CHAPTER 12PRICING DECISIONS AND COST MANAGEMENT

12-1 The three major influences on pricing decisions are:1. Customers, who influence price through their effect on demand for a product or service.2. Competitors, who offer alternative or substitute products or services a customer could choose.3. Costs that affect the supply of a product or service.

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, “Given what it costs us to make this product, what price should we charge that will recoup our costs and achieve a required return on investment?”

12-6 A target cost per unit is the estimated long-run cost per unit of a product or service that enables the company to achieve its target operating income per unit when selling at the target price.

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 designs, changes in material specifications, or modification in process methods, is a principal technique that companies use to achieve target cost 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.

12-1

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 cost of the product; and (d) full cost of the product.

12-12 Two examples where the difference in the costs of two products or services are 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 in coach class sold to a passenger traveling on business or a passenger traveling for pleasure is roughly the same. However, airline companies routinely charge business travelers––those who are likely to start and complete their travel during the same week excluding the weekend––a much higher price than pleasure travelers who generally stay at their destinations over at least one weekend.

12-13 Life-cycle budgeting is an estimate of the revenues and individual value-chain 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 out competitors and restrict supply and then raises prices rather than enlarge demand. Under U.S. laws, dumping occurs when a non-U.S. company sells a product in the United States at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the United States. Collusive pricing occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade.

12-2

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

1. Relevant revenues, $3.80 × 1,000 $3,800Relevant costs

Direct materials, $1.50 × 1,000 $1,500Direct manufacturing labor, $0.80 × 1,000 800Variable manufacturing overhead, $0.70 × 1,000 700Variable selling costs, 0.05 × $3,800 190 Total relevant costs 3,190

Increase in operating income $ 610

This calculation assumes that:a. The monthly fixed manufacturing overhead of $150,000 and monthly fixed marketing

costs of $65,000 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 when they should be included because they are relevant to the decision.

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, reducing the price from $5.00 to $3.80 can have a large negative effect on total revenues.

b. Is the 1,000-tape order a one-time-only order, or is there the possibility of sales in subsequent months? The fact that the customer is not in Dill Company’s “normal marketing channels” does not necessarily mean it is a one-time-only order. Indeed, the sale could well open a new marketing channel. Dill Company should be reluctant to consider only short-run variable costs for pricing long-run business.

12-3

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

1. Analysis of special order:Sales, 3,000 units × $80 $240,000Variable costs:

Direct materials, 3,000 units × $35 $105,000Direct manufacturing labor, 3,000 units × $10 30,000Variable manufacturing overhead, 3,000 units × $5 15,000Other variable costs, 3,000 units × $5 15,000Sales commission 6,000

Total variable costs 171,000Contribution margin $ 69,000

Note that the variable costs, except for commissions, are affected by production volume, not sales dollars. If the special order is accepted, operating income would be $1,000,000 + $69,000 = $1,069,000.

2. Whether McMahon is making a correct decision depends on many factors. He is incorrect if the capacity would otherwise be idle and if his objective is to increase operating income in the short run. If the offer is rejected, San Carlos, in effect, is willing to invest $69,000 in immediate gains forgone (an opportunity cost) to preserve the long-run selling-price structure. McMahon is correct if he thinks future competition or future price concessions to customers will hurt San Carlos’s operating income by more than $69,000.

There is also the possibility that Abrams could become a long-term customer. In this case, is a price that covers only short-run variable costs adequate? Would Holtz be willing to accept a $6,000 sales commission (as distinguished from her regular $36,000 = 15% × $240,000) for every Abrams order of this size if Abrams becomes a long-term customer?

12-4

12-18 (25 min.) Short-run pricing, capacity constraints.

1. With no constraints on availability of Pyrone or on plant capacity, Boutique would want to charge a minimum price for Seltium that would cover its incremental costs to manufacture Seltium. (Because there is excess capacity, there is no opportunity cost.) In this case, the incremental costs are the variable costs to manufacture a kilogram of Seltium:

Pyrone (2 kilograms × $4 per kilogram) $ 8Direct manufacturing labor 4Variable manufacturing overhead costs 3Total variable manufacturing costs $15

Hence, the minimum price that Boutique should charge to manufacture Seltium is $15 per kilogram. For 3,000 kilograms of Seltium, it should charge a minimum of $45,000 ($15 × 3,000).

2. Now Pyrone is in short supply. Using it to make Seltium reduces the Bolzene that Boutique can make and sell. There is, therefore, an opportunity cost of manufacturing Seltium, the lost contribution from using the Pyrone to manufacture Bolzene. To make 3,000 kilograms of Seltium requires 6,000 (2 × 3,000) kilograms of Pyrone.

The 6,000 kilograms of Pyrone can be used to manufacture 4,000 (6,000 ÷ 1.5) kilograms of Bolzene, since each kilogram of Bolzene requires 1.5 kilograms of Pyrone.

The contribution margin from 4,000 kilograms of Bolzene is $24,000 ($6 per kilogram × 4,000 kilograms). This is the opportunity cost of using Pyrone to manufacture Seltium. The minimum price that Boutique should charge to manufacture Seltium should cover not only the incremental (variable) costs of manufacturing Seltium but also the opportunity cost:

Costs of Manufacturing Seltium

Relevant Costs

Total for3,000 Kilograms

(1)Per Kilogram

(2) = (1) ÷ 3,000Incremental (variable ) costs of manufacturing

SeltiumOpportunity cost of forgoing manufacture and sale of

BolzeneMinimum cost of order

$45,000

24,000 $69,000

$15

8 $23

For 3,000 kilograms of Seltium, Boutique should charge a minimum of $69,000. The minimum price per kilogram that Boutique should charge for Seltium is $23 per kilogram ($69,000 ÷ 3,000 kilograms).

12-5

12–19 (25–30 min.) Value-added, nonvalue-added costs.

1.Category Examples

Value-added costs a. Materials and labor for servicing mach. tools $ 800,000 Nonvalue-added costs b. Rework costs

c. Expediting costs caused by work delaysg. Breakdown maintenance of equipmentTotal

$ 75,000 60,000 55,000 $190,000

Gray area d. Materials handling costse. Materials procurement and inspection costsf. Preventive maintenance of equipmentTotal

$ 50,00035,000

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 $ 865,000Total nonvalue-added costs: $190,000 + $35,000 225,000Total 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.

12-6

12-19 (Cont’d.)

3. Effect on Costs Classified as

ProgramValue-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 effectTransferring 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 effectTransferring 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 programsValue-added and nonvalue-added costs calculated in

requirement 2Expected 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 had been implemented in 2004, 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.

