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Select solutions to Chapter 15

15.9 Three limitations of the economic, profit-maximizing model of pricing are as


follows:
(1) The firms demand and marginal revenue curves are difficult to determine with
precision.
(2) The marginal-cost, marginal-revenue paradigm, as described in the text, is not
valid for all forms of market organization.
(3) Cost-accounting systems are not designed to measure the marginal changes
in cost incurred as production and sales increase unit by unit. To measure
marginal cost would entail a very costly information system.
15.10 Determining the best approach to pricing requires a cost-benefit trade-off. While
the marginal-cost, marginal-revenue paradigm results in a profit-maximizing price,
only a sophisticated and costly information system can collect marginal-cost
data. Thus, the firm will incur greater cost in order to obtain information for better
decisions.
15.13 Four reasons often cited for the widespread use of absorption cost as the cost
base in cost-plus pricing formulas are as follows:
(1) In the long run, the price must cover all costs and a normal profit margin.
(2) Absorption-cost and total-cost pricing formulas provide a justifiable price that
tends to be perceived as equitable by all parties.
(3) When a companys competitors have similar operations and cost structures,
cost-plus pricing based on full costs gives management an idea of how
competitors may set prices.
(4) Absorption-cost information is provided by a firms cost-accounting system,
because it is required for external financial reporting under generally accepted
accounting principles. Since absorption-cost information already exists, it is
cost-effective to use for pricing.
PROBLEM 15-38 (45 MINUTES)

1. The order will boost Heartlands net income by $13,950, as the following
calculations show.
Sales revenue...................................................... $82,500
Less: Sales commissions (10%)........................ 8,250 $74,250
Less manufacturing costs:
Direct material............................................... $14,600
Direct labor.................................................... 28,000
Variable manufacturing overhead*........................... 8,400
Total manufacturing costs 51,000
Income before taxes........................................... $ 23,250
Income taxes (40%)............................................. 9,300
Net income ...................................................... $ 13,950
*Based on an analysis of the year just ended, variable overhead is 30 percent of
direct labor ($1,125 $3,750). For Premiers Foods order:
Direct-labor cost x .30 = $28,000 x .30 = $8,400.
2. Yes. Although this amount is below the $82,500 full-cost price, the order is still
profitable. Heartland can afford to pick up some additional business, because the
company is operating at 75 percent of practical capacity.
Sales revenue............................................................ $63,500
Less: Sales commissions (10%).............................. 6,350 $57,150
Less manufacturing costs:
Direct material $14,600

Direct labor 28,000

Variable manufacturing overhead 8,400

Total manufacturing costs 51,000


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

Note that the fixed manufacturing overhead and fixed corporate administration
costs are not relevant in this decision, because these amounts will remain the
same regardless of what Heartlands management decides about the order.
PROBLEM 15-38 (CONTINUED)

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


Let P = break-even bid price
P 0.1P - $51,000 = 0
0.9P = $51,000
P = $56,667 (rounded)
Income taxes can be ignored, because there is no tax at the break-even point.
4. Profits will probably decline. Heartland originally used a full-cost pricing
formula to derive a $82,500 bid price. A drop in the selling price to $63,500 signifies
that the firm is now pricing its orders at less than full cost, which would decrease
profitability.
Reduced prices could lead to an increase in income if the company were able to
generate additional volume. This situation will not occur here, because the
problem states that Heartland has operated, and will continue to operate, at 75 percent
of practical capacity.
PROBLEM 15-39 (30 MINUTES)

1. (a) Time charges:


annual overhead (excluding
hourly charge to
Hourly labor cost + material handling and storage) + cover profit magin
annual labor hours
$135,000
= $20.00 + 12,000
+ $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 ...................................................................................................


400 hours
Rate ..........................................................................................................
$36.25 per hour
Total .............................................................................................................
$14,500
Material changes: Cost of materials for job ............................................................................
$75,000
7,500*
+ Charge for material handling and storage ............................................
Total .............................................................................................................
$82,500

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


$14,500
82,500
Material ........................................................................................................
Total .............................................................................................................
$97,000

*Charge for material handling and storage):


10% = $31,250 $312,500; 10% $75,000 = $7,500
PROBLEM 15-39 (CONTINUED)

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

PROBLEM 15-40 (25 MINUTES)


1,000,000 doses to be packaged
1. Direct-labor hours (DLH) required for job = 2,000 doses/DLH
= 500 DLH

Traceable out-of-pocket costs:

Direct labor ($16.00 500) ..................................................................... $ 8,000


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

total traceable out -of -pocket costs


Minimum price per dose = 1,000,000 doses

$16,000
= 1,000,000
= $.016

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

Direct labor ($16.00 500) ......................................................................... $ 8,000


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

total bid price $29,900


Bid price per dose = 1,000,000 doses = 1,000,000 =$.0299 per dose
PROBLEM 15-40 (CONTINUED)

3. Under the supposition that the price computed by Manhattan Pharmaceuticals,


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

PROBLEM 15-43 (30 MINUTES)

1. The minimum price per blanket that Detroit Synthetic Fibers, Inc. could bid
without reducing the companys net income is $48 calculated as follows:

Raw material (6 lbs. @ $3.00 per lb.) ......................................................... $18.00


Direct labor (.25 hrs. @ $14.00 per hr.) ..................................................... 3.50
Machine time ($20.00 per blanket) ............................................................ 20.00
Variable overhead (.25 hrs. @ $6.00 per hr.) ............................................. 1.50
Administrative costs ($5,000 1,000) ....................................................... 5.00
Minimum bid price .................................................................................. $48.00

