Q.1“Relevant costs for pricing decisions are full costs of the product.” Do you agree?
Explain.
No not always. 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.
Q.2Give two examples of pricing decisions with a short-run focus.
Answer.
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.
Q.3 How is activity-based costing useful for pricing decisions?
Answer:
Accurate Product Pricing; Activity-based costing (ABC analysis) provides a more accurate
measurement of costs associated with producing a particular product or service. This helps
businesses to set prices that reflect the true cost of production and allows them to avoid
pricing products too high or too low. ABC analysis categorize items based on their perceived
value and is used in inventory management. It helps companies identify the most valuable
products that match their customers’ demand, control and allocate resources efficiently,
reduce obsolete inventory, and increase sales.
Cost Management; By identifying the specific activities that consume resources and the
associated costs, ABC makes it easier for businesses to manage their costs. Managers can
identify areas of waste and inefficiency and take steps to improve their processes, which can
lead to cost savings and more competitive pricing.
Profitability analysis; The main goal of using the activity- based costing method is to increase
the profitability and overall performance of an organization. The ABC method does this by
identifying accurate overhead costs and cost drivers leading to more streamlined business
processes. When all direct and indirect costs are allocated to a product, managers begin to get
an idea of which business processes are performing well and which are inefficient, makes it
easier to understand the profitability of different products or services by assigning costs more
accurately. By understanding which products or services are more profitable, businesses can
adjust, their pricing strategies to maximize profits.
Target costing and cost reduction; Activity-based costing (ABC analysis) allows businesses to
focus attention on the most important items. By focusing on ‘A’ items, businesses can ensure
that they are properly managed and stocked. This helps to ensure that the business has the
items it needs when it needs them. It also identifies specific activities that are driving costs
which enables businesses to focus on cost reduction. Also companies can identify customer
demands and stock up goods accordingly. This as a result, reduces wastage of goods and
capital.
Q.4 Give two examples of a value-added cost and two examples of a non value-added cost.
Answer:
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 labuor, 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.
Q.5 “It is not important for a company to distinguish between cost incurrence and locked-in
costs.” Do you agree? Explain.
Answer:
I disagree. It is important for a company to distinguish between cost incurrence and locked in
cost in order to achieve good cost management.
Cost incurrence is when resources is consumed or used to meet specific objective. Also
costing systems measure cost incurrence, Example recognize direct material cost as each unit
of pervalue is assembled and sold while locked in cost is the cost that have not yet already
been incurred but based on decision have already been made, therefore is the cost that will be
incurred on future. It will be difficult for the manager to make good decisions if will not
distinguish between two concepts. Example during manufacturing stage some cost arise and
make cost to increase hence, before manufacturing process start, manager should be very
clearly to identify cost first and making decision by distinguishing between cost incurrence
and locked in cost for the purpose of accomplish company objectivity.
Q.6 Colorado Mountains Dairy, maker of specialty cheeses, produces a soft cheese from the
milk of Holstein cows raised on a special corn-based diet. One kilogram of soft cheese, which
has a contribution margin of $10, requires 4 liters of milk. A well-known gourmet restaurant
has asked Colorado Mountains to produce 2,600 kilograms of a hard cheese from the same
milk of Holstein cows. Knowing that the dairy has sufficient unused capacity, Elise Princiotti,
owner of Colorado Mountains, calculates the costs of making one kilogram of the desired
hard cheese:
Milk (8 liters $2.00 per liter) $16
Variable direct manufacturing labor 5
Variable manufacturing overhead 4
Fixed manufacturing cost allocated 6
Total manufacturing cost
Required:
1. Suppose Colorado Mountains can acquire all the Holstein milk that it needs. What is
the minimum price per kilogram it should charge for the hard cheese?
2. Now suppose that the Holstein milk is in short supply. Every kilogram of hard cheese
produced by Colorado Mountains will reduce the quantity of soft cheese that it can make and
sell. What is the minimum price per kilogram it should charge to produce the hard cheese?
Answer:
1. Per kilogram of hard cheese:
If Vermont Hills can get all the Holstein milk it needs, and has sufficient production capacity,
then, the minimum price per kilo it should charge for the hard cheese is the variable cost per
kilo
= $15+5+3 = $23 per kilo.
2.To determine the minimum price per kilogram it should be charged to produce hard cheese,
we should consider the contribution margin that Colorado Mountains will lose from not being
able to produce and sell the soft cheese. Each kilo of hard cheese displaces 2 kilograms of
soft cheese. The minimum price that Colorado Mountains should charge for the hard cheese
is as follows:-
$25 + (2 × $10 per kilo) = $45 per kilogram
This means that the minimum price is the variable cost per kilogram of hard cheese plus the
contribution margin from 2 kilograms of soft cheese.