12-7

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

1. The classification of total costs in 2004 into value-added, nonvalue-added, or in the gray area in between follows:

Value Gray Nonvalue- TotalAdded Area added (1) (2) (3) (4) = (1)+(2)+(3)

Doing calculations and preparing drawings75% × $400,000 $300,000 $300,000

Checking calculations and drawings4% × $400,000 $16,000 16,000

Correcting errors found in drawings7% × $400,000 $28,000 28,000

Making changes in response to clientrequests 6% × $400,000 24,000 24,000

Correcting errors to meet governmentbuilding code, 8% × $400,000 _______ ______ 32,000 32,000

Total professional labor costs 324,000 16,000 60,000 400,000Administrative and support costs at 40% ($160,000 ÷ $400,000) of professional labor costs 129,600 6,400 24,000 160,000Travel 18,000 — — 18,000Total $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. 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.

2. Reduction in professional labor-hours bya. Correcting errors in drawings (7% × 8,000) 560 hoursb. Correcting errors to conform to building code (8% × 8,000) 640 hours

Total 1,200 hoursCost savings in professional labor costs (1,200 hours × $50) $ 60,000Cost savings in variable administrative and support costs (40% × $60,000) 24,000Total cost savings $ 84,000Current operating income in 2004 $102,000Add cost savings from eliminating errors 84,000Operating income in 2004 if errors eliminated $186,000

12-8

12-20 (Cont’d.)

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 unchangedProfessional salary costs $400,000Administrative and support (40% × $400,000) 160,000Travel 18,000Total costs $578,000

Carasco’s operating income would beRevenues $800,000Total costs 578,000Operating income $222,000

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

1. Snappy’s operating income in 2003 is as follows:

Total for250,000 Tiles

(1)Per Unit

(2) = (1) ÷ 250,000Revenues ($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 costsOperating income

$1,000,000 750,00025,000

120,000 60,000 955,000 $ 45,000

$4 .00 3.000.100.48

0 .24 3 .82 $0 .18

2. Price to retailers in 2004 is 95% of 2003’s price = 0.95 × $4 = $3.80; cost per tile in 2004 is 96% of 2003’s cost = 0.96 × $3 = $2.88.

Snappy’s operating income in 2004 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 costsOperating income

$ 950,000 720,00025,000

120,000 60,000 925,000 $ 25,000

$3 .80 2.880.100.48

0 .24 3 .70 $0 .10

12-9

12-21 (Cont’d.)

3. Snappy’s operating income in 2004, if it makes changes in ordering and material handling, will be as follows:

Total for250,000 Tiles

(1)Per Unit

(2) = (1) ÷ 250,000Revenues ($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 costsOperating income

$950,000 720,000

5,00087,500

60,000 872,500 $ 77,500

$3 .80 2.880.020.35

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 2003 and 2004 are as follows: 2003 2004

Per Unit Per UnitTotal (2) = Total (4) =

(1) (1) ÷ 3,500 (3) (3) ÷ 4,000

Direct materials, $1,200 × 3,500; $1,100 × 4,000 $4,200,000 $1,200 $4,400,000 $1,100Batch-level costs, $8,000 × 70; $7,500 × 80 560,000 160 600,000 150Manuf. operations costs, $55 × 21,000;

$50 × 22,000 1,155,000 330 1,100,000 275Engineering change costs, $12,000 × 14;

$10,000 × 10 168,000 48 100,000 25Total $6,083,000 $1,738 $6,200,000 $1,550

3. = × 90% = $1,738 × 0.90 = $1,564.20

Actual manufacturing cost per unit of HJ6 in 2004 was $1,550. Hence, Medical Instruments did achieve its target manufacturing cost per unit of $1,564.20

4. To reduce the manufacturing cost per unit in 2004, Medical Instruments reduces the cost per unit of activity in each of the four cost categories—direct materials costs, batch-level costs, manufacturing operations costs, and engineering change costs. It also reduced machine-hours and number of engineering changes made—the quantities of the cost drivers. In 2003, Medical Instruments used 6 machine-hours per unit of HJ6 (21,000 machine-hours ÷3,500 units). In 2004, Medical Instruments used 5.5 machine-hours per unit of HJ6 (22,000 machine-hours ÷ 4,000 units). Medical Instruments reduced engineering changes from 14 in 2003 to 10 in 2004. Medical Instruments achieved these gains through value engineering activities that retained only those product features that customers wanted while eliminating activities and their costs.

12-10

12-23 (20 min.) Cost-plus target return on investment pricing.

1. Target operating income = Target return on investment × Invested capitalTarget operating income (25% × $960,000) $240,000Total fixed costs 352,000Target contribution margin $592,000

Target contribution margin per room, ($592,000 ÷ 16,000) $37Add variable costs per room 3Price to be charged per room $40

ProofTotal room revenues ($40 × 16,000 rooms) $640,000Total costs:

Variable costs ($3 × 16,000) $ 48,000Fixed costs 352,000

Total costs 400,000Operating income $240,000

The full cost of a room = variable cost per room + fixed cost per roomThe full cost of a room = $3 + ($352,000 ÷ 16,000) = $3 + $22 = $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%

2. 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% × $40 $36The number of rooms Beck expects to rent is 110% of 16,000 17,600The contribution margin per room would be $36 – $3 $33Contribution 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.

12-11

12-24 (20−25 min.) Cost-plus and target pricing (S. Sridhar, adapted).

1. Investment $1,800,000Return on investment 20%Operating income (20% × $1,800,000) $360,000Operating income per unit of RF17 ($360,000 ÷ 15,000) $24Full cost per unit of RF17 $200Selling price ($200 + $24) $224Markup percentage on full cost ($24 ÷ $200) 12%

2. Selling price of RF17 = Variable costs per unit of RF17 × 1.40

Hence, Variable costs per unit of RF17 = Selling price of RF17

1.40=

$224

.140= $160

3. Fixed costs are $40 ($200 − $160) per unit × 15,000 units = $600,000Revenues ($230 × 13,500) $3,105,000Variable costs ($160 × 13,500) 2,160,000Contribution margin ($70 × 13,500) 945,000Fixed costs 600,000Operating income $ 345,000

The operating income if Waterford increases the selling price of RF17 to $230 is $345,000. This is less than the $360,000 operating income Waterford earns by selling 15,000 units at a price of $224. The $6 ($230 – $224) increase in price causes demand to decrease by 1,500 units (15,000 – 13,500). The demand for RF17 is elastic—an increase in price causes a significant decrease in demand. Waterford should not increase the selling price to $230.

4. Target investment in 2005 $1,650,000Target return on investment 20%Target operating income in 2005, 20% × $1,650,000 $330,000

Target revenues in 2005, $210 × 15,000 $3,150,000Less target operating income in 2005 330,000Target costs in 2005 $2,820,000

Target cost per unit in 2005, $2,820,000 ÷ 15,000 $188

12-12

12-25 (25 min.) Life-cycle product costing, activity-based costing.

