Companies,

15-1 15- 1

15.5 15.5

In most most indu indust stri ries es,, both both mark market et forc forces es and and cost cost cons consid ider erat atio ions ns heav heavil ilyy infl influe uenc ncee prices. No organization can price its products below their production costs in the long run. On the other hand, no company can set prices at cost plus a markup without keeping an eye on the market. The product or service must be sold at a price customers are willing to pay.

15.6 15.6

The The prof profit it-m -max axim imiz izin ing g pric pricee is the the pric pricee for for whic which h the the asso associ ciat ated ed quan quanti tity ty is determined by the intersection of the marginal cost and marginal revenue curves. This intersection is shown in Exhibit 15-3 in the text.

15.7 15.7

(a) (a) Tota Totall reve revenu nue: e: Pri Price ce mul multi tipl plie ied d by quan quanti tity ty sol sold. d. (b) (b) Marg Margin inal al reve revenue nue:: The The amou amount nt by whic which h tota totall reve revenu nuee incr increa ease sess when when one one additional unit is sold. (c) Demand Demand curve: curve: A graphi graphical cal or mathem mathemati atical cal expre expressi ssion on of the relati relations onship hip between the price and the quantity sold. (d) Price elasticity: elasticity: The impact impact of price changes on sales volume. (e) Cross-e Cross-elas lastic ticity ity:: The extent extent to which which a change change in a produc product’s t’s price price affect affectss the demand for substitute products.

15-8 15-8

(a) (a) Tota Totall cost: cost: Unit Unit cost cost mult multip ipli lied ed by qua quant ntit ityy produ produce ced. d. (b) Marginal cost: cost: Additional cost when one more more unit is produced.

15.9

Three limitation limitationss of the the economi economic, c, profit-ma profit-maximiz ximizing ing model model of of pricing pricing are as as follows: follows: (1) The firm’s demand demand and marginal marginal revenue revenue curves are difficult difficult to determine determine with precision. (2) The marginal-co marginal-cost, st, marginal-re marginal-revenu venuee paradigm, as described described in the text, is not valid for all forms of market organization. (3) Cost-accoun Cost-accounting ting systems systems are not designed designed to measure the marginal 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 15.10 Determinin Determining g the best approach approach to pricing pricing requires requires a cost-bene cost-benefit fit trade-off. trade-off. While 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.

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Solutions Manual

15.11 15.11 The general general formul formulaa for cost-pl cost-plus us pricing pricing is is as follows follows:: Price = cost + (markup percentage

cost)

The price is equal to cost plus a markup. Depending on how cost is defined, the markup percentage may differ. Several different definitions of cost, each combined with a different markup percentage, can result in the same price for a product or service. 15-1 15-122 The The four four cost cost base basess comm common only ly used used in cost cost-p -plu luss pric pricin ing g are are the the foll follow owin ing: g: absorption manufacturing cost, total cost, variable manufacturing cost, and total variable cost. Each of these cost bases can result in the same price under costbased pricing if the markup percentage used in the cost-plus pricing formula is changed. For example, a lower markup percentage would be applied to total cost than would be applied to total variable cost. 15.13 15.13 Four reasons reasons often often cited for for the widespread widespread use use of absorption absorption cost cost as the cost base base in cost-plus pricing formulas are as follows: (1) In the long run, the price must cover cover all costs costs and a normal profit margin. (2) AbsorptionAbsorption-cost cost and total-cost total-cost pricing formulas formulas provide a justifiabl justifiablee price that tends to be perceived as equitable by all parties. (3) When When a compan company’s y’s compet competito itors rs have have simila similarr operat operation ionss and cost cost struct structure ures, s, cost cost-pl -plus us pric pricin ing g base based d on full full cost costss give givess mana manage geme ment nt an idea idea of how how competitors may set prices. (4) Absorp Absorptio tion-co n-cost st inform informati ation on is provid provided ed by a firm’s firm’s cost-a cost-acco ccount unting ing system system,, because it is required for external financial reporting under generally accepted accounting accounting principles. principles. Since Since absorption-c absorption-cost ost information information already exists, it is cost-effective to use for pricing. 15.14 15.14 The primary primary disadvan disadvantag tagee of absorpti absorption-c on-cost ost or total-c total-cost ost pricing pricing formulas formulas is that that they obscure the cost behavior pattern of the firm. Since absorption-cost and totalcost data include allocated fixed costs, it is not clear from these data how the firm’s total costs will change as volume changes. 15.15 15.15 Three advanta advantages ges of pricing pricing based based on varia variable ble cost cost are as follows follows:: (1) Variab Variable-c le-cost ost data do not obscure obscure the cost behavi behavior or patter pattern n by unitiz unitizing ing fixed costs and making them appear variable. (2) Variable-c Variable-cost ost data do not require allocation allocation of common fixed fixed costs to individual product lines. McGraw-Hill/Irwin Inc. Managerial Accounting, 8/e