Q.7 Calvert Associates prepares architectural drawings to conform to local structural-safety
codes. Its income statement for 2012 is as follows:
Revenues $701,250
Salaries of professional staff (7,500 hours $52 per hour) 390,000
Travel 15,000
Administrative and support costs 171,600
Total costs 576,600
Operating income $124,650
Following is the percentage of time spent by professional staff on various activities:
Making calculations and preparing drawings for clients 77%
Checking calculations and drawings 3
Correcting errors found in drawings (not billed to clients) 8
Making changes in response to client requests (billed to clients) 5
Correcting own errors regarding building codes (not billed to clients) 7
Total 100
Assume administrative and support costs vary with professional-labor costs. Consider each
requirement independently.
Required:
1. How much of the total costs in 2012 are value-added, nonvalue-added, or in the gray
area between? Explain your answers briefly. What actions can Calvert take to reduce its
costs?
2. Suppose Calvert could eliminate all errors so that it did not need to spend any time
making corrections and, as a result, could proportionately reduce professional-labor costs.
Calculate Calvert’s operating income for 2012.
3. Now suppose Calvert could take on as much business as it could complete, but it
could not add more professional staff. Assume Calvert could eliminate all errors so that it
does not need to spend any time correcting errors. Assume Calvert could use the time saved
to increase revenues proportionately. Assume travel costs will remain at $15,000. Calculate
Calvert’s operating income for 2012.
Answer:
1.
Value Gray Nonvalueadded
Added Area Total
Doing preparations
and preparing
drawings (77% ×
$390,000) $300,300 $300,300
Checking $11,700 $11,700
calculations and
drawings (3% ×
$390,000)
Correcting errors $31,200 $31,200
found in drawings
(8% × $390,000)
Making changes in
response to client
requests (5% ×
$390,000) $19,500 $19,500
Correcting errors to meet $27,300 $27,300
government building code (7% ×
$390,000)
Total professional $319,800 $11,700 $58,500 $390,000
labor costs
Administrative and
support costs at 44%
($171,600 +
$390,000) of
professional labor
costs $140,712 $5,148 $25,740 $171,600
Travel $15,000 $15,000
Total $475,512 $16,848 $84,240 $576,600
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.
Details
Reduction in professional labor hours by
Correcting errors in drawings (8% × 7,500) 600 hours
Correcting errors to conform to building code (7% × 7,500) 525 hours
Total 1,125 hours
Cost savings on professional labor costs (1,125 hours × $52) $58,500
Cost savings in variable administrative support costs (44% ×
$58,500) $25,740
Total cost savings $84,240
Current operating income in 2012 $124,650
Add: Cost savings from eliminating errors $84,240
Operating income in 2012 if errors eliminated $208,890
3. If Calvert could take on as much business as it could complete without adding more
professional staff, it would need to increase its efficiency to complete more work in the same
amount of time. If it could eliminate all errors, it would have more time to complete work and
increase its revenues proportionately.
Calvert bills clients at the rate of $701,250 ÷ 6,375 = $110 per professional labour hour
Calvert’s revenue would increase by 1,125 hours × $110 = $123,750
Current revenue would be $701,250 ÷ $123,750 = $825,000
Calvert’s operating income would be Revenues – Total costs
Total costs = $390,000 + $171,600 + $15,000 = $576,600
Calvert’s operating income = $825,000 - $576,600
Operating income = $248,400
Q.8 John Blodgett is the managing partner of a business that has just finished building a 60-
room motel. Blodgett anticipates that he will rent these rooms for 15,000 nights next year (or
15,000 room-nights). All rooms are similar and will rent for the same price. Blodgett
estimates the following operating costs for next year:
Variable operating costs $5 per room-night
Fixed costs
Salaries and wages $173,000
Maintenance of building and pool 52,000
Other operating and administration costs 150,000
Total fixed costs $375,000
The capital invested in the motel is $900,000. The partnership’s target return on investment is
25%. Blodgett expects demand for rooms to be uniform throughout the year. He plans to
price the rooms at full cost plus a markup on full cost to earn the target return on investment.
1. What price should Blodgett charge for a room-night? What is the markup as a
percentage of the full cost of a room-night?
2. Blodgett’s market research indicates that if the price of a room-night determined in
requirement 1 is reduced by 10%, the expected number of room-nights Blodgett could rent
would increase by 10%. Should Blodgett reduce prices by 10%? Show your calculations.
