Pricing Decisions andCost Management
PPT-4
Learning Objective 1
Discuss the three major
influences on pricing.
Major Influences on
Pricing Decisions
Customers influence prices through
their effect on demand.
Competitors influence prices through
their actions.
Costs influence prices because they
affect supply.
Learning Objective 2
Distinguish between short-run
and long-run pricing decisions.
Time Horizon of
Pricing Decisions
Short-run decisions
have a time horizon
of less than a year:
 pricing a one-timeonly special order
 adjusting product
mix and output volume
Long-run decisions
involve a time horizon
of a year or longer:
 pricing a product in
a major market where
price setting has
some leeway
Time Horizon of
Pricing Decisions
1. Costs that are often
irrelevant for short-run
pricing decisions
(fixed costs) are often
relevant in the long run.
2. Profit margins in
long-run pricing
decisions are often set
to earn a reasonable
return on investment.
Costing and Pricing
for the Short Run – Example
Lomas Corporation operates a plant with
a monthly capacity of 500,000 cases
of tomato sauce.
Lomas is presently producing
300,000 cases per month.
Del Valle has asked Lomas and two other
companies to bid on supplying 150,000
cases each month for the next four months.
Costing and Pricing
for the Short Run – Example
Cost Per Case
Variable manufacturing
Variable marketing and distribution
Fixed manufacturing
Fixed marketing and distribution
Total
38
13
14
15
80
Costing and Pricing
for the Short Run – Example
If Lomas makes the extra 150,000 cases, the existing
total fixed manufacturing overhead (4,200,000 per
month) would continue, plus an additional 165,000
of fixed overhead will be incurred per month.
Total fixed marketing and distribution
costs will not change.
What price should Lomas bid?
Costing and Pricing
for the Short Run – Example
Relevant Costs
Variable manufacturing
Fixed manufacturing
Total
38.00
1.10
39.10
165,000 ÷ 150,000 = 1.10
Any bid above 39.10 will improve
Lomas’s profitability in the short run.
Costing and Pricing
for the Short Run – Example
Suppose that Lomas believes that Del Valle
will sell the tomato sauce in Lomas’s current
markets but at a lower price than Lomas.
Relevant costs of the bidding decision
should include revenues lost on sales
to existing customers.
Costing and Pricing
for the Long Run – Example
Latisha Computer Corporation manufactures
two brands of computers: Simple Computer (SC)
and Complex Computer (CC).
Latisha uses a long-run time horizon to price
Complex Computer (CC).
Costing and Pricing
for the Long Run – Example
Direct materials costs vary with the
number of units produced.
Direct manufacturing labor costs vary
with direct manufacturing labor-hours.
Ordering and receiving, testing and
inspection, and rework costs vary
with their chosen cost drivers.
Costing and Pricing
for the Long Run – Example
Ordering:
78 per order
Testing:
2 per inspection hour
Rework:
38 per unit reworked
Cost per Unit
Direct materials
450.00
Direct labor:
3.50 hours @ 19 per hour
66.50
Total
516.50
Costing and Pricing
for the Long Run – Example
Number of orders placed:
17,000
Number of testing hours:
3,000,000
Number of units reworked:
8,000
The direct fixed costs of machines used
exclusively for the manufacture of
Complex Computer total 7,000,000.
What is the cost of producing 100,000
units of Complex Computer?
Costing and Pricing
for the Long Run – Example
Direct material and labor
51,650,000
Direct fixed costs
7,000,000
Ordering (17,000 × 78)
1,326,000
Testing (3,000,000 × 2)
6,000,000
Rework (8,000 × 38)
304,000
Total
66,280,000
66,280,000 ÷ 100,000 units = 662.80/unit
Alternative Long-Run
Pricing Approaches
Market-based
Cost-based
(also called cost-plus)
Learning Objective 3
Price products using the
target-costing approach.
Target Price and Target Cost
Target price is the estimated price for
a product (or service) that potential
customers will be willing to pay.
Target Price
– Target operating income per unit
= Target cost per unit
Target Price and Target Cost
Steps in developing target prices and target costs:
1. Develop a product that satisfies the needs
of potential customers.
2. Choose a target price.
3. Derive a target cost per unit.
4. Perform value engineering to achieve target costs.
Implementing Target Pricing
and Target Costing
Latisha’s management wants a 15% target
operating income on sales revenues of CC.
Target sales revenue is 750 per unit.
