Chapter 12
12-16 (20–30 min.)
1.
Relevant-cost approach to pricing decisions, special order.
Relevant revenues, $3.80  1,000
Relevant costs
Direct materials, $1.50  1,000
Direct manufacturing labor, $0.80  1,000
Variable manufacturing overhead, $0.70  1,000
Variable selling costs, 0.05  $3,800
Total relevant costs
Increase in operating income
$3,800
$1,500
800
700
190
3,190
$ 610
This calculation assumes that:
a.
The monthly fixed manufacturing overhead of $150,000 and $65,000 of
monthly fixed marketing costs will be unchanged by acceptance of the 1,000
unit order.
b.
The price charged and the volumes sold to other customers are not affected by
the special order.
Chapter 12 uses the phrase “one-time-only special order” to describe this special case.
2.
The president’s reasoning is defective on at least two counts:
a.
The inclusion of irrelevant costs––assuming the monthly fixed manufacturing
overhead of $150,000 will be unchanged; it is irrelevant to the decision.
b.
The exclusion of relevant costs––variable selling costs (5% of the selling
price) are excluded.
3.
Key issues are:
a.
Will the existing customer base demand price reductions? If this 1,000-tape
order is not independent of other sales, cutting the price from $5.00 to $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.
12-17 (20–30 min.) Relevant-cost approach to short-run pricing decisions.
1.
Analysis of special order:
Sales, 3,000 units  $80
Variable costs:
Direct materials, 3,000 units  $35
Direct manufacturing labor, 3,000 units  $10
Variable manufacturing overhead, 3,000 units  $5
Other variable costs, 3,000 units  $5
Sales commission
Total variable costs
Contribution margin
$240,000
$105,000
30,000
15,000
15,000
6,000
171,000
$ 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’s decision to quote full price is correct depends on many
factors. He is incorrect if the capacity would otherwise be idle and if his objective is to
increase operating income in the short run. If the offer is rejected, San Carlos, in effect, is
willing to invest $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?
12-20 (2530 min.) Target operating income, value-added costs, service company.
1.
The classification of total costs in 2007 into value-added, nonvalue-added, or in
the gray area in between follows:
Value
Gray
NonvalueTotal
Added
Area
added
(4) =
(1)
(2)
(3)
(1)+(2)+(3)
Doing calculations and preparing drawings
75% × $400,000
$300,000
$300,000
Checking calculations and drawings
4% × $400,000
$16,000
16,000
Correcting errors found in drawings
7% × $400,000
$28,000
28,000
Making changes in response to client
requests 6% × $400,000
Correcting errors to meet government
building code, 8% × $400,000
Total professional labor costs
Administrative and support costs at 40%
($160,000 ÷ $400,000) of professional
labor costs
Travel
Total
24,000
24,000
16,000
32,000
60,000
32,000
400,000
129,600
6,400
18,000
$471,600 $22,400
24,000
—
$84,000
160,000
18,000
$578,000
324,000
Doing calculations and responding to client requests for changes are value-added costs
because customers perceive these costs as necessary for the service of preparing
architectural drawings. Costs incurred on correcting errors in drawings and making
changes because they were inconsistent with building codes are nonvalue-added costs.
Customers do not perceive these costs as necessary and would be unwilling to pay for
them. Carasco should seek to eliminate these costs by making sure that all associates are
well-informed regarding building code requirements and by training associates to
improve the quality of their drawings. Checking calculations and drawings is in the gray
area (some, but not all, checking may be needed). There is room for disagreement on
these classifications. For example, checking calculations may be regarded as value added.
2.
Reduction in professional labor-hours by
a. Correcting errors in drawings (7% × 8,000)
b. Correcting errors to conform to building code (8% × 8,000)
Total
Cost savings in professional labor costs (1,200 hours × $50)
Cost savings in variable administrative and support
costs (40% × $60,000)
Total cost savings
Current operating income in 2007
Add cost savings from eliminating errors
Operating income in 2007 if errors eliminated
560 hours
640 hours
1,200 hours
$ 60,000
24,000
$ 84,000
$102,000
84,000
$186,000
3.