Answer:
Target operating income=target return on investment
Target operating income=target return on investment
1 Target operating income (25% of $900,000) $225,000
Total fixed costs $375,000
Target contribution margin $600,000
Target contribution per room-night, ($600,000 ÷ 15,000) $40
Add variable costs per room-night $5
Price to be charged per room-night $45
Operating income calculations:
Total room revenues ($45 × 15,000) $675,000
Total costs:
Variable costs ($5 × 15,000) $75,000
Fixed costs $375,000
Total costs $450,000
Operating income $225,000
Mark up:
The full cost of a room = variable cost per room + fixed cost per room
the full cost of a room = $5 + ($375,000 ÷ 15,000) $30
Markup per room = Rental price per room - Full cost of a room
Markup per room = $45 - $30 $15
Markup percentage as a fraction of full cost = $15 ÷ $30 50%
2. If price is reduced by 10%, the number of rooms Beck could rent would increase by 10%.
The new price per room (90% of $45) $40.50
The number of rooms Beck expects to rent (110% of
16,500
15,000)
The contribution margin per room ($40.50 - $5) $35.50
Contribution margin ($35.50 × 16,500) $585,750
The contribution margin of $585,750 at the reduced price of $40.50 is less than the
contribution margin of $600,000 at a price of $45. Therefore, Blodgett should not reduce the
price of the rooms.
Q.9 Burst, Inc., cans peaches for sale to food distributors. All costs are classified as either
manufacturing or marketing. Burst prepares monthly budgets. The March 2012 budgeted
absorption-costing income statement is as follows:
Revenues (1,000 crates $117 a crate) $117,000
Cost of goods sold 65,000
Gross margin 52,000
Marketing costs 30,000
Operating income $22,000
Gross margin markup percentage: $52,000 ÷ $65,000 = 80% of cost of goods sold (full
manufacturing cost
Monthly costs are classified as fixed or variable (with respect to the number of crates
produced for manufacturing costs and with respect to the number of crates sold for marketing
costs):
Fixed Variable
Manufacturing $30,000 $35,000
Marketing 13,000 17,000
Burst has the capacity to can 2,000 crates per month. The relevant range in which monthly
fixed manufacturing costs will be “fixed” is from 500 to 2,000 crates per month.
1. Calculate the markup percentage based on total variable costs.
2. Assume that a new customer approaches Burst to buy 200 crates at $55 per crate for cash.
The customer does not require any marketing effort. Additional manufacturing costs of
$3,000 (for special packaging) will be required. Burst believes that this is a one-time-only
special order because the customer is discontinuing business in six weeks’ time. Burst is
reluctant to accept this 200-crate special order because the $55-per-crate price is below the
$65-per-crate full manufacturing cost. Do you agree with this reasoning? Explain.
3. Assume that the new customer decides to remain in business. How would this longevity
affect your willingness to accept the $55-per-crate offer? Explain.
Answer:
1.
Details Amount Amount
Revenues (1000 crates at $117 per
crate) $117,000
Variable costs:
Manufacturing $35,000
Marketing $17,000
Total variable costs $52,000
Contribution margin $65,000
Fixed costs:
Manufacturing $30,000
Marketing $13,000
Total fixed costs $43,000
Operating income $22,000
Markup percentage= $65,000 ÷ $52,000
=125% 2.
ONE TIME ONLY
SPECIAL ORDER
Net Income
Details Accept Reject (Incremental)
Revenue (200 × 55) 11,000 - 11,000
Variable Manufacturing
Cost -7,000 - -7,000
Marginal cost 4,000 - 4,000
Special Packaging -3000 - -3,000
Net Income 1,000 - 1,000
Burst should not reject the one time only special order of 200 crates because it has positive
impact on Net Income for 1,000 even if it is at a lower price of $55 compared to the market
price of $65.
Also, Relevant cost per crate is $50 (10,000 ÷ 200). Therefore any selling price above $50
will improve Burst profitability in the short run. Thus, Burst can accept the order for $55.
3. The longevity of the customer will affect the market price for other regular customers as it
will be lowered and will lower the revenue and Net income of the Burst.
Also the competitors will detect low price and will lower their prices and Burst will not win
the market by lowering its price to $55 per crate.
Q.10 Executive Suites operates a 100-suite hotel in a busy business park. During April, a 30-
day month, Executive Suites experienced a 90% occupancy rate from Monday evening
through Thursday evening (weeknights), with business travelers making up virtually all of its
guests. On Friday through Sunday evenings (weekend nights), however, occupancy dwindled
to 20%. Guests on these nights were all leisure travelers. (There were 18 weeknights and 12
weekend nights in April.) Executive Suites charges $68 per night for a suite. Fran Jackson has
recently been hired to manage the hotel, and is trying to devise a way to increase the hotel’s
profitability. The following information relates to Executive Suites’ costs:
Fixed Cost Variable Cost
Depreciation $20,000 per month
Administrative costs $35,000 per month
Housekeeping and supplies $12,000 per month $25 per room night
Breakfast $ 5,000 per month $5 per breakfast served
Executive Suites offers free breakfast to guests. In April, there were an average of 1.0
breakfasts served per room night on weeknights and 2.5 breakfasts served per room night on
weekend nights.