What is the target cost per unit?
750 × .15 = 112.50, $750 – 112.50 = 637.50
Current full cost per unit of CC is 662.80
Implementing Target Pricing
and Target Costing
Value engineering is a systematic
evaluation of all aspects of the
value-chain business function with
the objective of reducing costs.
Value-Added Costs
A value-added cost is a cost that customers perceive
as adding value, or utility, to a product or service:
Adequate memory
Pre-loaded software
Reliability
Easy-to-use keyboards
Nonvalue-Added Costs
A nonvalue-added cost is a cost that
customers do not perceive as adding
value, or utility, to a product or service.
Cost of expediting
Rework
Repair
Learning Objective 4
Apply the concepts of cost
incurrence and locked-in costs.
Cost Incurrence
This describes when a resource is sacrificed
or forgone to meet a specific objective.
Research and development
Design
Manufacturing
Marketing
Distribution
Customer support
Locked-in Costs
These are those costs that have not yet been
incurred but which, based on decisions that
have already been made, will be incurred
in the future (designed-in costs).
It is difficult to alter or reduce
costs that are already locked in.
Cumulative Costs per Unit
Cost Incurrence and
Locked-in Costs
Value-Chain
Functions
R&D and
Design
Manufacturing
Mkt., Dist.,
& Cust. Svc.
Cost Incurrence and
Locked-in Costs
At the end of the design stage, direct materials,
direct manufacturing labor, and many
manufacturing, marketing, distribution,
and customer-service costs are all locked in.
Cost Incurrence and
Locked-in Costs
When a sizable fraction of the costs are locked in
at the design stage, the focus of value engineering
is on making innovations and modifying designs
at the product design stage.
Learning Objective 5
Price products using the
cost-plus approach.
Cost-Plus Pricing
The general formula for setting a
cost-based price is to add a markup
component to the cost base.
Cost base
X
Markup component
Y
Prospective selling price
X+Y
Cost-Plus Pricing
Assume that Latisha’s engineers
have redesigned CC into CCI at
a new cost of 637.50.
The company desires a 20% markup
on the full unit cost.
What is the prospective selling price?
Cost-Plus Pricing
Cost base:
637.50
Markup component: (637.50 ×.20)
127.50
Prospective selling price:
765.00
Cost-Plus Pricing
Assume that the capital investment needed for
CCI is $75 million, and the company (pretax)
target rate of return on investment is 17%.
What is the target annual operating income
that Latisha needs to earn from CCI?
75,000,000 × .17 = 12,750,000
Cost-Plus Pricing
What is the target operating income per unit?
$12,750,000 ÷ 100,000 units = $127.50/unit
Cost-Plus Pricing
The 17% target rate of return on investment
expresses the company’s expected annual
operating income as a percentage of investment.
The 20% markup expresses operating
income per unit as a percentage of the
full product cost per unit.
Advantages of Using Full Costs
Full recovery of all costs of the product
Price stability
Simplicity
Alternative Cost-Plus Methods
Variable manufacturing costs
Variable costs of the product
Manufacturing function costs
Learning Objective 6
Use life-cycle budgeting
and costing when making
pricing decisions.
Life-Cycle Budgeting
The product life cycle spans the time from
original research and development, through
sales, to when customer support is no longer
offered for that product.
A life-cycle budget estimates revenues and
costs of a product over its entire life.
Life-Cycle Budgeting
Features that make life-cycle budgeting important:
Nonproduction costs
Development period for R&D and design
Other predicted costs
Nonproduction Costs
These costs are less visible on a
product-by-product basis.
When nonproduction costs are significant,
identifying these costs by product is
essential for target pricing, target costing,
value engineering, and cost management.
Development Period
When a high percentage of total life-cycle
costs are incurred before any production
begins and before any revenues are received,
it is crucial for the company to have as
accurate a set of revenue and cost
predictions for the product as possible.
Predicted Costs
Many of the production, marketing, distribution
and customer service costs are locked in
during the R&D and design stage.
Life-cycle budgeting facilitates value engineering
at the design stage before costs are locked in.
Life-Cycle Budgeting
and Costing
Consider a life-cycle average sales
price of 55,000 per unit.
If the desired life-cycle contribution is
45%, what is the allowable cost over
the life cycle of the product?
55,000 – (55,000 × .45) = 30,250
Learning Objective 7
Describe two pricing practices
in which noncost factors are
important when setting prices.
