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CHAPTER 12

PRICING DECISIONS AND COST MANAGEMENT

12-1 The three major influences on pricing decisions are

1. Customers

2. Competitors

3. 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:

1. Pricing for a one-time-only special order with no long-term implications.

2. Adjusting product mix and volume in a competitive market.

12-4 Activity-based costing helps managers in pricing decisions in two ways.

1. It gives managers more accurate product-cost information for making pricing decisions.

2. 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

1. 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?”

2. 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 do 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.

12-10 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:

1. The difference in prices charged for a telephone call, hotel room, or car rental during busy versus slack periods is often much greater than the difference in costs to provide these services.

2. 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 price discriminate. They 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:

1. The full set of revenues and costs associated with each product becomes more visible.

2. Differences among products in the percentage of total costs committed at early stages in the life cycle are highlighted.

3. 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.

12-16 (20–30 min.) Relevant-cost approach to pricing decisions, special order.

1. Relevant revenues, $4.00  1,000 $4,000

Relevant costs

Direct materials, $1.60  1,000 $1,600

Direct manufacturing labor, $0.90  1,000 900

Variable manufacturing overhead, $0.70  1,000 700

Variable selling costs, 0.05  $4,000 200

Total relevant costs 3,400

Increase in operating income $ 600

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.

2. 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.

3. 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 $4.00 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.

12-17 (20–30 min.) Relevant-cost approach to short-run pricing decisions.

1. Analysis of special order:

Sales, 3,000 units  $75 $225,000

Variable costs:

Direct materials, 3,000 units  $35 $105,000

Direct manufacturing labor, 3,000 units  $10 30,000

Variable manufacturing overhead, 3,000 units  $6 18,000

Other variable costs, 3,000 units  $5 15,000

Sales commission 8,000

Total variable costs 176,000

Contribution margin $ 49,000

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 + $49,000 = $1,049,000.

2. 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 $49,000 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 $49,000.

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 $8,000 sales commission (as distinguished from her regular $33,750 = 15%  $225,000) for every Abrams order of this size if Abrams becomes a long-term customer?

12-18 (15-20 min.) Short-run pricing, capacity constraints.

1. Per kilogram of hard cheese:

Milk (10 liters $1.50 per liter)

$15

Direct manufacturing labor

5

Variable manufacturing overhead

3

Fixed manufacturing cost allocated

6

Total manufacturing cost

$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.

2. 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 4 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.

1.

Category

Examples

Value-added costs

a. Materials and labor for regular repairs

$ 800,000

Nonvalue-added costs

b. Rework costs

c. Expediting costs caused by work delays

g. Breakdown maintenance of equipment

Total

$ 75,000

60,000

55,000

$190,000

Gray area

d. Materials handling costs

e. Materials procurement and inspection costs

f. Preventive maintenance of equipment

Total

$ 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 nonvalue-adding breakdown maintenance.

2. 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.

3.

Effect on Costs Classified as

Program

Value-Added

Nonvalue-Added

Gray

Area

(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

–$ 40,000

–$ 40,000

–$56,250

– 45,000

–$101,250

(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

–$ 12,675

–$ 12,675

– $ 6,825

– $6,825

–$7,000

–12,500

–19,500

+ 19,500

$ 0

(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

+$ 4,875

+$ 4,875

– $22,000

– 22,000

+ 2,625

– $19,375

+$7,500

+ $7,500

– 7,500

$ 0

Total effect of all programs

Value-added and nonvalue-added costs calculated in requirement 2

Expected value-added and nonvalue-added costs as a result of implementing these programs

– $ 47,800

865,000

$817,200

–$127,450

225,000

$ 97,550

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.

12-20 (2530 min.) Target operating income, value-added costs, service company.

  1. The classification of total costs in 2009 into value-added, nonvalue-added, or in the gray area in between follows:

Value Gray Nonvalue- Total

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 do not perceive these costs as necessary and would be unwilling to pay for them. Carasco should seek to eliminate these costs by making sure that all associates are 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.

  1. Reduction in professional labor-hours by

a. Correcting errors in drawings (7% × 8,000) 560 hours

b. Correcting errors to conform to building code (8% × 8,000) 640 hours

Total 1,200 hours

Cost savings in professional labor costs (1,200 hours × $50) $ 60,000

Cost savings in variable administrative and support

costs (40% × $60,000) 24,000

Total cost savings $ 84,000

Current operating income in 2009 $102,000

Add cost savings from eliminating errors 84,000

Operating income in 2009 if errors eliminated $186,000

3. 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 $400,000

Administrative and support (40% × $400,000) 160,000

Travel 18,000

Total costs $578,000

Carasco’s operating income would be

Revenues $800,000

Total costs 578,000

Operating income $222,000

12-21 (25–30 min.) Target prices, target costs, activity-based costing.

1. Snappy’s operating income in 2008 is as follows:

Total for

250,000 Tiles

(1)

Per Unit

(2) = (1) ÷ 250,000

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

$1,000,000

750,000

25,000

120,000

60,000

955,000

$ 45,000

$4.00

3.00

0.10

0.48

0.24

3.82

$0.18

2. Price to retailers in 2009 is 95% of 2008 price = 0.95  $4 = $3.80; cost per tile in 2009 is 96% of 2008 cost = 0.96  $3 = $2.88.

Snappy’s operating income in 2009 is as follows:

Total for

250,000 Tiles

(1)

Per Unit

(2) = (1) ÷ 250,000

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

$ 950,000

720,000

25,000

120,000

60,000

925,000

$ 25,000

$3.80

2.88

0.10

0.48

0.24

3.70

$0.10

3. Snappy’s operating income in 2009, if it makes changes in ordering and material handling, will be as follows:

Total for

250,000 Tiles

(1)

Per Unit

(2) = (1) ÷ 250,000

Revenues ($3.80  250,000)

Purchase cost of tiles ($2.88  250,000)

Ordering costs ($25  200)

Receiving and storage ($28  3,125)

Shipping ($40  1,500)

Total costs

Operating income

$950,000

720,000

5,000

87,500

60,000

872,500

$ 77,500

$3.80

2.88

0.02

0.35

0.24

3.49

$0.31

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).

12-22 (20 min.) Target costs, effect of product-design changes on product costs.

1. and 2. Manufacturing costs of HJ6 in 2008 and 2009 are as follows:

2008 2009



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