Currently 85% × 8,000 hours = 6,800 hours are billed to clients generating
revenues of $680,000. The remaining 15% of professional labor-hours (15% × 8,000 =
1,200 hours) is lost in making corrections. Carasco bills clients at the rate of $680,000 ÷
6,800 = $100 per professional labor-hour. If the 1,200 professional labor-hours currently
not being billed to clients were billed to clients, Carasco’s revenues would increase by
1,200 hours × $100 = $120,000 from $680,000 to $800,000.
Costs remain unchanged
Professional labor costs
Administrative and support (40% × $400,000)
Travel
Total costs
Carasco’s operating income would be
Revenues
Total costs
Operating income
$400,000
160,000
18,000
$578,000
$800,000
578,000
$222,000
12-21 (25–30 min.) Target prices, target costs, activity-based costing.
1.
Snappy’s operating income in 2006 is as follows:
Revenues ($4  250,000)
Purchase cost of tiles ($3  250,000)
Ordering costs ($50  500)
Receiving and storage ($30  4,000)
Shipping ($40  1,500)
Total costs
Operating income
Total for
250,000 Tiles
(1)
$1,000,000
750,000
25,000
120,000
60,000
955,000
$ 45,000
Per Unit
(2) = (1) ÷ 250,000
$4.00
3.00
0.10
0.48
0.24
3.82
$0.18
2.
Price to retailers in 2007 is 95% of 2006 price = 0.95  $4 = $3.80; cost per tile in
2007 is 96% of 2006 cost = 0.96  $3 = $2.88.
Snappy’s operating income in 2007 is as follows:
Revenues ($3.80  250,000)
Purchase cost of tiles ($2.88  250,000)
Ordering costs ($50  500)
Receiving and storage ($30  4,000)
Shipping ($40  1,500)
Total costs
Operating income
Total for
250,000 Tiles
(1)
$ 950,000
720,000
25,000
120,000
60,000
925,000
$ 25,000
Per Unit
(2) = (1) ÷ 250,000
$3.80
2.88
0.10
0.48
0.24
3.70
$0.10
3. Snappy’s operating income in 2007, if it makes changes in ordering and material
handling, will be as follows:
Total for
250,000 Tiles
Per Unit
(1)
(2) = (1) ÷ 250,000
$950,000
$3.80
Revenues ($3.80  250,000)
720,000
2.88
Purchase cost of tiles ($2.88  250,000)
5,000
0.02
Ordering costs ($25  200)
87,500
0.35
Receiving and storage ($28  3,125)
60,000
0.24
Shipping ($40  1,500)
872,500
3.49
Total costs
$ 77,500
$0.31
Operating income
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 2006 and 2007 are as follows:
2006
Total
(1)
Direct materials, $1,200 × 3,500; $1,100 × 4,000 $4,200,000
Batch-level costs, $8,000 × 70; $7,500 × 80
560,000
Manuf. operations costs, $55 × 21,000;
$50 × 22,000
1,155,000
Engineering change costs, $12,000 × 14;
$10,000 × 10
168,000
Total
$6,083,000
3.
Per Unit
(2) =
(1) ÷ 3,500
$1,200
160
2007
Per Unit
Total
(4) =
(3)
(3) ÷ 4,000
$4,400,000 $1,100
600,000
150
330
1,100,000
275
48
$1,738
100,000
$6,200,000
25
$1,550
Target manufacturing cost Manufacturing cost
per unit of HJ6 in 2007 = per unit in 2006 × 90%
= $1,738 × 0.90 = $1,564.20
Actual manufacturing cost per unit of HJ6 in 2007 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 2007, Medical Instruments reduced
the cost per unit 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 2006, Medical Instruments used 6 machine-hours per unit of HJ6 (21,000
machine-hours 3,500 units). In 2007, 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 2006 to 10 in 2007. Medical Instruments achieved these
gains through value engineering activities that retained only those product features that
customers wanted while eliminating nonvalue-added activities and costs.
12-23 (20 min.) 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-night, ($592,000 ÷ 16,000)
Add variable costs per room-night
Price to be charged per room-night
Proof
Total room revenues ($40  16,000 room-nights)
Total costs:
Variable costs ($3  16,000)
Fixed costs
Total costs
Operating income
$37
3
$40
$640,000
$ 48,000
352,000
400,000
$240,000
The full cost of a room = variable cost per room + fixed cost per room
The full cost of a room = $3 + ($352,000 ÷ 16,000) = $3 + $22 = $25
= Rental price per room – Full cost of a room
= $40 – $25 = $15
Markup percentage as a fraction of full cost = $15 ÷ $25 = 60%
Markup per room
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% 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 hence, are irrelevant to the analysis.