Other Considerations in
Pricing Decisions
Price discrimination
Peak-load pricing
Name of the Student:
Class Roll No.
Date:
University No.:
Marks:10
QUIZ No. 4
PRICING DECISIONS AND COST MANAGEMENT
ATTEMPT ALL QUESTIONS
MULTIPLE CHOICE QUESTIONS
1. A short run pricing decision typically has a time horizon of less
than
 A. ten years. B. one year. C. five years. D.
 two years.
 ANS. B
QUIZ-4
2. Which one of the following activities would most likely be considered a long run pricing decision?
 A. Setting prices to generate a reasonable rate of return on investment
 B. One-time-only special order pricing
 C. Changing prices in response to weak demand

D. Product mix adjustments in a competitive market
 ANS. A
3. The department in the firm that is most likely positioned to identify the customers' needs and their
perceived value for a product is the
 A. purchasing department. B. marketing department. C. production department. D.
accounting department.
 ANS. B
QUIZ-4
4.The costs that should be considered relevant in a company's target-cost calculation are
 A. fixed costs only. B. variable costs only.
 C. only fixed and variable overhead costs.
 D. all variable and fixed costs.
 ANS.D
5. When the firm uses the target-costing approach to pricing, the target cost per unit is the difference
between the per unit target price and the per unit target
 A. gross margin. B. production costs. C. operating income. D. contribution margin.
 ANS. C
QUIZ-4
TRUE OR FALSE STATEMENTS
6. The only competition a firm must be concerned about when setting
prices are those in the local market.
 True
False
ANS. FALSE
7. Target costing begins with the price the customer is willing to pay and then
"backs-into" what the product should cost.
 True
False
ANS.TRUE

QUIA-4
8. Cost-plus pricing starts with what customers are willing to pay, and
then adds a desired profit.
 True
False
 ANS. FALSE
9. Value engineering can be used to make cost improvements in order
to meet a target cost.
 True
False
 ANS.TRUE
QUIZ-4
10.Whether the firm uses the market-based
approach or the cost-based approach for
pricing decisions, the market forces must be
considered.
 True
False
 ANS.TRUE
HOME ASSIGNMENT-4
1. HOW IS ACTIVITY BASED
FOR PRICING DECISIONS?
COSTING USEFUL
2. WHAT IS COST PLUS PRICING? DESCRIBE THREE
ALTERNATIVE COST PLUS PRICING METHODS.
QUESTIONS RELATING TP PRICING DECISIONS AND COST MANAGEMENT
Q.No. 1
Crasco Associates prepares architectural drawings to conform to local
structural safety codes. Its income statement for 2001 is :
PARTICULARS
AMOUNT IN
$
REVENUES
680,000
SALARIES OF PROFESSIONAL STAFF (8000 HOURS X $
400,000
50 PER HOURS
TRAVEL
18,000
ADMINISTRATIVE AND SUPPORT COSTS
160,000
TOTAL COSTS
578,000
OPERATING INCOME
102,000
Following is percentage of time spent by professional staff on various activities:
PARTICULARS
%
Making calculations and preparing drawings for clients
75
Cecking calculations and drawings
4
Correcting errors found in drawings (not billed to clients)
7
Making changes in response to client requests (billed to clients)
6
Correcting own errors regarding building codes (not billed to clients) 8
Total
100
Assume administrative and support costs vary with professional labour costs.How
much of the tota costs in 2009 are value added, non value added or in the gray are in
between.
ANS.
Target operating income, value-added costs, service company.
1.
The classification of total costs in 2001 into value-added, nonvalue added, or in the gray area in between
follows.
Value
Added
(1)
Doing calculations and preparing drawings
75%  $400,000
Checking calculations and drawings
4%  $400,000
Correcting errors found in drawings
7%  $400,000
Making changes in response to client requests
6%  $400,000
Correcting errors to meet government building code,
8%  $400,000
Total professional labor costs
Administration and support costs at 40% ($160,000 
Gray
Area
(2)
Nonvalue
added
(3)
$300,000
$300,000
$16,000
16,000
$28,000
24,000
324,000
Total
(4)=
(1)+(2)+(3)
28,000
24,000
16,000
32,000
60,000
32,000
400,000
$400,000) of professional labor costs
Travel
Total
129,600
18,000
$471,600
6,400
–
$22,400
24,000
–
$84,000
160,000
18,000
$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. 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, and making changes to conform to the building code might be regarded as in the gray area.