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

Relevant costs from requirement (1) ........................................................ $48.00


Fixed overhead (.25 hrs. @ $16.00 per hr.) ............................................... 4.00
Subtotal ................................................................................................... $52.00
Allowable return (.15 $52.00) ................................................................. 7.80
Bid price .................................................................................................. $59.80

3. Factors that management should consider before deciding whether to submit a


bid at the maximum acceptable price of $50 per blanket include the following:
The company should be sure there is sufficient excess capacity to fill the
order and that no additional investment is necessary in facilities or equipment
that would increase fixed costs.
If the order is accepted at $50 per blanket, there will be a $2 contribution per
blanket to cover fixed costs. However, the company should consider whether
there are other jobs that would make a greater contribution.
Acceptance of the order at a low price could cause problems with current
customers who might demand a similar pricing arrangement.
PROBLEM 15-44 (25 MINUTES)

1. Target costing is more appropriate. MSC is limited in terms of what price it can
charge due to market conditions. A cost-plus-markup approach will use the desired
markup for the company; however, the resulting price may too high and not
competitive. In such an environment it makes more sense to use target costing, which
begins with the price to be charged and works backward to determine the allowable
cost.

2. Target profit = asset investment x rate of return


= $27,000,000 x 12%
= $3,240,000

3. Revenue = target profit + variable cost + fixed cost


= $3,240,000 + (25,000 hours x $33) + $2,850,000
= $6,915,000

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

4. Target profit = asset investment x rate of return


= $27,000,000 x 14%
= $3,780,000

Revenue = target profit + variable cost + fixed cost


= $3,780,000 + (25,000 hours x $33) + $2,850,000
= $7,455,000

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

5. To achieve a 14% return and a $265 revenue-per-hour figure, the company must trim
its costs. MSC could use value engineering, a technique that utilizes information
collected about a services design and associated production process. The goal is to
examine the design and process and then identify improvements that would produce
cost savings.

PROBLEM 15-46 (50 MINUTES)

1. Budgeted overhead costs:

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

budgeted overhead
Predetermined overhead rate = budgeted direct -labor hours

$1,125,000
= 75,000

= $15.00 per direct-labor hour

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

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

$675,000 $450,000
Calculation of predetermined overhead rate ............................................
37,500 37,500

Predetermined overhead rate ....................................................................


$18.00 $12.00
PROBLEM 15-46 (CONTINUED)

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

5. Standard Deluxe
Total cost (from requirement 4).................................................................. $582.00 $768.00
Markup (15% of cost)
Standard: $582 .15 .............................................................................. 87.30
Deluxe: $768 .15 ..................................................................................
______ 115.20
Price ............................................................................................................
$669.30 $883.20

6. The management of Super Sounds, Inc. should use departmental overhead rates.
The overhead cost structures in the two production departments are quite different,
and departmental rates more accurately assign overhead costs to products. When
the company used a plantwide overhead rate, the Standard speakers were
overcosted and the Deluxe speakers were undercosted. This in turn resulted in the
Standard model being overpriced and the Deluxe model being underpriced. The
cost and price distortion resulted from the following facts: (1) the Standard
speakers spend most of their production time in Department II, which is the least
costly of the two departments; and (2) the Deluxe speakers spend most of their
production time in Department I, which is more costly than Department II.
PROBLEM 15-47 (35 MINUTES)

1. Target costing is market driven, beginning with a determination of the selling price
that customers are willing to pay. That price is dependent on the product they
purchase and the products features. It is only natural that a marketing team becomes
heavily involved in this process, since customer feedback is crucial to the design
process.

2. Add cabinet doors: [(10 x 1) + (20 x 2) + (30 x 3) + (60 x 4) + (80 x 5)] = 780; 780
200 = 3.900

Expand storage area: [(10 x 1) + (40 x 2) + (70 x 3) + (50 x 4) + (30 x 5)] = 650; 650
200 = 3.250
Add security lock: [(30 x 1) + (60 x 2) + (50 x 3) + (40 x 4) + (20 x 5)] = 560; 560
200 = 2.800

New appearance for table top: [(10 x 1) + (20 x 2) + (50 x 3) + (60 x 4) + (60 x 5)] =
740; 740 200 = 3.700

Extend warranty: [(40 x 1) + (70 x 2) + (30 x 3) + (35 x 4) + (25 x 5)] = 535; 535
200 = 2.675
PROBLEM 15-47 (CONTINUED)

Ranking (from strongest to weakest):


1Add cabinet doors (3.900)
2New appearance for table top (3.700)
3Expand storage area (3.250)
4Add security lock (2.800)
5Extend warranty (2.675)

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

(b) Customers feel most strongly about adding cabinet doors and giving the table
top a new appearance. Both of these features can be added, and Danish
Interiors will be able to earn its 20% markup. The third and fifth most
desirable features (the expanded storage area and extended warranty) are too
costly. If it desires, management could also add a lock to the storage area.
Supporting calculations follow.

Maximum allowable $228.00


cost...
Less: Current 192.00
cost...
Cost of additional features $ 36.00

1Add cabinet $ 18.00


doors.
2New appearance for table top 12.75
Subtotal $ 30.75

4Add security __ 4.95
lock..
Total $ 35.70
..

4. An expanded storage area would be the most logical additional feature in view of its
no. 3 ranking. Danish Interiors might use value engineering to study the design and
production process of both the table as currently manufactured as well as the proposed
new features. The goal is to identify improvements and associated reductions in cost
that may allow the company to add previously rejected options.