1. The budgeted life-cycle operating income for the new watch MX3 is $2,420,000, as shown below.

Life-Cycle Revenuesand Costs

Revenues, $40 × 400,000 $16,000,000R&D and design costs 1,000,000Manufacturing costs:

Variable, $15 × 400,000 6,000,000Batch, $600 × 8001 batches 480,000Fixed 1,800,000

Marketing costs:Variable, $3.20 × 400,000 1,280,000Fixed 1,000,000

Distribution costs:Batch, $280 × 2,5002 batches 700,000Fixed 720,000

Customer-service costs:Variable, $1.50 × 400,000 600,000

Total costs 13,580,000Operating income $ 2,420,000

1400,000 watches ÷ 500 watches per batch = 800 batches2400,000 watches ÷ 160 watches per batch = 2,500 batches

2. Budgeted product life-cycle costs for R&D and design $1,000,000Total budgeted product life-cycle costs $13,580,000

stagesdesign and D&R the tillincurredcosts cycle-lifeproduct budgeted of Percentage

= 000,580,13$

000,000,1$ = 7.36%

3. An analysis reveals that 80% of the total product life-cycle costs of the new watch will be locked in at the end of the R&D and design stages when only 7.36% of the costs are incurred (requirement 2). The implication is that it will be difficult to alter or reduce the costs of MX3 once Destin finalizes the design of MX3. To reduce and manage total costs, Destin must act to modify the design before costs get locked in.

12-13

12-25 (Cont’d.)

4. The budgeted life-cycle operating income for MX3 if Destin reduces its price by $3 is $1,912,000, as shown next. This is less than the operating income of $2,420,000 calculated in requirement 1. Therefore, Destin should not reduce MX3’s price by $3.

Life-CycleRevenuesAnd Costs

Revenues, $37 × 440,000 $16,280,000R&D and design costs 1,000,000Manufacturing costs:

Variable, $15 × 440,000 6,600,000Batch, $600 × 8003 batches 480,000Fixed 1,800,000

Marketing costs:Variable, $3.20 × 440,000 1,408,000Fixed 1,000,000

Distribution costs:Batch, $280 × 2,5004 batches 700,000Fixed 720,000

Customer-service costs:Variable, $1.50 × 440,000 660,000

Total costs 14,368,000Operating income $ 1,912,000

3440,000 watches ÷ 550 watches per batch = 800 batches4440,000 watches ÷ 176 watches per batch = 2,500 batches

12-26 (15 min.) Considerations other than cost in pricing.

1. No. We would expect the incremental costs of providing telephone services to be no different in peak versus off-peak hours. Most costs of maintaining and operating the telephone network are fixed costs that are the same in peak and off-peak periods. In fact, the unit cost per telephone call is likely to be higher during off-peak hours when fewer calls are made. Yet the prices charged for telephone calls during peak periods are higher than the prices charged for off-peak evenings, nights, and weekends.

2. Charging higher prices for peak period calls is an example of price discrimination. Price discrimination occurs because calls made between 8 A.M. and 5 P.M. on working days are generally made by businesses that are relatively more price insensitive—they must make telephone calls to conduct their regular day-to-day business activities. Charging a higher price for calls during business hours maximizes the telephone company’s operating income. Charging higher prices during business hours is also an example of peak-load pricing. Because the number of telephone calls that can be put through at any one time is limited, the telephone company raises prices to levels that the market will bear when demand is high.Calls during evenings, nights, and weekends are generally made by individuals for personal or

pleasure reasons. Because they pay for the calls themselves, individuals are much more sensitive to price than business callers—that is, their demand is more price-elastic. It is profitable for AT&T to charge low rates to stimulate demand for personal and pleasure calls.

12-14

12-27 (30 min.) Relevant-cost approach to pricing decisions.

1. Revenues (1,000 crates at $100 per crate) $100,000Variable costs:

Manufacturing $40,000Marketing 14,000

Total variable costs 54,000 Contribution margin 46,000Fixed costs:

Manufacturing $20,000Marketing 16,000

Total fixed costs 36,000 Operating income $ 10,000

Normal markup percentage: $46,000 ÷ $54,000 = 85.19% of total variable costs.

2. Only the manufacturing-cost category is relevant to considering this special order; no additional marketing costs will be incurred. The relevant manufacturing costs for the 200-crate special order are:

Variable manufacturing cost per unit $40 × 200 crates $ 8,000Special packaging 2,000

$10,000

Any price above $50 per crate ($10,000 ÷ 200) will make a positive contribution to operating income. Hence, based on financial considerations, Stardom should accept the 200-crate special order.

The reasoning based on a comparison of $55 per crate price with the $60 per crate absorption cost ignores monthly cost-volume-profit relationships. The $60 per crate absorption cost includes a $20 per crate cost component that is irrelevant to the special order. The relevant range for the fixed manufacturing costs is from 500 to 1,500 crates per month; the special order will increase production from 1,000 to 1,200 crates per month. Furthermore, the special order requires no incremental marketing costs.

3. If the new customer is likely to remain in business, Stardom should consider whether a strictly short-run focus is appropriate. For example, what is the likelihood of demand from other customers increasing over time? If Stardom accepts the 200-crate special offer for more than one month, it may preclude accepting other customers at prices exceeding $55 per crate. Moreover, the existing customers may learn about Stardom’s willingness to set a price based on variable cost plus a small contribution margin. The longer time frame over which Stardom keeps selling 200 crates of canned peaches at $55 a crate, the more likely that the existing customers will approach Stardom for their own special price reductions. If the new customer wants the contract to extend over a longer time period, Stardom should negotiate a higher price.

12-15

12-28 (25 min.) Cost-plus and market-based pricing.

1. California Temps’s full cost per hour of supplying contract labor is:

Variable costs $12Fixed costs ($240,000 ÷ 80,000 hours) 3Full cost per hour $15

Price per hour at full cost plus 20% = $15 × 1.20 = $18 per hour.

2. Contribution margins for different prices and demand realizations are as follows:

Price per Hour(1)

Variable Cost per Hour

(2)

Contribution Margin per

Hour(3)=(1)–(2)

Demand in Hours

(4)

Total Contribution(5)=(3)×(4)

$16

17

$12

12

$4

5

120,000

100,000

$480,000500,000

181920

121212

678

80,00070,00060,000

480,000490,000480,000

Fixed costs will remain the same regardless of the demand realizations. Fixed costs are, therefore, irrelevant since they do not differ among the alternatives.

The table above indicates that California Temps can maximize contribution margin and, hence, operating income by charging a price of $17 per hour.

3. The cost-plus approach to pricing in requirement 1 does not explicitly consider the effect of prices on demand. The approach in requirement 2 models the interaction between price and demand and determines the optimal level of profitability using concepts of relevant costs. The two different approaches lead to two different prices in requirements 1 and 2. As the chapter describes, pricing decisions should consider both demand or market considerations and supply or cost factors. The approach in requirement 2 is the more balanced approach. In most cases, of course, managers use the cost-plus method of requirement 1 as only a starting point. They then modify the cost-plus price on the basis of market considerations—anticipated customer reaction to alternative price levels and the prices charged by competitors for similar products.

12-29 (60 min.) Cost-plus and market-based pricing.

1. Single pool:

hourtestingper$11.91hours106,000

$1,262,460rateCost -==

Hourly billing rate = $11.91 × 1.45= $17.27 per billing-hour

2. See Solution Exhibit 12-29.

12-16

12-29 (Cont’d.)

SOLUTION EXHIBIT 12-29

HTT ATT SST ACT AQT Total

Test pool labor

(.3, .2, .2, .1, .2) $126,000 $ 84,000 $ 84,000 $ 42,000 $ 84,000 $ 420,000Supervision (.40, .15, .15, .15, .15) 28,800 10,800 10,800 10,800 10,800 72,000Equip. depreciation 48,230 22,000 39,230 32,000 37,000 178,460Heat (.50, .05, .05, .30, .10) 85,000 8,500 8,500 51,000 17,000 170,000Electricity (.30, .10, .10, .40, .10) 37,200 12,400 12,400 49,600 12,400 124,000Water (.00, .00, .20, .20, .60) 0 0 14,800 14,800 44,400 74,000Set-up (.20, .15, .30, .15, .20) 11,600 8,700 17,400 8,700 11,600 58,000Indirect materials (.15, .15, .30, .20, .20) 15,600 15,600 31,200 20,800 20,800 104,000

Operating supplies (.10, .10, .25, .20, .35) 6,200 6,200 15,500 12,400 21,700 62,000Total costs $358,630 $168,200 $233,830 $242,100 $259,700 $1,262,460

Total test-hours 29,680 12,720 27,560 22,260 13,780Hourly test-cost $12.08 $13.22 $8.48 $10.88 $18.85Hourly billing rate (hourly test-cost × 1.45) $17.52 $19.17 $12.30 $15.78 $27.33

3. The new costing method will have the following effects on the pricing structure for each of the five test types given the competitors’ hourly billing rates.

HTT ATT SST ACT AQT

New hourly billing rate (hourly test-cost × 1.45) $17.52 $19.17 $12.30 $15.78 $27.33Competitor rate $17.50 $19.00 $15.50 $16.00 $20.00New rate over/(under) market $.02 $.17 $(3.20) $(.22) $7.33Percent over/(under) market 0.1% 0.9% (20.6)% (1.4)% 36.7%

Common pool hourly billing-rate $17.27 $17.27 $17.27 $17.27 $17.27New rate over/(under) old rate $0.25 $1.90 $(4.97) $(1.49) $10.06Percent over/(under) old rate 1.4% 11.0% (28.8)% (8.7)% 58.3%

• Best Test will now be pricing all its lab tests more competitively in the market.

• For Heat Testing (HTT), there is minimal variance between the common pool rate, the new separate rate, and the competitors’ rates. The HTT rate could either be left at the old rate, or nominally raised to the competitors’ rates or new pool rate without much impact, depending on how Best Test wanted to position the test compared to the competition.

12-17

12-29 (Cont’d.)

• For Air Turbulence Testing (ATT), the new separate computed billing rate is significantly different than the common pool rate as well as close to the competitors’ rates. The same is true of Arctic Condition Testing (ACT). In both cases, Best Test would probably want to adjust billing rates (raise ATT rate and lower ACT rate) to the newly computed rates or competitors’ rates to better reflect resources consumed by the tests.

• For Stress Testing (SST), the newly computed rate is dramatically less than both the common pool rate and the competitors’ rates. Best Test would want to significantly reduce the price to at least meet the competitors’ price or reduce it further to the newly computed price, depending upon how aggressively it wanted to market this test.

• For Aquatic Testing (AQT), the newly computed rate is significantly higher than both the common pool rate and the competitors’ rates. Best Test would want to raise the billing rate at least to the competitors’ rates to recover its cost plus some contribution towards administrative costs. Its current common billing rate of $17.27 is below the $18.85 cost to perform the AQT test.

• Because the newly computed billing prices for both SST and AQT are significantly different than competitors’ prices, the cost assumptions should be further analyzed to verify accuracy and identify opportunities.

4. In general, at least three other internal or external factors that influence pricing structure include:

• number and nature of competitors for additional tests and their quality and timeliness of service.

• company’s overall capacity and its ability to react to volume and mix changes for tests if the demand changes due to the new pricing structure.

• number of potential customers, overall demand for the tests, and price elasticity of demand for the tests.

• strategic focus, such as desire to gain or defend market share, long-term support for entry into or exit from a market, or stage in the test’s product life cycle (introduction, growth, mature, or dying).

12-18

12-30 (20–25 min.) Product costs, activity-based costing.

This problem assumes knowledge of activity-based costing systems as described in Chapter 5. The problem illustrates how both product designers and manufacturing personnel can play key roles in a company manufacturing competitively priced products. Solution Exhibit 12-30 presents an overview of the product costing system at Executive Power. The following table presents the manufacturing cost per unit for different cost categories for P-41 and P-63.

Cost Categories P-41 P-63Direct manufacturing product costs

Direct materials $407 .50 $292 .10 Indirect manufacturing product costs

Materials handling (85 × $1.20; 46 × $1.20) 102.00 55.20Assembly management (3.2 × $40; 1.9 × $40) 128.00 76.00Machine insertion of parts (49 × $0.70; 31 × $0.70) 34.30 21.70Manual insertion of parts (36 × $2.10; 15 × $2.10) 75.60 31.50Quality testing(1.4 × $25; 1.1 × $25) 35 .00 27 .50 Total indirect manufacturing product costs $374 .90 $211 .90

Total manufacturing product costs $782 .40 $504 .00

SOLUTION EXHIBIT 12-30Overview of Product Costing at Executive Power

12-19

INDIRECTCOST

POOLS

COSTALLOCATION

BASES

COST OBJECT:PRODUCT

DIRECTPRODUCT

COSTS

MaterialsHandling

Number ofParts

AssemblyManagement

Hours ofAssembly

Time

MachineInsertionof Parts

Number ofMachine-

Inserted Parts

ManualInsertionof Parts

Number ofManually-

Inserted Parts

QualityTesting

Hours ofQuality-

Testing Time

INDIRECT COSTS

DIRECT COSTS

DirectMaterials

12-30 (Cont’d.)

12-30 Excel Application

Pricing Decisions and Cost ManagementExecutive Power

Original Data

Indirect Manufacturing Cost Pool Allocation Rate Materials Handling $1.20 per partAssembly Management $40.00 per hour of

assembly time Machine Insertion of Parts $0.70 per machine-

inserted part Manual Insertion of Parts $2.10 per manually-

inserted part Quality Testing $25.00 per testing-hour

Product Characteristics P-41 P-63 Direct Materials Costs $407.50 $292.10

Number of Parts 85 46Hours of Assembly Time 3.2 1.9

Number of Machine-Inserted Parts 49 31Number of Manually-Inserted Parts 36 15

Hours of Quality Testing 1.4 1.1

Manufacturing Cost Calculations

Cost Categories P-41 P-63 Direct Manufacturing Costs

Direct Materials $407.50 $292.10 Indirect Manufacturing CostsMaterials Handling 102.00 55.20 Assembly Management 128.00 76.00 Machine-Insertion of Parts 34.30 21.70 Manual-Insertion of Parts 75.60 31.50 Quality Testing 35.00 27.50 Total Indirect Manufacturing Costs 374.90 211.90 Total Manufacturing Product Costs $782.40 $504.00

12-20

12-31 (50–60 min.) Target cost, activity-based costing (continuation of 12-30).

1. 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 target operating income per unit. A target cost per unit is the estimated unit long-run cost of a product that will enable a company to enter or to remain in the market and compete profitably against its competitors.

2. The following table presents the manufacturing cost per unit for different cost categories for P-41REV and P-63 REV.

Cost Categories P-41 REV P-63 REV

Direct manufacturing product costs:Direct materials $381 .20 $263 .10

Indirect manufacturing product costs:Materials handling (71 × $1.20; 39 × $1.20) 85.20 46.80Assembly management (2.1 × $40; 1.6 × $40) 84.00 64.00Machine insertion of parts (59 × $0.70; 29 × $0.70) 41.30 20.30Manual insertion of parts (12 × $2.10; 10 × $2.10) 25.20 21.00Quality testing (1.2 × $25; 0.9 × $25) 30 .00 22 .50

Total indirect manufacturing costs 265 .70 174 .60 Total manufacturing costs $646 .90 $437 .70 Target cost $680 .00 $390 .00

P-41 REV is $33.10 ($680 – $646.90) below its target cost. However, P-63 REV is $47.70 ($437.70 – $390) above its target cost. It appears Executive Power will have major problems competing with the foreign printer costing $390.

12-21

12-31 (Cont’d.)

3. P-41 = $782.40 P-63 = $504.00P-41 REV = 646 .90 P-63 REV = 437 .70 Difference = $135 .50 Difference = $ 66 .30

The sources of the cost reductions in the redesigned products are:

P-41 P-63

(a) Reduction in direct materials costs $ 26.30 $29.00(b) Changes in design:

Reduced materials handling costs due to fewer parts (85 – 71); (46 – 39) × $1.20 16.80 8.40Reduced assembly time (3.2 – 2.1); (1.9 – 1.6) × $40 44.00 12.00Reduced insertion of parts1 (49 – 59) × $0.70 + (36 – 12) × $2.10 43.40 (31 – 29) × $0.70 + (15 – 10) × $2.10 11.90Reduced quality testing (1.4 – 1.2); (1.1 – 0.9) × $25 5.00 5.00

$135.50 $66.30

1Note that the reduced costs for insertion of parts comes from two sources: (a) a reduction in total number of parts to be inserted, and (b) an increase in the percentage of parts inserted by the lower-cost machine method.

4. The $12 reduction in cost per hour of assembly time (from $40 to $28) reduces product costs as follows:

P-41 REV: $12 × 2.1 hours = $25.20. The new total manufacturing product cost is $621.70 ($646.90 – $25.20)

P-63 REV: $12 × 1.6 hours = $19.20. The new total manufacturing product cost is $418.50 ($437.70 – $19.20)

The reduction in the assembly management activity rate further reduces the cost of P-41 REV below the target cost. It also moves P-63 REV closer toward its target cost.

12-22

12-32 (40–45 min.) Target prices, target costs, value engineering, cost incurrence, locked-in cost, activity-based costing.

1.Old

CE100 Cost ChangeNew

CE100

Direct materials costs $182,000 $2.20 × 7,000 = $15,400 less $166,600

Direct manufacturing labor costs 28,000 $0.50 × 7,000 = $3,500 less 24,500Machining costs 31,500 Unchanged because capacity same 31,500

Testing costs 35,000 (20% × 2.5 × 7,000) × $2 = $7,000 less 28,000Rework costs 14,000 (See Note 1) 5,600Ordering costs 3,360 (See Note 2) 2,100Engineering costs 21,140 Unchanged because capacity same 21,140

Total manufacturing costs $315,000 $279,440

Note 1: 10% of old CE100s are reworked. That is, 700 (10% of 7,000) CE100s made are reworked. Rework costs = $20 per unit reworked × 700 = $14,000. If rework falls to 4% of New CE100s manufactured, 280 (4% of 7,000) New CE100s manufactured will require rework. Rework costs = $20 per unit × 280 = $5,600.

Note 2 : Ordering costs for New CE100 = 2 orders/month × 50 components × $21/order

= $2,100

Unit manufacturing costs of New CE100 = $279,440 ÷ 7,000 = $39.92

2. Total manufacturing cost reductions based on new design = $315,000 – $279,440= $35,560

Reduction in unit manufacturing costs based on new design = $35,560 ÷ 7,000= $5.08 per unit.

The reduction in unit manufacturing costs based on the new design can also be calculated as:

Unit cost of old design, $45 ($315,000 ÷ 7,000 units) – Unit cost of new design, $39.92 = $5.08

Hence, the target cost reduction of $6 per unit is not achieved by the redesign.

3. Changes in design have a considerably larger impact on costs per unit relative to improvements in manufacturing efficiency ($5.08 versus $1.50). One explanation is that many costs are locked in once the design of the radio-cassette is completed. Improvements in manufacturing efficiency cannot reduce many of these costs. Design choices can influence many direct and overhead cost categories, for example, by reducing direct materials requirements, by reducing defects requiring rework, and by designing in fewer components that translate into fewer orders placed and lower ordering costs.

12-23

12-33 (20−25 min.) Cost-plus pricing.

1.

jobfor required(DMLH) hours-labor

ingmanufacturDirect =

doses/DMLH 1,000

packaged be todoses 1,000,000 = 1,000 DMLH

Incremental costs:Direct manufacturing labor costs, $16.00 × 1,000 $16,000Variable overhead costs, $9.00 × 1,000 9,000Incremental administrative costs 5,000 Total incremental costs $30,000

Minimum price per dose = doses 1,000,000

costs lincrementa Total =

1,000,000

30,000= $0.03

2. As in part 1, 1,000 DMLH are required for the job.

Direct manufacturing labor costs, $16 × 1,000 $16,000Variable overhead costs, $9 × 1,000 9,000Fixed overhead costs, $30 × 1,000 30,000Incremental administrative costs 5,000Total (full) costs 60,000Maximum allowable return before taxes (15%*) 9,000Total bid price $69,000

Bid price per dose = 069.0$1,000,000

$69,000

doese 1,000,000

price bid Total ==

* 15.60.

09.