Carasco’s staff can reduce nonvalue-added costs by checking government building code requirements
before drawing up the plans and taking more care when doing the actual work. To reduce value-added costs, Carasco’s
staff must work faster and more efficiently while at the same time maintaining quality. To achieve these goals, Carasco
may want to consider investing in computer-aided drawing programs and training its professional staff to work with
these tools.
Q.No. 2
Crasco Associates prepares architectural drawings to conform to local
structural safety codes. Its income statement for 2001 is :
PARTICULARS
AMOUNT IN
$
REVENUES
680,000
SALARIES OF PROFESSIONAL STAFF (8000 HOURS X $
400,000
50 PER HOURS
TRAVEL
18,000
ADMINISTRATIVE AND SUPPORT COSTS
160,000
TOTAL COSTS
578,000
OPERATING INCOME
102,000
Following is percentage of time spent by professional staff on various activities:
PARTICULARS
%
Making calculations and preparing drawings for clients
75
Cecking calculations and drawings
4
Correcting errors found in drawings (not billed to clients)
7
Making changes in response to client requests (billed to clients)
6
Correcting own errors regarding building codes (not billed to clients) 8
Total
100
Assume administrative and support costs vary with professional labour costs.
Suppose Crasco could eliminate all errors so that it did not need to spend any time
making corrections and , as a result could proportionately reduce professional labour
costs. Calculate Carsco’s operating income for 2009.
ANS.2
Reduction in professional labor-hours by
a.
b.
Correcting errors in drawings (7%  8,000)
560 hours
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 administration and support
costs (40%  $60,000)
24,000
Total cost savings
$ 84,000
Current operating income in 2001
Add cost savings from eliminating errors
Operating income in 2001 if errors eliminated
$102,000
84,000
$186,000
Q.No. 3
Crasco Associates prepares architectural drawings to conform to local
structural safety codes. Its income statement for 2001 is :
PARTICULARS
AMOUNT IN
$
REVENUES
680,000
SALARIES OF PROFESSIONAL STAFF (8000 HOURS X $
400,000
50 PER HOURS
TRAVEL
18,000
ADMINISTRATIVE AND SUPPORT COSTS
160,000
TOTAL COSTS
578,000
OPERATING INCOME
102,000
Following is percentage of time spent by professional staff on various activities:
PARTICULARS
%
Making calculations and preparing drawings for clients
75
Cecking calculations and drawings
4
Correcting errors found in drawings (not billed to clients)
7
Making changes in response to client requests (billed to clients)
6
Correcting own errors regarding building codes (not billed to clients) 8
Total
100
Assume administrative and support costs vary with professional labour costs. Now
suppose Carasco could take on as much business as it couould complete, but it could
not add more professional staff. Assume Carasco could eliminate all errors so that it
does not need to spend any time correcting errors. Assume Carasco could use the
time saved to increase revenues proportionately. Assume travel costs will remain at $
18,000. Calculate Carasco’s operating income for 2009.
ANS. 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
Administration 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
Q. No. 4
Water bury Inc. Manufactureres and sells RF 17 a speciality raft used for
whitewater rafting in 2009, it reported the following:
PARTICULARS
2009
UNITS PRODUCED AND SOLD
20,000
INVESTMENT
$ 2,400,000
FULL COST PER UNIT
$ 300
RATE OF RETURN ON IN VESTMENT
20%
MARKUP PERCENTAGE ON VARIABLE COST 5%
What was the selling price in 2009? What was the percentage markup on full
cost? What was the variable cost per unit?
ANS.
Cost-plus target return on investment pricing
1.
Target operating income = target return on investment  invested capital
Target operating income (25% of $960,000)$240,000
Total fixed costs
352,000
Target contribution margin $592,000
Target contribution per room, ($592,000 ÷ 16,000)
Add variable costs per room
3
Price to be charged per room
$40
$37
Proof
Total room revenues ($40  16,000 rooms)$640,000
Total costs:
Variable costs ($3  16,000)$ 48,000
Fixed costs
352,000
Total costs
Operating income
400,000
$240,000
The full cost of a room
= variable cost per room + fixed cost per
The full cost of a room
= $3 + ($352,000 ÷ 16,000) = $3 + $22 =
room
$25
Markup per room =
Rental price per room – Full cost of a room
= $40 – $25 = $15
Markup percentage as a fraction of full cost = $15 ÷ $25 = 60%
Q. No. 5
Water bury Inc. Manufactureres and sells RF 17 a speciality raft used for
whitewater rafting in 2009, it reported the following:
PARTICULARS
2009
UNITS PRODUCED AND SOLD
20,000
INVESTMENT
$ 2,400,000
FULL COST PER UNIT
$ 300
RATE OF RETURN ON IN VESTMENT
20%
MARKUP PERCENTAGE ON VARIABLE COST 5%
The company is considering raising its selling price to $ 348. However at this price
its sales volume is predirected to fall by 10%. If Waterbury’s cost structure (variable
cost per unit and total fixed costs) remains unchanged and if its demand forecast is
accurate, should it raise the selling price to $ 348.