1. Calculate the average cost per guest night for April. What was Executive Suites’ operating
income or loss for the month?
2. Fran Jackson estimates that if Executive Suites increases the nightly rates to $80,
weeknight occupancy will only decline to 85%. She also estimates that if the hotel reduces
the nightly rate on weekend nights to $50, occupancy on those nights will increase to 50%.
Would this be a good move for Executive Suites? Show your calculations.
3. Why would the $30 price difference per night be tolerated by the weeknight guests?
4. A discount travel clearing-house has approached Executive Suites with a proposal to offer
last-minute deals on empty rooms on both weeknights and weekend nights. Assuming that
there will be an average of two breakfasts served per night per room, what is the minimum
price that Executive Suites could accept on the last-minute room?
Answer:
1. Guest nights on weeknights:
18 weeknights × 100 rooms × 90% = 1,620 Guest
nights on weekend nights:
12 weekend nights × 100 rooms × 20% = 240 Total
guest nights in April = 1,620 + 240 = 1,860
Breakfast served:
1,620 weeknight guest nights × 1.0 = 1,620
240 weekend guest nights × 2.5 = 600
Total breakfasts served in April = 1,620 + 600 = 2,220
To calculate the average cost per guest night, we need to first calculate the total cost for the
hotel in April:
Details Amount in $
Depreciation 20,000
Administrative costs 35,000
Fixed housekeeping and supplies 12,000
Variable housekeeping and supplies (1,860 ×
$25) 46,500
Fixed breakfast costs 5,000
Variable breakfast costs (2,220 × $5) 11,100
Total costs for April 129,600
Cost per guest night ($129,600 ÷ 1,860) 69.68
Revenue for April ($68 × 1,860) 126,480
Total costs for April 129,600
Operating income (loss) -3,120
2. With the new pricing strategy, weeknight occupancy would be:
New weeknight guest nights;
18 weeknights × 100 rooms × 85% = 1,530
New weekend guest nights;
12 weeknights × 100 rooms × 50% = 600
Total guest nights in April = 1,530 + 600 = 2,130
Breakfast served;
1,530 weeknight guest nights × 1.0 =1,530
600 weekend guest nights × 2.5 = 1,500
Total breakfasts served in April = 1,530 + 1,500 = 3,030
Total costs for April:-
Details Amount in $
Depreciation 20,000
Administrative costs 35,000
Fixed housekeeping and supplies 12,000
Variable housekeeping and supplies (2,130 × $25)
53,250
Fixed breakfast costs 5,000
Variable breakfast costs (3,030 × $5) 15,150
Total costs 140,400
Revenue ($80 × 1,530) + ($50 × 600) 152,400
Total costs 140,400
Operating income 12,000
Therefore, the new pricing strategy would be a good move for Executive Suites.
3. The weeknight guests may be willing to tolerate the price difference because they are
mostly business travelers who are reimbursed by their companies, and the hotel's location in a
busy business park may provide convenience for them. They may also value the free
breakfast and other amenities provided by the hotel.
4. To calculate the minimum price that Executive Suites could accept on the last-minute
rooms, we need to consider the variable costs of providing the room and breakfast:
Variable cost per last-minute room night = $25 per room night + $5 per breakfast x 2
breakfasts per room night = $35
Assuming the hotel still wants to make a profit on these rooms, it could accept a price slightly
above the variable cost, such as $40 per last-minute room night.
Q.11Florida Temps, a large labor contractor, supplies contract labor to building-construction
companies. For 2012, Florida Temps has budgeted to supply 84,000 hours of contract labor.
Its variable costs are $13 per hour, and its fixed costs are $168,000. Roger Mason, the general
manager, has proposed a cost-plus approach for pricing labor at full cost plus 20%.
1. Calculate the price per hour that Florida Temps should charge based on Mason’s proposal.
2. The marketing manager supplies the following information on demand levels at different
prices:
Price per Hour Demand (Hours)
$16 124,000
17 104,000
18 84,000
19 74,000
20 61,000
Florida Temps can meet any of these demand levels. Fixed costs will remain unchanged for
all the demand levels. On the basis of this additional information, calculate the price per hour
that Florida Temps should charge to maximize operating income.