12-29 (20–25 min.) Product costs, target costing, activity-based costing systems.
This problem assumes knowledge of activity-based costing systems as described in
Chapter 5. It illustrates how both product designers and manufacturing personnel can play
key roles in a company manufacturing competitively priced products. Solution Exhibit 1229 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-81 and P63.
Cost Categories
Direct manufacturing product costs
Direct materials
Indirect manufacturing product costs
Materials handling
(90  $0.80; 50  $0.80)
Assembly management
(2.8  $48; 1.8  $48)
Machine insertion of parts
(49  $0.75; 31  $0.75)
Manual insertion of parts
(41  $1.90; 19  $1.90)
Quality testing
(1.2  $35; 1.0  $35)
Total indirect manufacturing product costs
Total manufacturing product costs
P-81
P-63
$400.50
$286.50
72.00
40.00
134.40
86.40
36.75
23.25
77.90
36.10
42.00
$363.05
$763.55
35.00
$220.75
$507.25
SOLUTION EXHIBIT 12-29
Overview of Product Costing at Executive Power
INDIRECT
COST
POOLS
COST
ALLOCATION
BASES
Materials
Handling
Assembly
Management
Machine
Insertion
of Parts
Manual
Insertion
of Parts
Quality
Testing
Number of
Parts
Hours of
Assembly
Time
Number of
MachineInserted Parts
Number of
ManuallyInserted Parts
Hours of
QualityTesting Time
COST OBJECT:
PRODUCT
DIRECT
PRODUCT
COSTS
INDIRECT COSTS
DIRECT COSTS
Direct
Materials
2.
The following table presents the manufacturing cost per unit for different cost
categories for P-81 REV and P-63 REV.
Cost Categories
Direct manufacturing product costs:
Direct materials
P-81 REV
P-63 REV
$385.00
$260.00
Indirect manufacturing product costs:
Materials handling (75  $0.80; 42  $0.80)
Assembly management (2.0  $48; 1.5  $48)
Machine insertion of parts (59  $0.75; 29  $0.75)
Manual insertion of parts (16  $1.90; 13  $1.90)
Quality testing (1.2  $35; 0.9  $35)
Total indirect manufacturing costs
Total manufacturing costs
Target cost
60.00
96.00
44.25
30.40
42.00
272.65
$657.65
$675.00
33.60
72.00
21.75
24.70
31.50
183.55
$443.55
$435.00
P-81 REV is $17.35 below its target cost. However, P-63 REV is $8.55 above its target
cost.
3.
The $8 reduction in cost per hour of assembly time and the increased testing-hours
per unit result in the following product costs:
Cost Categories
Direct manufacturing product costs:
Direct materials
Indirect manufacturing product costs:
Materials handling (75  $0.80; 42  $0.80)
Assembly management (2.0  $40; 1.5  $40)
Machine insertion of parts (59  $0.75; 29  $0.75)
Manual insertion of parts (16  $1.90; 13  $1.90)
Quality testing (1.6  $35; 0.95  $35)
Total indirect manufacturing costs
Total manufacturing costs
Target cost
P-81 REV
P-63 REV
$385.00
$260.00
60.00
80.00
44.25
30.40
56.00
270.65
$655.65
$675.00
33.60
60.00
21.75
24.70
33.25
173.30
$433.30
$435.00
The reduction in the assembly management activity rate, despite the increase in testing
time, further reduces the cost of P-81 REV below the target cost. It also makes it more
likely that P-63 REV will achieve its target cost. Farnham should reduce the supervisory
staff. (In general, testing time is more of a value-added activity than is supervision –
another reason to implement the change).
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
$40,000
Direct manufacturing labor
10,000
30% of overhead costs (30% × $30,000)
9,000
Incremental 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 Chapter 1 (p. 16), that the management accountant should
consider are listed below.
Competence
Clear 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.
Integrity
The 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.
Objectivity
The 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
in deciding on the price to bid are clearly violating both of these precepts. For the reasons
cited above, the behavior described by Lazarus and Decker (if he goes along with
Lazarus’s wishes) is unethical.
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 engaging in unethical behavior.