ANS. If price is reduced by 10%, the number of rooms Beck could rent would
increase by 10%.
The new price per room would be 90% of $40 $36
The number of rooms Beck expects to rent is 110% of 16,000 17,600
The contribution margin per room would be $36 – $3
$33
Contribution margin ($33 17,600)$580,800
Because the contribution margin of $580,800 at the reduced price of $36 is
less than the contribution margin of $592,000 at a price of $40, Beck should not
reduce the price of the rooms. Note that the fixed costs of $352,000 will be the same
under the $40 and the $36 price alternatives and are, hence, irrelevant to the analysis.
Q.NO. 6
Astel Co. wants to reduce its product (named ProValue) price by 20%, from
$1,000 to $800 per unit. At this lower price, Astel’s marketing manager forecasts an
increase in annual sales from 150,000 to 200,000 units. To earn the target return on
the capital invested in the business, Astel’s management needes a 10% target
perating income on target revenues. reports the profiability of ProValue.
Answer:
1. total target revenues = $800 per unit × 200,000 units = $160,000,000;
2. total target operating income = 10% × $160,000,000 = $16,000,000;
3. total operating income per unit= $16,000,000 ÷ 200,000 per unit = $80/units;
4. target cost per unit= $800 per unit − $80 units = $720 per unit;
5. total current full costs of ProValue = $135,000,000 (from Exhibit 12-2);
6. current full costs of ProValue/unit = $135,000,000 ÷ 150,000 units = $900/unit.
ProValue’s $720 target cost per uint is well bellow its existing $900 unit cost.
Astel must reduce its unit cost by $180 to reach its goal.
Q.No. 7.
A firm determines full manufacturing cost (the total of variable and fixed
manufacturing costs) and applies a markup percentage to cover other operating costs
plus profit. The firm has the following unit cost: (1): materials ($40), (2): labor ($50);
(3) bactch level costs ($20); (4) other plant overhead ($40). In addition to
manufacturing costs of $150 per unit (i.e., $40 + $50 + $20 + $40 = $150), the
previous firm has S&A costs of $25 per unit, for a total of $175 life-cycle cost.
Required:
1. The firm uses a market rate of 40 percent based on manufacturing costs;
2. The firm uses a market rate of 25 percent based on life-cycle costs;
3. The desired gross margin is 30 percent of sales;
4. The desired return on life-cycle costs is 15 percent;
5. The firm has $3.5 million of assets and desired a 10 percent before-tax return on
assets (sales = 10,000 units) ) what is the markup percentage and the price (by a lifecycle cost approach);
Answer:
1. $150 × 140% = $210;
2. $175 × 125% = $218.75;
3. Price = Full manufacturing cost
1−Desired gross margin percentage = $150 = $ 214.29
1−0.3
4 Price = Full life cycle cost
1−Desired life cycle margin percentage = $175 = $ 205.88
1−0.15
5. Markup rate = Desired before tax return
Life cycle cost of expected sales = $3,500,000×10% = 20%
10,000×$175
Price = Life-cycle cost × 120% = $175 × 120% = $210.
Q. No. 8
The following financial data apply to the Videotape production plant of the
Dill company for October, 2009
PARTICULARS
BUDGETED
MANUFACTURING
DIRECT MATERIALS
DIRECT MANUFACTURING LABOUR
VARIABLE MANUFACTURING OVERHEAD
FIXED MANUFACTURING OVERHEAD
TOTAL MANUFACTURING COST
COST PER VIDEO
TAPE IN $
1.60
0.90
0.70
1.00
4.2
Variable manufacturing overhead varies with the number of units produced. Fixed
manufacturing overhead of $ 1 per tape is based on budgeted fixed manufacturing
overhead of $ 150,000 per month and budgeted production of 150,000 tapes per
month. The Dill company sells each tape for $ 5.