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15-3 15- 3

(3) Variab Variable-c le-cost ost data are exactly exactly the type type of inform informati ation on manage managers rs need need when when facing certain decisions, such as whether to accept a special order. 15.1 15.166 The The beha behavi vior oral al prob proble lem m that that can can resu result lt from from the the use use of a vari variab able le-c -cos ostt pric pricin ing g formula formula is that managers managers may perceive perceive the variable variable cost of a product product or service service as the floor for the price. They may tend to set the price too low for the firm to cover its fixed costs. 15.17 15.17 Return-on-in Return-on-investm vestment ent pricing pricing is an approa approach ch under which which the price price is set set so that it will cover costs and also earn a profit profit that will provide a target return on the invested capital. 15.18 15.18 PricePrice-led led costin costing g refers refers to the proces processs under under target target costing costing of first determining the acceptable market price for a product or service and then determining the cost at which the product or service must must be produced. 15.1 15.199 To be succ succes essf sful ul at targ target et cost costin ing, g, mana manage geme ment nt must must list listen en to the the comp compan any’ y’ss customers. By doing so, management management will learn the products, products, features, and quality that customers are willing to buy as well as the price they are willing to pay. 15.20 15.20 Value-engin Value-engineeri eering ng is a cost-reduction cost-reduction and process process-impro -improveme vement nt technique technique used to help bring the cost of manufactur manufacturing ing a product product or providing providing a service service into line with its target cost. 15.21 15.21 Tear-d Tear-down own method methodss can be used used in a servic service-in e-indus dustry try firm firm just as they they are used in the manufac manufactur turing ing industry industry.. The variou variouss steps steps in provid providing ing a servic servicee can be analyzed for cost improvements just as a product’s materials and manufacturing operations can be analyzed for the same purpose. 15.22 15.22 Under time-and time-and-mate -material rial pricing, pricing, the the price includes includes a cost-base cost-based d charge for labor, labor, a cost-based charge for material, and generally a markup on one or both of these production-cost factors. 15.2 15.233 When When a firm firm has has exce excess ss capa capaci city ty,, ther theree is no oppo opport rtun unit ityy cost cost in acce accept ptin ing g an addi additi tion onal al prod produc ucti tion on job. job. Ther Theref efor ore, e, it is not not nece necess ssar aryy to refl reflec ectt such such an opportunity cost in setting a bid price. On the other hand, if the firm is already at full capacity, there is an opportunity cost to accepting another production job. In this case, it is appropriate to include in the price an estimate of the opportunity cost associated with the job for which the bid is being prepared.