3. Comment on your answers to requirements 1 and 2. Why are they the same or different?
Answer:
1. Price per hour = Full cost per hour + (20% of full cost)
Variable costs = $13
Fixed costs per hour = ($168,000 ÷ 84,000 hours) = $2
Full cost per hour = $13 + $2 = $15
Price per hour = $15 + (20% × $15) = $18 per hour
2. Maximum operating income depends on maximum contribution margin. Contribution
margins are calculated as follows:-
Contribution margin per hour = Price per hour – Variable cost per hour
Total contribution = Contribution margin per hour × Demand in hours
Variable Cost per Contribution margin per Demand in Total
Price per hour $ hour $ hour $ hours contribution
16 13 3 124,000 372,000
17 13 4 104,000 416,000
18 13 5 84,000 420,000
19 13 6 74,000 444,000
20 13 7 61,000 427,000
Therefore, the price per hour is $19 which will maximize the contribution margin of $444,000
which means maximum operating income.
3. The answers in question 1 and 2 are different because question 2 considers the effect of
prices on demand. The approach used in question 2 is more balanced because it determines
the optimal level of profitability using concepts of relevant costs.
Q12.Apex Art has been requested to prepare a bid on 500 pieces of framed artwork for a new
hotel. Winning the bid would be a big boost for sales representative Jason Grant, who works
entirely on commission. Sonja Gomes, the cost accountant for Apex, prepares the bid based
on the following cost information:
Direct costs Artwork $30,000
Framing materials 40,000
Direct manufacturing labor 20,000
Delivery and installation 7,500
Overhead costs
Production order 2,000
Setup 4,000
Materials handling 5,500
General and administration 12,000
Total overhead costs 23,500
Full product costs $121,000
Based on the company policy of pricing at 125% of full cost, Gomes gives Grant a figure of
$151,250 to submit for the job. Grant is very concerned. He tells Gomes that at that price,
Apex has no chance of winning the job. He confides in her that he spent $500 of company
funds to take the hotel’s purchasing agent to a basketball playoff game where the purchasing
agent disclosed that a bid of $145,000 would win the job. He hadn’t planned to tell Gomes
because he was confident that the bid she developed would be below that amount. Gomes
reasons that the $500 he spent will be wasted if Apex doesn’t capitalize on this valuable
information. In any case, the company will still make money if it wins the bid at $145,000
because it is higher than the full cost of $121,000.
1. Is the $500 spent on the basketball tickets relevant to the bid decision? Why or why not?
2. Gomes suggests that if Grant is willing to use cheaper materials for the frame, he can
achieve a bid of $145,000. The artwork has already been selected and cannot be changed,
so the entire amount of reduction in cost will need to come from framing materials. What
is the target cost of framing materials that will allow Grant to submit a bid of $145
assuming a target markup of 25% of full cost?
3. Evaluate whether Gomes’ suggestion to Grant to use the purchasing agent’s tip is
unethical. Would it be unethical for Grant to redo the project’s design to arrive at a lower
bid? What steps should Grant and Gomes take to resolve this situation?
Answer:
1. The $500 spent on basketball tickets is irrelevant to the bid decision because it is a
sunk cost. Hence Apex will incur the $500 cost.
2. Grant’s relationship with the purchasing agent and the information he obtained from
him gives Apex Art an advantage over other bidders. However, the way in which Grant
obtained this information is questionable and unethical. To achieve a bid of $145,000 and
maintain a target mark up of 25% of full cost, the target cost of framing materials can be
calculated as follows:
Target full cost = $145,000 ÷ 1.25 = $116,000
Original cost of framing materials per unit = $40,000 ÷ 500 units = $80
Difference in full cost = $121,000 - $116,000 = $5,000
Target cost of framing materials = $40,000 - $5,000 = $35,000
Target cost of framing materials per unit = $35,000 ÷ 500 = $70
3. Gomes’ suggestion to Grant to use the purchasing agent’s tip to undercut competitors’
bid is unethical. It is a violation of the company’s policy of pricing at 125% full cost, and it
could damage the company’s reputation if it becomes known. Similarly, if Grant were to redo
the project’s design to arrive at a lower bid, it would compromise the quality of the artwork
and framing materials.
To resolve this situation, Grant and Gomes should report the purchasing agent’s unethical
behavior to the hotel management and refuse to submit a bid lower than the full cost plus the
required markup.
They should also disclose Grant’s $500 expenditure and ensure that the bidding process is
transparent and fair to all bidders.
The company should reevaluate its policies and procedures to prevent similar ethical lapses in
the future.
References:
