1) Julian Pharma manufactures hospital beds. Its most popular model, Deluxe, sells for $5,000.
It has
variable costs totaling $2,650 and fixed costs of $1,200 per unit, based on an average production run of
5,000 units. It normally has four production runs a year, with $400,000 in setup costs each time. Plant
capacity can handle up to six runs a year for a total of 30,000 beds.
A competitor is introducing a new hospital bed similar to Deluxe that will sell for $3,800. Management
believes it must lower the price to compete. The marketing department believes that the new price will
increase sales by 25% a year. The plant manager thinks that production can increase by 25% with the
same level of fixed costs. The company currently sells all the Deluxe beds it can produce.
Required:
a. What is the annual operating income from Deluxe at the current price of $5,000?
b. What is the annual operating income from Deluxe if the price is reduced to $3,800 and sales in units
increase by 25%?
c. What is the target cost per unit for the new price if target operating income is 30% of sales?
Answer: a. Sales (20,000 × $5,000) 100,000,000
Costs:
Variable costs ($2,650 × 20,000) 53,000,000
Fixed costs ($1,200 × 20,000) 24,000,000
Setup costs ($400,000 × 4) 1,600,000 78,600,000
Annual operating income 21,400,000
b.
Current Sales (5,000 × 4) 20,000
Increased sales [20,000 × (1+.25)] 25,000
Sales (25,000 × $3,800) 95,000,000
Costs:
Variable costs ($2,650 × 25,000) 66,250,000
Fixed costs (same as before) 24,000,000
Setup costs ($400,000 × 5) 2,000,000 92,250,000
Annual operating income 2,750,000
c.
New selling price $3,800
Target profit $1,140
Target cost per unit $2,660
2) Colise Services is a repair-service company specializing in small household jobs. Each client pays a
fixed monthly service fee based on the number of rooms in the house. Records are kept on the time and
material costs used for each repair. The following profitability data apply to five customers:
Customer Revenues Customer Costs
Marveline Burnett $360 $270
J Jackson 240 366
Roger Jones 96 90
Paul Saas 90 132
Becky Stephan 420 264
Required:
a. Compute the operating income for each of the five customers.
b. What options should Colise Services consider in light of the customer-profitability results?
c. What problems might Colise Services encounter in accurately estimating the operating costs of each
customer?
b. 1. Pay increased attention to the profitable customers Stephan and Burnett.
2. Seek ways of reducing costs and increasing revenues for the loss accounts of J Jackson and Paul
Saas. Work with the customers so their behavior reduces overall costs. Reduce costs with better
scheduling. Maybe a different fee schedule needs to be implemented depending on the age of the house,
the distance to the home, if the repair is preventive or an emergency, etc. Determine whether the
operating income pattern will probably continue or not and why.
3. As a last resort, the company may want to discontinue the Jackson account if the customer does
not agree to a fee increase and the operating loss pattern is expected to continue.
c. Problems in accurately estimating operating costs of each customer include:
1. The basic underlying records may not be accurate.
2. Some repair personnel may be efficient and more experienced, others may be less experienced
and slower, and still others may "chit-chat" more with the clients than others.
3. Costs that are allocated to more than one customer may be distorting operating income.
3. Best Drugs is a distributor of pharmaceutical products. Its ABC system has five activities:
Rick Flair, the controller of Best Drugs, wants to use this ABC system to examine individual
customer profitability within each distribution market. He focuses first on the Ma and Pa single-
store distribution market. Using only two customers helps highlight the insights available with the
ABC approach. Data pertaining to these two customers in August 2017 are as follows:
Use the ABC information to compute the operating income of each customer in August 2017.
Comment on the results and what, if anything, Flair should do.
San Diego Pharmacy has a lower gross margin percentage than does Ann Arbor [10.5%
($1,400 ÷ $13,300) vs. 19.2% ($2,500 ÷ $13,000)] and consumes a lot of resources to
obtain this lower margin. Overall, Ann Arbor is a profitable customer, while San Diego is
not.