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Solutions Manual

15.24 The decision to accept or reject a special order and the selection of a price for a special order are similar decisions. If a price has been offered for a special order, management can base its acceptance or rejection decision on whether or not that price covers the incremental cost of producing the order. Another way of viewing the problem is to set the minimum price for the special order at a level sufficient to cover the incremental cost of producing the order. 15.25 (a) Skimming pricing: Setting a high initial price for a new product in order to reap short-run profits. Over time, the price is reduced gradually. (b) Penetration pricing: Setting a low initial price for a new product in order to penetrate a market deeply and gain a large and broad market share. (c) Target costing: Conducting market research to determine the price at which a new product will sell and then, given the likely sales price, computing the cost for which the product must be manufactured in order to provide the firm with an acceptable profit margin. Then engineers and cost analysts work together to design a product that can be manufactured for the allowable cost. This process is used widely in the development stages of new products. 15-26 (a) Unlawful price discrimination: Quoting different prices to different customers for the same product or service, even though the different prices cannot be justified by differences in the cost incurred to produce, sell, and deliver the product or service. (b) Predatory pricing: Temporarily cutting a price to broaden demand for a product with the intention of later restricting the supply and raising the price again. 15-27 Traditional, volume-based product-costing systems often overcost high-volume and relatively simple products while undercosting low-volume and complex products. This practice can result in overpricing high-volume and relatively simple products and underpricing low-volume and complex products. Such strategic pricing errors can have a disastrous impact on a firm’s competitive position.


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15-5

SOLUTIONS TO EXERCISES EXERCISE 15-28 (25 MINUTES) Dollars Total cost

Total revenue

Total profit at profit-maximizing quantity and price

Quantity sold per month

q* Dollars per unit

Marginal cost p*

Demand (average revenue) Marginal revenue Quantity sold per month

q*


15-6

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15-7

EXERCISE 15-29 (30 MINUTES) 1.

Tabulated price, quantity, and revenue data: (1)

(2)

Quantity Sold per Month

Unit Sales Price

20 40 60 80 100

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

$500 475 450 425 400

(4)

(3) Total Revenue per Month* ..................... ..................... ..................... ..................... .....................

$10,000 19,000 27,000 34,000 40,000

Changes in Total Revenue } .................... } .................... } .................... } ....................

$9,000 8,000 7,000 6,000

*Column (1) times column (2). †

Differences between amounts in column (3).


15-8

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Solutions Manual

EXERCISE 15-29 (CONTINUED) 2.

Total revenue curve: Dollars •

$40,000

Total revenue

$35,000

•

$30,000 •

$25,000

$20,000

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

•

$15,000

$10,000

•

$ 5,000

20


40

60

80

100

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15-9


Tabulated cost and quantity data:

(1) (2) (3) Quantity Produced Average Total and Sold per Cost per Cost per Month Unit Month* 20 ..................... $450 ..................... $ 9,000 40 ..................... 425 ..................... 17,000 60 ..................... 410 ..................... 24,600 80 ..................... 430 ..................... 34,400 100 ..................... ..................... 445 44,500

(4) Changes in Total Cost† } ..................... $ 8,000 } ..................... 7,600 } ..................... 9,800 } ..................... 10,100


Differences between amounts in column (3).


15-10

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Solutions Manual

EXERCISE 15-30 (CONTINUED) 2. Total cost curve: Dollars $45,000

Total cost

•

$40,000

$35,000

•

$30,000

$25,000

Total cost increases at an increasing rate

•

$20,000 •

$15,000

$10,000 •

Total cost increases at an declining rate

$ 5,000

20 McGraw-Hill/Irwin Inc. Managerial Accounting, 8/e

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60

80 © 2009

100



15-11


15-12

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Tabulated revenue, cost, and profit data:

(1) (2) (3) Quantity Total Produced Sales Revenue and Sold Price per per Month per Unit Month* 20 ............... $500 ................ $10,000 40 ............... 475 ................ 19,000 60 ............... 450 ................ 27,000 80 ............... 425 ................ 34,000 100 ............... 400 ................ 40,000

(4) Total Cost per Month† $ 9,000 17,000 24,600 34,400 44,500

(5)

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

Profit per Month** $1,000 2,000 2,400 (400) (4,500)


Column (1) times average cost per unit given in the preceding exercise.

**Column (3) minus column (4). 2.

Total revenue and cost curves: see next page.

3.

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


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15-13

EXERCISE 15-31 (CONTINUED) 2.

Total revenue and cost curves: Dollars $45,000

•

Total cost $40,000

•

Total revenue $35,000

• •

$30,000 •

$25,000

•

$20,000

Total profit at the profitmaximizing quantity and price.

•

•

$15,000

$10,000

• •

$ 5,000

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Price = total unit cost + (markup percentage $495 = total unit cost + (12.5% $495 = total unit cost Total unit cost =

$495 1.125

Allocated fixed selling and administrative cost

2.

total unit cost)

total unit cost)

1.125 = $440

=

total unit cost

=

$440

=

$44

–

all manufacturing costs

variable – selling and administrative cost

–

($275 + $55)

–

$66

a.

Cost-Plus Pricing Formula Variable manufacturing cost .................. $275 $495 = $275 + (80% $275)* Applied fixed manufacturing cost ......... 55

b.

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

$330)†

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

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

$341)**

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


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15-15


Profit on sales of 60,000 units: Sales revenue (60,000 9.00 p) .............................................. Less: Variable costs: Manufacturing and administrative (60,000 4.50 p) ....... Sales commissions (60,000 9.00 p 10%) ................... Contribution margin ............................................................... Less: Fixed costs (90,000 p + 7,500 p) .................................... Profit ........................................................................................

540,000 p 270,000 p 54,000 p

324,000 p 216,000 p 97,500 p 118,500 p

p denotes Argentina’s peso

2.

Required price on special order: target additional profit

Unit contribution margin required on special order

= =

Sales price required

unit sales volume in special order 30,000 p 10,000

3.00 p per unit

=

unit variable cost + required unit contribution margin

=

4.50 p + 3.00 p = 7.50 p per unit

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


15-16

10,000 X – 10,000(4.50 p)

=

30,000 p

10,000 X

=

75,000 p

X

=

7.50 p per unit

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Solutions Manual

EXERCISE 15-34 (25 MINUTES) (1)

Cost-Plus Pricing Formula Variable manufacturing cost .............................. $300 $600 = $300 + (100% $300)a Applied fixed manufacturing cost ..................... 105

(2)

Absorption manufacturing cost ......................... $405 $600 = $405 + (48.15% Variable selling and administrative cost ........... 45 Allocated fixed selling and administrative cost ........................................... 75

$405)b

(3)

Total cost

$525)c

$525 $600 = $525 + (14.29%

Variable manufacturing cost .............................. $300 Variable selling and administrative cost ........... 45 (4)

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

$345)d

Explanatory Notes: a

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

EXERCISE 15-35 (30 MINUTES) Markup percentage applied to cost base in cost-plus pricing formula


profit required to achieve target ROI =

+

annual volume

© 2009

total annual costs not included in cost base cost base per unit used in cost-plus pricing formula


15-17

1.

Markup percentage

=

$60,000

total variable selling and

total annual

administra tive costs

fixed costs

480

=

=

$60,000

(480

$50) 480

$60,000

$24,000

$400

[480

($250

$100)]

$400

$168,000

$192,000

= 131.25% Thus the Wave Darter’s price would be set equal to $925, where $925 = $400 + ($400 131.25%).


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EXERCISE 15-35 (CONTINUED) In the preceding formula: $60,000 480 $400 $50 $250 $100

2.

= = = = = =

target profit (given) annual volume of Wave Darter production and sales (from Exhibit 15-5) variable manufacturing cost per unit (from Exhibit 15-5) variable selling and administrative cost per unit (from Exhibit 15-5) applied fixed manufacturing cost per unit (from Exhibit 15-5) allocated fixed selling and administrative cost per unit (from Exhibit 15-5)

$60,000

Markup percentage = =

=

total selling and

+

administra tive costs 480 ×$650*

$60,000

+

[480 ×($50 +$100)]

480 ×$650

$60,000

+

$72,000

$312,000

= 42.31% (rounded) Thus the Wave Darter’s price would be set equal to $925, where $925 = $650 + ($650 42.31%) with rounding. *$650 = absorption manufacturing cost (from Exhibit 15-5). The other amounts used in this formula were defined in requirement (1).