Marketing costs have two components:
1. Variable marketing costs (sales commissions) of 5% of revenues.
2. Fixed monthly costs of $ 65,000.
During October, 2009 Lyn Randell , A Dill company sales person asked the president
for permission to sell 1,000 tapes at $ 4.0 per tape to a customer not in Dill’s
normal marketing channels. The president refused this special order because the
selling price was below the total budgeted manufacturing cost.
What would have been the effect on monthly operating income of accepting the
special order.
ANS.
Relevant-cost approach to pricing decisions, special order.
1.
Relevant revenues, $4.00  1,000
Relevant costs
Direct materials, $1.60 1,000
Direct manufacturing labor, $0.90  1,000
Variable manufacturing overhead, $0.70  1,000
Variable selling costs, 0.05  $4,000
Total relevant costs
Increase in operating income
$4,000
$1,600
900
700
200
3,400
$ 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.
.
Q. No. 9
The following financial data apply to the Videotape production plant of the
Dill company for October, 2009
PARTICULARS
BUDGETED
MANUFACTURING
COST PER VIDEO
DIRECT MATERIALS
DIRECT MANUFACTURING LABOUR
VARIABLE MANUFACTURING OVERHEAD
FIXED MANUFACTURING OVERHEAD
TOTAL MANUFACTURING COST
TAPE IN $
1.60
0.90
0.70
1.00
4.2
Variable manufacturing overhead varies with the number of units produced. Fixed
manufacturing overhead of $ 1 per tape is based on budgeted fixed manufacturing
overhead of $ 150,000 per month and budgeted production of 150,000 tapes per
month. The Dill company sells each tape for $ 5.
Marketing costs have two components:
3. Variable marketing costs (sales commissions) of 5% of revenues.
4. Fixed monthly costs of $ 65,000.
During October, 2009 Lyn Randell , A Dill company sales person asked the president
for permission to sell 1,000 tapes at $ 4.0 per tape to a customer not in Dill’s
normal marketing channels. The president refused this special order because the
selling price was below the total budgeted manufacturing cost.
Comment on the president’s below manufacturing costs reasoning for rejecting the
special order.
ANS.
Relevant-cost approach to pricing decisions, special order.
Relevant revenues, $4.00  1,000
Relevant costs
1.
Direct materials, $1.60 1,000
Direct manufacturing labor, $0.90  1,000
Variable manufacturing overhead, $0.70  1,000
Variable selling costs, 0.05  $4,000
Total relevant costs
Increase in operating income
$4,000
$1,600
900
700
200
3,400
$ 600
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.
Q. NO. 10.
Q. No. 10
The following financial data apply to the Videotape production plant of the
Dill company for October, 2009
PARTICULARS
BUDGETED
MANUFACTURING
DIRECT MATERIALS
DIRECT MANUFACTURING LABOUR
VARIABLE MANUFACTURING OVERHEAD
FIXED MANUFACTURING OVERHEAD
TOTAL MANUFACTURING COST
COST PER VIDEO
TAPE IN $
1.60
0.90
0.70
1.00
4.2
Variable manufacturing overhead varies with the number of units produced. Fixed
manufacturing overhead of $ 1 per tape is based on budgeted fixed manufacturing
overhead of $ 150,000 per month and budgeted production of 150,000 tapes per
month. The Dill company sells each tape for $ 5.
Marketing costs have two components:
5. Variable marketing costs (sales commissions) of 5% of revenues.
6. Fixed monthly costs of $ 65,000.
During October, 2009 Lyn Randell , A Dill company sales person asked the president
for permission to sell 1,000 tapes at $ 4.0 per tape to a customer not in Dill’s
normal marketing channels. The president refused this special order because the
selling price was below the total budgeted manufacturing cost.
What other factors should the president consider before accepting or rejecting the
special order.
ANS.
Relevant-cost approach to pricing decisions, special order.
1.
Relevant revenues, $4.00  1,000
Relevant costs
Direct materials, $1.60 1,000
Direct manufacturing labor, $0.90  1,000
Variable manufacturing overhead, $0.70  1,000
Variable selling costs, 0.05  $4,000
Total relevant costs
Increase in operating income
$4,000
$1,600
900
700
200
3,400
$ 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.
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- ru n business.