40.1

09.

rateTax -1

safter taxereturn allowable Maximum taxesbeforereturn

allowable Maximum ==−

==

3. The factors that Hall should consider before deciding whether or not to submit a bid at the maximum allowable price include (a) whether Hall has excess capacity, (b) whether there are available jobs for which profitability might be greater, and (c) whether the maximum bid of $0.07 per dose contributes toward recovering fixed costs.

12-34 (30–40 min.) Life-cycle product costing, product mix.

1. A life-cycle income statement traces revenue and costs of each individual software package from its initial research and development to its final customer servicing and support. The two main differences from a conventional income statement are:

a. Costs incurred in different calendar periods are included in the same statement.b. Costs and revenue of each package are reported separately rather than aggregated into

companywide categories.

The benefits of using a product life-cycle report are:a. The full set of revenues and costs associated with each product becomes visible.b. Differences among products in the percentage of total costs committed at early stages

in the life cycle are highlighted.

12-24

12-34 (Cont’d.)

c. Interrelationships among business function cost categories are highlighted. What is the effect, for example, of cutting back on R&D and product-design cost categories on customer-service costs in subsequent years?

2.EE-46 ME-83 IE-17

Revenue ($000s) $2,500 $1,500 $1,600Costs ($000s)

Research & development $700 $450 $240 Design 200 120 96 Production 300 210 208 Marketing 500 270 448 Distribution 75 60 96 Customer service 375 2,150 150 1,260 608 1,696

Operating income ($000s) $ 350 $ 240 $ (96)

As emphasized in this chapter, the time value of money is not taken into account when summing life-cycle revenue or life-cycle costs. Chapter 21 discusses this topic in detail.

Rankings of the three packages on profitability (and relative profitability) are:

Operating income

1. EE-46: $350,000 1. ME-83: 16.0%2. ME-83: $240,000 2. EE-46: 14.0%3. IE-17: $ (96,000) 3. IE-17: (6.0%)

The EE-46 and ME-83 packages should be emphasized, and the IE-17 package should be de-emphasized. It is interesting that IE-17 had the lowest R&D costs but was the least profitable. DSS should evaluate whether reducing R&D costs contributed in any way to IE-17’s poor performance.

3. The cost structures of the three software packages are:

EE-46 ME-83 IE-17

Research & development 32.5% 35.7% 14.1%Design 9.3 9.5 5.7Production 14.0 16.7 12.3Marketing 23.3 21.4 26.4Distribution 3.5 4.8 5.7Customer service 17 .4 11 .9 35 .8

100 .0 % 100 .0 % 100 .0 %

12-25

12-34 (Cont’d.)

The major differences are:a. EE-46 and ME-83 have over 30% of their costs in the R&D/product design categories,

compared to less than 15% (14.1%) for IE-17.b. IE-17 has 35.8% of its costs in the customer-service category, compared to 17.4% for

EE-46 and 11.9% for ME-83.

There are several explanations for these differences:a. EE-46 and ME-83 differ sizably from IE-17 in their R&D/product design intensity. For

example, EE-46 and ME-83 may require considerably (a) more interaction with users, and (b) more experimentation with software algorithms than does IE-17.

b. The software division should have invested more in the R&D/product design categories for IE-17. The high percentage for customer service costs could reflect the correcting of problems that should have been corrected prior to manufacture. Life-cycle reports highlight possible causal relationships among cost categories.

12-35 (15 min.) Considerations other than cost in pricing.

1. The business travelers predominantly stay on a Sunday-through-Thursday basis. They return home after their business is conducted during weekdays. They are price insensitive because they must travel to conduct their business during weekdays and their travel costs are reimbursed to them by their companies. Hotels can earn higher operating income by charging business travelers higher prices because higher prices have little effect on their demand for hotel stays.

In contrast, pleasure travelers who are paying for their hotel rooms are more sensitive to the hotel room rates. They may make their travel plans in a way that enables them to take advantage of lower weekend room rates. This may be done either by “mini” vacations taken during the weekends only, or extending their stay over the weekend because of lower rates. It is profitable for hotels to charge lower rates to stimulate demand among pleasure travelers.

Most of the hotel costs are fixed. The variable costs are a relatively minor part of the total costs and relate mainly to linen services. Therefore during “off peak” periods, hotels often reduce their room rates to attract customers. Even at reduced rates, hotels can cover their variable costs and generate contribution margin. Since fixed costs do not increase, any increase in contribution margin contributes to higher profits.

2. The hotels located in Anaheim and San Francisco’s Fisherman’s Wharf cater primarily to pleasure travelers. Therefore, the occupancy rates in those hotels do not go down during weekends. For this reason, the hotels can charge the same rate both during weekdays and weekends.

12-36 (30 min.) Airline pricing, considerations other than cost in pricing.

1. If the fare is $2,000,a. Air Americo would expect to have 190 business and 20 pleasure travelers.b. Variable cost per passenger would be $180.c. Contribution margin per passenger = $2,000 – 180 = $1,820.

12-26

12-36 (Cont’d.)

If the fare is $500,a. Air Americo would expect to have 200 business and 100 pleasure travelers.b. Variable cost per passenger would be $80.c. Contribution margin per passenger = $500 – $80 = $420.

Contribution margin from business travelers at prices of $500 and $2,000, respectively, follow:

At a price of $500: $420 × 200 passengers = $ 84,000At a price of $2,000: $1,820 × 190 passengers = $345,800

Air Americo would maximize contribution margin and operating income by charging business travelers a fare of $2,000.

Contribution margin from pleasure travelers at prices of $500 and $2,000, respectively, follow:

At a price of $500: $420 × 100 passengers = $42,000At a price of $2,000: $1,820 × 20 passengers = $36,400

Air Americo would maximize contribution margin and operating income by a price differentiation strategy, where business travelers are charged $2,000 and pleasure travelers $500. In deciding between the alternative prices, all other costs such as fuel costs, allocated annual lease costs, allocated ground services costs, and allocated flight crew salaries are irrelevant. That’s because these costs will not change whatever prices Air Americo chooses.

2. The elasticity of demand of the two classes of passengers drives the different demands of the travelers. Business travelers are relatively price insensitive because they must get to their destination during the week (exclusive of weekends) and their fares are paid by their companies. A 300% increase in fares from $500 to $2,000 will deter only 5% of the business passengers from flying with Air Americo.

In contrast, a similar fare increase will lead to an 80% drop in pleasure travelers who are paying for their own travel, unlike business travelers, and who may have alternative vacation plans they could pursue instead. Furthermore, lowering fares stimulates demand for pleasure travelers and results in higher contribution margins and operating incomes.

3. Since business travelers often want to return within the same week, while pleasure travelers often stay over weekends, a requirement that a Saturday night stay is needed to qualify for the $500 discount fare would discriminate between the passenger categories. This price discrimination is legal because airlines are service companies rather than manufacturing companies and because these practices do not, nor are they intended to, destroy competition.

12-27

12-37 (25 min.) Ethics and pricing.

1. Baker prices at full product costs plus a mark-up of 10% = $80,000 + 10% of $80,000 = $80,000 + $8,000 = $88,000.

2. The incremental costs of the order are as follows:

Direct materials $40,000Direct manufacturing labor 10,00030% of overhead costs 30% × $30,000 9,000Incremental costs $59,000

Any bid above $59,000 will generate a positive contribution margin for Baker. Baker may prefer to use full product costs because it regards the new ball-bearings order as a long-term business relationship rather than a special order. For long-run pricing decisions, managers prefer to use full product costs because it indicates the bare minimum costs they need to recover to continue in business rather than shut down. For a business to be profitable in the long run, it needs to recover both its variable and its fixed product costs. Using only variable costs may tempt the manager to engage in excessive long-run price cutting as long as prices give a positive contribution margin. Using full product costs for pricing thereby prompts price stability.

3. Not using full product costs (including an allocation of fixed overhead) to price the order, particularly if it is in direct contradiction of company policy, may be unethical. In assessing the situation, the specific “Standards of Ethical Conduct for Management Accountants,” described in Exhibit 1-7 (p. 18), that the management accountant should consider are listed below.

CompetenceClear reports using relevant and reliable information should be prepared. Reports prepared on the basis of excluding certain fixed costs that should be included would violate the management accountant’s responsibility for competence. It is unethical for Lazarus to suggest that Decker change the cost numbers that were prepared for the bearings order and for Decker to change the numbers in order to make Lazarus’s performance look good.

IntegrityThe management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Lazarus’s motivation for wanting Decker to reduce costs was precisely to earn a larger bonus. This action could be viewed as violating the standard for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. In this regard, both Lazarus’s and Decker’s behavior (if Decker agrees to reduce the cost of the order) could be viewed as unethical.

ObjectivityThe Standards of Ethical Conduct for Management Accountants require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, reducing fixed overhead costs when deciding on the price to bid clearly violates both these precepts. For the reasons cited above, the behavior described by Lazarus and Decker (if he goes along with Lazarus’s wishes) is unethical.

12-28

12-37 (Cont’d.)

Decker should indicate to Lazarus that the costs were correctly computed and that determining prices on the basis of full product costs plus a mark-up of 10% are required by company policy. If Lazarus still insists on making the changes and reducing the costs of the order, Decker should raise the matter with Lazarus’s superior. If, after taking all these steps, there is continued pressure to understate the costs, Decker should consider resigning from the company, rather than engage in unethical behavior.

12.38 (40 min.) Target prices, target costs, value engineering.

1. Activity-based allocation of overhead costs to Tvez are as follows:

CostUnits of Allocation

Cost Drivers (2) = (1) ×(1) Rate/Hour

Machine setup costs:$25 per setup-hour 100a × 12 = 1,200 hrs. $ 30,000

Testing costs:$2 per testing-hour 50,000 × 2.5 = 125,000 hrs. 250,000

Engineering costs 170,000 Total ABC overhead allocation $450,000

a 100 setups = 50,000 units ÷ 500 units per setup

Activity-based full-product costs of Tvez are as follows:Direct materials costs $ 850,000Direct manufacturing labor costs 300,000Direct machine costs 150,000Machine setup costs 30,000Testing costs 250,000Engineering costs 170,000Total manufacturing and full product costs $1,750,000Number of units 50,000Full product cost per unit $35.00

2. Markup on full product cost per unit of Tvezcostproduct Full

costproduct Fullprice Selling −=

%1635$

60.5$

35$

35$60.40$ ==−=

3. The target price for New Tvez is $34.80. Suppose the target cost per unit of New Tvez is $X

Then 80.34$)16.1(X =

That is 30$16.1

80.34$X ==

12-29

12-38 (Cont’d.)

4. Activity-based costs of New Tvez are as follows:

Direct materials ($17 – $3) × 50,000 units $ 700,000Direct manufacturing labor ($6 – $0.75) × 50,000 units 262,500Direct machining 150,000Machine setup costs(6 hours × 100 setups × $25 per setup-hour) 15,000Testing costs (2.5 hours – 0.5 hours) × 50,000 × $2 200,000Engineering costs (same as for Tvez) 170,000Manufacturing and full costs of the product $1,497,500Number of units 50,000Manufacturing and full costs per unit ($1,497,500 ÷ 50,000) $29.95

The New Tvez design will reduce the manufacturing costs per unit by $5.05 ($35 – $29.95) more than the $5.00 ($35 – $30) necessary to reduce the cost of New Tvez to $30.00. Hence, New Tvez will achieve the targeted cost reductions.

5. Price of New Tvez using a 16% markup on full product cost of $29.95 = $29.95 × 1.16 = $34.74.

Chapter 12 Internet Exercise

The Internet exercise is available to students only on the Prentice Hall Companion Website www.prenhall.com/horngren. Students can click on Cost Accounting, 11th ed., and access the Internet Exercise for the chapter, which links to the Web site of a company or organization. The Internet Exercise on the Web will be updated periodically so that it is current with the latest information available on the subject organization's Web site. A printout copy of the Internet exercise for this chapter as of early 2002 appears below.

The solution to the Internet exercise, which will also be updated periodically, is available to instructors from the Companion Website's faculty view. To access the solution, click on Cost Accounting, 11th ed., Faculty link, and then register once to obtain your password through the online form. After the initial registration, you will have a personal login ID and password to use to log in. A printout of the solution to the Internet exercise for this chapter as of early 2002 follows. The exercise and solution provide instructors with an idea of the content of the Internet exercise for this chapter.

Internet Exercise

Three major influences on pricing decisions are customers, competitors, and costs. This is certainly true for the airline industry, with its high fixed cost and inventory of seats that must be sold for each flight or be lost forever. In this exercise you will examine factors that influence pricing decisions in the airline industry.

1a. Major operating expenses for an airline include fuel, maintenance, wages, landing fees, aircraft rental/depreciation, airport facilities, and agency commissions. Which of these costs are relevant to an airline when making a decision to enter the New York-to-Chicago market? Why?

12-30

Internet Exercise (Cont’d.)

1b. Which costs are relevant in deciding to offer an additional flight between New York and Chicago? Why?

1c. Which costs are relevant for setting fares on an existing New York-to-Chicago flight? Why?

1d. What accounts for the success of a “name your own price” site such as Priceline.com?

2. The airline industry serves two distinct customer classes: business and leisure travelers. How does the airline industry use this fact to maximize revenues?

3a. Go to Travelocity.com, www.travelocity.com. What is the round-trip fare for a flight leaving New York next Monday and returning from Chicago on Friday? Compare this with the lowest fare you can find on a New York-to-Chicago flight. What are the travel restrictions on this fare?

3b. Click on the “Tips to find low fares” link. How do airlines discriminate in favor of pleasure travelers compared with business travelers?

4a. How many different airlines offer flights between New York and Chicago?

4b. How does this compare with a flight between New York and Cleveland, Ohio?

4c. What is the round-trip fare for a flight leaving New York next Monday and returning from Cleveland on Friday? How does this compare with the New York-to-Chicago flight? What might account for the difference?

5. Why do we see variable pricing more frequently used in the services industry rather than in the tangible goods industry?

Solution to Internet Exercise

1a. The decision to enter the New York-to-Chicago market would be a long-run decision, and all of these costs would be relevant to an airline. In the absence of strategic motivations, an airline would not want to enter a new market unless it expects average ticket revenues to exceed the average cost of flying passengers, plus a return on investment. This is an example of a capital budgeting decision that will be considered in a later chapter.

1b. In deciding to offer an additional flight between New York and Chicago an airline would want to consider the incremental cost of offering the additional fight. Incremental cost would be a function of capacity constraints. Does the airline have free gates, idle aircraft, and adequate counter and baggage handling capacity? If the answers to these questions were “no,” the airline would need to consider these costs. If the answers were “yes,” the airline would want to consider the incremental costs of an additional New York-to-Chicago flight: fuel, crew time, maintenance, agency commissions, and landing fees. It would also want to consider how an additional flight might affect the demand for its existing flights.

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Internet Exercise (Cont’d.)

1c. Due to its ability to price discriminate, an airline must consider incremental costs at two levels when establishing fares on existing flights. First, an airline must consider the incremental cost of the flight. At a minimum this would include fuel, maintenance, landing fees, wages, and agency commissions. The average ticket price should cover the average cost of flying a passenger from New York to Chicago.

However, due to an airline’s ability to price discriminate, setting prices is not that straightforward. In establishing fares, it should consider the incremental cost of flying each additional passenger, which is next to nothing, an airline meal and agency commissions. Moreover, if an airplane seat goes vacant for a flight, it is lost forever. This encourages airlines to get any price (as long as it covers their incremental cost) that they can get for it.

1d. Since the variable cost of flying an additional passenger is very low, airlines value the ability to price discriminate and offer low-priced tickets on empty flights to travelers with flexible flight plans. Publishing low fares would reduce average ticket prices and total revenues, but a system in which passengers make price offers for seats offers the airlines the opportunity to price discriminate on an individual passenger basis.

2. Business travelers must travel to conduct business for their companies, so their demand for air travel is relatively insensitive to price. So airlines charge business travelers higher prices. Also, business travelers travel to their destinations, complete their work, and return home within the same week.

Pleasure travelers prefer to spend weekends at their destinations. Because they pay for the ticket themselves, they are much more sensitive to price than business travelers. Airlines profit by charging low fares to stimulate demand among pleasure travelers.

By requiring a Saturday night stay, airlines can price discriminate and charge higher fares to business travelers and lower fares to pleasure customers.

3a. The answer will vary. At the time this exercise was prepared the lowest fare for a Monday-to-Friday flight was $346. This is significantly higher than a $178 fare for a flight with a Saturday night stay and a 14-day advance purchase.

3b. Demand by business travelers is generally less elastic than demand for pleasure travelers, and airlines can charge business travelers higher prices. They discriminate between business and pleasure travelers several ways. First, they offer lower fares on flights with a Saturday night stay. Second, fares are generally higher on prime travel days (Mondays and Fridays). Finally, fares are generally lower on flights with advance purchases of more than 14 days.

4a. At the time this exercise was prepared, nine airlines offered flights between New York and Chicago (United, American, Continental, TWA, USAir, AirTrans, Delta, Northwest, and America West).

4b. At the time this exercise was prepared, four airlines offered flights between New York and Cleveland (Allegheny Airlines, Continental, American Eagle, and Northwest).

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Internet Exercise (Cont’d.)

4c. The lowest fare on a Monday-to-Friday flight was $672. Since the New York-to-Cleveland flight is shorter, the difference is most likely due to less competition. In addition, while the Cleveland airport is likely to have lower operating costs, there may be slight economies of scale present in the New York-to-Chicago market.

5. The service industry has the problem of products that can’t be stored, whereas the tangible goods industry does not. Thus, if an airplane seat goes vacant for a flight, it is lost forever. This situation encourages airlines to get any price (as long as it covers their incremental cost) that they can get for it. If one could store services, we would see far less variability in the pricing of similar services, such as airline seats.

Chapter 12 Video Case

The video case can be discussed using only the case writeup in the chapter. Alternatively, instructors can have students view the videotape of the company that is the subject of the case. The videotape can be obtained by contacting your Prentice Hall representative. The case questions challenge students to apply the concepts learned in the chapter to a specific business situation.

GRAND CANYON RAILWAY PRICING VIDEO CASE

1. Environmental and market forces that might affect the Grand Canyon Railway’s pricing decisions include:

a. Appealing to the environmentally friendly aspects of the Railway because of less wear and tear on nature resulting from train travel. The Railway is endorsed by National Park Service, Grand Canyon Trust, and Parks and Conservation Association.

b. The cost of alternative transportation, such as tour buses, driving and parking, and flying.

c. The cost of substitute products, that is, visiting other local sites such as Sedona red rock country, Sunset Crater, Wupatki National Monument, Walnut Canyon, Arizona ghost towns, Lake Powell, etc.

d. Promoting the Railway to tour groups and travel agents and giving discount coupons.

e. The closure of the Grand Canyon for four days in November of one year severely impacted the railway’s operations. Because winter is typically the slow season and profit margins are slim anyway, ceasing operations for even this short time period adversely affected any chance of profitability for that month.

f. The discretionary income levels of people who might use the Railway.

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Video Exercise (Cont’d.)

2. Grand Canyon Railway has high fixed costs of insurance, interest, restoration and maintenance of engines and track; and low variable costs for fuel, food and beverages, train labor, and sales/marketing. Moreover, demand is usually low in winter and strong in summer. Hence, in terms of pricing:

a. Grand Canyon Railway gives discounts during winter months and

b. Raises prices to peak-load levels in summer, when few discounts are offered.

3. To fill empty seats on the day of departure, managers:

a. Offer customers in Coach the opportunity to upgrade for a fixed amount.

b. Offer discounted fares when seats are available.

4. Offering fewer pricing packages has the following effects:

a. Reduces phone time spent explaining different packages to customers and increases time spent taking reservations from different callers.

b. Less time and costs analyzing results of different pricing promotions.

c. Less money spent on confusing advertising messages.

d. Fewer staff needed to answer phones, which reduces customer-service costs.

5. The benefits of tour packages that include train transport, hotels, and meals, are:

a. Capture customers’ discretionary travel dollars for the company rather than competitors, since payment is required at the time the reservation is made. This approach precludes customer dollars from going to competitors.

b. They increase market appeal of an all-inclusive tour experience.

c. Travel agents are more likely to sell larger dollar packages because of higher commissions rather than just train travel.

d. Customers prefer one-stop shopping for all these elements.

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