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15-19


2.

Material component of time and material pricing formula: material

material

material handling

cost

cost

incurred

incurred

and storage costs annual cost of materials

on job

on job

used in Repair Department

1.05

Material component of price, using formula developed in requirement (1): [$8,000 + ($8,000 .04)] = $8,320 1.05 = $8,736

1.05

New price to be quoted on yacht refurbishment: Total price of job = time charges + material charges = $9,000* + $8,736** = $17,736 *From Exhibit 15-7. **

From requirement (1).

EXERCISE 15-37 (30 MINUTES) Answers will vary widely, depending on the company and the product chosen. The answer should include a general discussion of the use of target costing in setting a price for a new product. The target-costing approach includes the following key features: priceled costing; focus on the customer; focus on product design; focus on process design; use of cross-functional teams; analysis of life-cycle costs; and a value-chain orientation. Target costing makes extensive use of value engineering to reduce production costs and bring them into line with the target cost.


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SOLUTIONS TO PROBLEMS PROBLEM 15-38 (45 MINUTES) 1.

The order will boost Heartland’s net income by $13,950, as the following calculations show. Sales revenue...................................................... Less: Sales commissions (10%)........................ Less manufacturing costs: Direct material............................................... Direct labor.................................................... Variable manufacturing overhead *.......................... Total manufacturing costs Income before taxes........................................... Income taxes (40%)............................................. Net income ......................................................

$82,500 8,250

$74,250

$14,600 28,000 8,400 51,000 $ 23,250 9,300 $ 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............................................................ Less: Sales commissions (10%).............................. Less manufacturing costs: Direct material Direct labor Variable manufacturing overhead

$63,500 6,350

$57,150

$14,600 28,000 8,400

Total manufacturing costs…………………… Income before taxes................................................. Income taxes (40%)................................................... Net income ............................................................

51,000 $ 6,150 2,460 $ 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. McGraw-Hill/Irwin Inc. Managerial Accounting, 8/e

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15-21

PROBLEM 15-38 (CONTINUED) 3.

The break-even price is $56,667, computed as follows: Let P = break-even bid price P – 0.1P - $51,000 = 0

0.9P = $51,000 P = $56,667 (rounded)

Income taxes can be ignored, because there is no tax at the break-even point. 4.

Profits will probably decline. Heartland originally used a full-cost pricing formula to derive a $82,500 bid price. A drop in the selling price to $63,500 signifies that the firm is now pricing its orders at less than full cost, which would decrease profitability. Reduced prices could lead to an increase in income if the company were able to generate additional volume. This situation will not occur here, because the problem states that Heartland has operated, and will continue to operate, at 75 percent of practical capacity.

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


15-22

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PROBLEM 15-39 (30 MINUTES) 1.

(a) Time charges: annual overhead (excluding

Hourly labor cost +

material handling and storage)

+

annual labor hours

= $20.00 +

$135,000 12,000

hourly charge to cover profit magin

+ $5.00

= $36.25 per labor hour (b) Material charges:

Material cost

material cost material handling and storage costs

incurred on job incurred on job annual cost of materials used =

Material cost

material cost

$31,250

incurred on job

incurred on job

$312,500

2.

PRICE QUOTATION Time charges:

Labor time ......................................................... Rate ................................................................ Total ...................................................................

400 hours $36.25 per hour $14,500

Material changes: Cost of materials for job .................................. + Charge for material handling and storage ... Total ...................................................................

$75,000 7,500 * $82,500

Total price of job: Time ................................................................... Material .............................................................. Total ...................................................................

$14,500 82,500 $97,000

*Charge for material handling and storage): 10% = $31,250 ÷ $312,500; 10% McGraw-Hill/Irwin Inc. Managerial Accounting, 8/e

$75,000 = $7,500 © 2009


15-23


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

$ 97,000 8,250 $105,250


Direct-labor hours (DLH) required for job =

1,000,000 doses to be packaged 2,000 doses/DLH

= 500 DLH Traceable out-of-pocket costs: Direct labor ($16.00 500) .................................................................... Variable overhead ($12.00 500) ......................................................... Administrative cost ................................................................................ Total traceable out-of-pocket costs.................................................. Minimum price per dose = = 2.

total traceable out-of -pocket costs 1,000,000 doses

$16,000 1,000,000

= $.016

As in requirement (1), 500 direct-labor hours are required for the job. Direct labor ($16.00 500) ......................................................................... Variable overhead ($12.00 500) .............................................................. Fixed overhead ($20.00 500) .................................................................. Administrative cost .................................................................................... Total cost ................................................................................................ Maximum allowable return (15%) .............................................................. Total bid price ........................................................................................

Bid price per dose


15-24

$ 8,000 6,000 2,000 $16,000

=

total bid price 1,000,000 doses

=

$29,900 1,000,000

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=

$ 8,000 6,000 10,000 2,000 $26,000 3,900 $29,900

$.0299 per dose


Solutions Manual


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.


The manufacturing overhead rate is $27.00 per direct-labor hour, and the product cost includes $13.50 of manufacturing overhead per pressure valve. Accordingly, the direct-labor hours per finished valve is 1/2 hour ($13.50 ÷ $27.00). Therefore, 30,000 units per month would require 15,000 direct-labor hours.

2.

The analysis of accepting the Glasgow Industries’ order of 120,000 units is as follows: Totals for Per Unit 120,000 Units Incremental revenue .............................................................. $28.50 $3,420,000 Incremental costs: Variable costs: Direct material ................................................................ $ 7.50 Direct labor ..................................................................... 9.00 Variable overhead .......................................................... 4.50 Total variable costs ................................................... $21.00

$ 900,000 1,080,000 540,000 $2,520,000

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

72,000 $2,592,000 $ 828,000

The following costs are irrelevant to the analysis: •

Shipping

•

Sales commission

•

Fixed manufacturing overhead (both traceable and allocated)


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15-25


The minimum unit price that Wolverine Valve and Fitting Company could accept without reducing net income must cover the variable unit cost plus the additional fixed costs. Variable unit cost: Direct material .................................................................... $ 7.50 Direct labor ......................................................................... 9.00 Variable overhead .............................................................. 4.50 Additional fixed cost ($72,000 ÷ 120,000) ............................. Minimum unit price ................................................................

4.

$21.00 .60 $21.60

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

•

•

•

•

The effect of the special order on Wolverine’s sales at regular prices. The possibility of future sales to Glasgow Industries and the effects of participating in the international marketplace. The company’s relevant range of activity and whether or not the special order will cause volume to exceed this range. The effect on machinery or the scheduled maintenance of equipment. Other possible production orders that could come in and require the capacity allocated to the Glasgow job.

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


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Cost-plus pricing begins by computing an item’s cost and then adds an appropriate markup. The result is the item’s selling price. In contrast, target costing begins by determining an appropriate selling price. A target profit is next subtracted from that price to yield the cost (i.e., the “target cost”) that must be achieved. Target costing could be labeled price-led costing because it begins by determining a target selling price. In contrast, cost-plus pricing methods begin with the cost and culminate in determination of the selling price.

2.

The current selling price is $675: Direct material……………………………... Direct labor………………………………… Manufacturing overhead………………… Selling and administrative expenses…. Total cost………………………………. Markup ($540 x 25%)……………………... Selling price………………………………...

3.

$ 90 225 150 75 $540 135 $675

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

$585 117 $468

Current cost……………………………….. Less: Target cost…………………………. Required cost reduction…………………

$540 468 $ 72


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Yes. The company should focus its efforts on trimming non-value-added costs. These costs are associated with non-value-added activities (i.e., activities that are either (a) unnecessary and dispensable or (b) necessary, but inefficient and improvable).

5.

If costs cannot be reduced below $540, Lehigh will have to reduce its markup to remain competitive. Assuming a desire to achieve the going market price of $585, the markup must equal $45 ($585 - $540), or 8.33% of cost ($45 ÷ $540). Given that the current markup on cost is 25%, a reduction of 16.67% is needed (25.00% - 8.33%).

6.

The statement means that selling prices are a function of market conditions; however, the selling prices must cover a company’s costs in the long run. Also, in a number of industries, prices are based on costs. Yet, the prices are subject to the reaction of customers and competitors.

7.

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


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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.) ......................................................... Direct labor (.25 hrs. @ $14.00 per hr.) ..................................................... Machine time ($20.00 per blanket) ............................................................ Variable overhead (.25 hrs. @ $6.00 per hr.) ............................................ Administrative costs ($5,000 ÷ 1,000) ....................................................... Minimum bid price .................................................................................

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) ........................................................ Fixed overhead (.25 hrs. @ $16.00 per hr.) ............................................... Subtotal .................................................................................................. Allowable return (.15 $52.00) ................................................................. Bid price .................................................................................................

3.

$18.00 3.50 20.00 1.50 5 .00 $48.00

$48.00 4 .00 $52.00 7 .80 $59.80

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.


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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.


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Target costing is the design of a product, and the processes used to produce it, so that ultimately the product can be manufactured at a cost that will enable a firm to make a profit when the product is sold at an estimated market-driven price. This estimated price is called the target price, the desired profit margin is called the target profit, and the cost at which the product must be manufactured is called the target cost.

2.

Value engineering (or value analysis) refers to a cost-reduction and process improvement technique that utilizes information collected about a product's design and production processes and then examines various attributes of the design and processes to identify candidates for improvement efforts.

Value engineering focuses on improving those qualities that the customer desires, while reducing or eliminating unnecessary moves, queues, setups, and other such activities that the customer will not pay for. The process is reengineered to eliminate non-value-added work and thereby enhance the value of the process to the customer.


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Portland Electronics' current profit on sales is 10 percent [($700 $630)/$700]. Therefore, the target cost for the new product must be $600 less 10 percent, or $540 [$600 – ($600 10%)].

4.

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

Current

Increase/ (Decrease)

Revised

Material: Purchased components.................................. All other............................................................

$215 85

Labor: Manufacturing, direct...................................... Setups............................................................... Material handling............................................. Inspection.........................................................

130 18 36 46

$ 30 (18) (36) (46)

160 0 0 0

Machining: All......................................................................

70

(10)

60

Other: Finished-goods warehousing......................... Warranty*..........................................................

10 20

(10) (8)

0 12

Total cost................................................................

$630

$(98)

$532

$215 85

*40% reduction


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Budgeted overhead costs: Department I Variable overhead Department I: 37,500 $12 ....................................... Department II: 37,500 $6 ......................................... Fixed overhead ................................................................ Total overhead ................................................................ Total budgeted overhead for both departments ($675,000 + $450,000) ............................. Total expected direct-labor hours for both departments (37,500 + 37,500) ............................ Predetermined overhead rate = =

Department II

$450,000 225,000 $675,000

$ 225,000 225,000 $ 450,000 $1,125,000 75,000

budgeted overhead budgeted direct-labor hours

$1,125,000 75,000

= $15.00 per direct-labor hour 2. Total cost .............................................................................. Markup (15% of cost) Standard: $600 .15 ...................................................... Deluxe: $750 .15 ........................................................... Price ...................................................................................... 3.

Standard $600.00

Deluxe $750.00

90.00 ______ $690.00

112.50 $862.50

Department I Budgeted overhead (from requirement 1)...................... $675,000 Budgeted direct-labor hours .......................................... 37,500 Calculation of predetermined overhead rate ................ Predetermined overhead rate .........................................


Department II $450,000 37,500

$675,000

$450,000

37,500

37,500

$18.00

$12.00

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PROBLEM 15-46 (CONTINUED) 4. Direct material ...................................................................... Direct labor ........................................................................... Manufacturing overhead: Department I: Standard: 2 $18 ........................................................ Deluxe: 8 $18 ............................................................ Department II: Standard: 8 $12 ........................................................ Deluxe: 2 $12 ............................................................ Total cost .............................................................................. 5. Total cost (from requirement 4)........................................... Markup (15% of cost) Standard: $582 .15 ....................................................... Deluxe: $768 .15 ........................................................... Price ...................................................................................... 6.

Deluxe $390 210

36 144 96 $582

24 $768

Standard $582.00

Deluxe $768.00

87.30 ______ $669.30

115.20 $883.20

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.


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Standard $240 210

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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


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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.

4.

(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. $228.00 192.00 $ 36.00

1—Add cabinet doors………………. 2—New appearance for table top… Subtotal…………………………… 4—Add security lock……………….. Total………………………………..

$ 18.00 12.75 $ 30.75 __ 4.95 $ 35.70

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.


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Maximum allowable cost…………... Less: Current cost…………………... Cost of additional features…………

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SOLUTIONS TO CASES CASE 15-48 (40 MINUTES) 1.

Bid based on standard pricing policy: Direct material ........................................................................................... Direct labor (11,000 DLH @ $18.00) ......................................................... Manufacturing overhead (11,000 DLH @ $10.80) ................................... Full manufacturing costs ..................................................................... Markup (50% of full cost) ......................................................................... Standard pricing policy bid ......................................................................

2.

$307,200 198,000 118,800 $624,000 312,000 $936,000

Minimum bid acceptable to Bair Company: Direct material ........................................................................................... Direct labor (11,000 DLH @ $18.00) ......................................................... Variable manufacturing overhead (11,000 @ $6.48a ) .............................. Opportunity cost of lost salesb ................................................................. Minimum bid .............................................................................................. a

Proportion of variable overhead

= =

$307,200 198,000 71,280 42,240 $618,720

budgeted variable overhead budgeted total overhead

$1,166,400 $1,944,000

= 60% Variable overhead rate =

total overhead

variable

rate

overhead proportion

= ($10.80)

(.6)

= $6.48


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CASE 15-48 (CONTINUED) b

Selling price per unit of standard product......................... Variable costs per unit Direct material ............................................................. Direct labor (250 DLH @ $18.00) ................................ Variable overhead (250 DLH @ $6.48) ....................... Net contribution per unit ..................................................... Standard product requirements (12,000 DLH 3) ............ Special order requirements ................................................. Total hours required ............................................................ Plant capacity per quarter (15,000 DLH 3) ...................... Shortage in hours ................................................................ Lost unit sales (2,000 DLH ÷ 250 DLH) ............................... Lost contribution .................................................................

3.

$3,000 4,500 1,620

9,120 $ 5,280

36,000 DLH 11,000 DLH 47,000 DLH 45,000 DLH 2,000 DLH 8 $42,240

Lyan Company’s assistant purchasing manager is not acting ethically. The details of the bid submitted by Bair Company are confidential between Bair Company and Lyan Company. It is unfair and unethical to give this information to Bair’s competitor. If Lyan Company had wanted competing bids on the specialized equipment, the bids should have been solicited at the same time from the relevant set of manufacturers. Each competing firm should receive the same specifications on the customized equipment and be given the same time frame in which to complete the bid. Moreover, the competing firms should be made aware that more than one bid is being solicited.


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$14,400

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CASE 15-49 (50 MINUTES) 1.

Handy Household Products, Inc. should price the standard compound at $44 per case and the commercial compound at $60 per case. The contribution margin is the highest at these prices as shown in the following calculations: Standard Compound Selling price per case .............................................. $ 38 $ 40 $ Variable cost per case ............................................. 32 32 Contribution margin per case ................................. $ 6 $ 8 $ Volume in cases (in thousands) ............................. 120 100 Total contribution margin (in thousands) .............. $ 720 $ 800 $

42 $ 44 $ 46 32 32 32 10 $ 12 $ 14 90 80 50 900 $ 960 $ 700

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


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Target Costing and Cost Analysis for Pricing Decisions: Answers To Review Questions

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