1. MPE, Inc.

will very soon enter a very competitive market place in which it will
have limited influence over the prices that are charged. Management and
consultants are currently working to fine tune the company’s sole service,
which hopefully will generate a 12% first year return(profit) on the firm’s
$18,000,000 asset investment. Although the normal return in MPE’s industry
is 14% executives are willing to accept the lower figure because of various set
up inefficiencies. The following information is available for first year
operations:
Hours of service to be provided: 25,000
Anticipated variable cost per service hour:$22
Anticipated fixed cost:$1,900,000 per year

Required:
a) Assume the management is contemplating what price to charge in the first
year of operation. The company can take its cost and add a markup to achieve
a 12% return; alternatively, it can use target costing. Given MPE’s
marketplace, which of the approaches would be appropriate? Why?
b) How much profit must MPE generate in the first year to achieve a 12%
return? Also calculate the revenue per hour.
c) Assume that prior to the start of business in Year 1, management conducted a
planning exercise to determine if MPE could achieve a 14% return in year 2.
Can the company achieve this return if (a) competitive pressures dictate a
maximum selling price of $175 per hour and (b) service hours and the variable
cost per service hour are the same as the amounts anticipated in Year1. Show
calculations.

Solution

a. Expected return=12% on $18,000,000

Ie. $2,160,000

Given that the market place is extremely competitive, MPE will have to follow
the market and consequently opt for target costing.

b. Fixed cost=1,900,000
Expected Return=2,160,000
Per hour fixed cost + Return= 162.4(1900000+2160000/25000)
Per hour variable cost=22
Total Revenue per hour=184.4(162.4+22)

c. Given that the revenue should be 184.4 even for a return of 12%, MPE cannot
achieve a 14% return if the revenue is fixed at $175 per hour. If MPE charges
by marking up the desired margin on cost, then it is doubtful if they can
survive with a higher selling price.

As suggested above, if they are to take a target cost approach then they will
have to limit their total cost as follows:

Revenue 175 175

Desired profit 86.4 100.8
 Target Cost per hour 88.6 74.2
Existing var cost per hour 22 22
Existing fixed cost per
hour 76 76
Total cost per hour 98 98

Step 1
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This problem requires us to apply the concepts we have learned about target
costing and cost analysis to determine MPE Inc.’s profit goals and figure out
which approach is best to use in a marketplace with limited control or influence
over market price.
Step 2
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Requirement 1:

Since the company has a limited influence or control over the market price, it
would be better to use the concept of target costing.
Step 3
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The problem states that the company can take its cost and add a markup to
achieve a 12% return. This approach is not valid because it does not recognize
that there are multiple price points for each good, which means the prices would
have to be changed constantly. Since this option does not recognize market
conditions or consumer demands, target costing is more appropriate because it
accommodates these factors in determining the product's final price.
Step 4
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The following are the given information necessary to solve the next requirements
of this problem:

Asset Investment $18,000,000

Hours of Service To Be Provided 25,000
Anticipated Variable Cost Per Service Hour $22
Anticipated Fixed Costs $1,900,000
Target Return % - First Year 12%
Target Return % - Second Year 14%
Step 5
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Requirement 2:
In order to determine the profit MPE Inc. should obtain in the first year of their
operation to reach their target return of 12% of their asset investment, the
following formula and the computation can be utilized:

Target Profit=Asset Investment×Target Return %=$18,000,000×12%=$2,
160,000Target Profit=Asset Investment×Target Return %=$18,000,000×1
2%=$2,160,000
Thus, the target profit MPE Inc. should be set to $2,160,000 in order to achieve
their target return of 12% of their $18,000,000 asset investment.
Step 6
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Requirement 3:

To calculate the revenue per hour that MPE must generate in order to attain their
first year’s target return, the following steps can be followed:

Step 1: Determine the target total revenue in the first year of operation using the
formula:

Target Total Revenue (First Year)=TP + TFC + TVC=$2,160,000 + $1,90
0,000 + ($22× 25,000 hours)=$2,160,000 + $1,900,000 + $550,000=$4,61
0,000Target Total Revenue (First Year)=TP + TFC + TVC=$2,160,000 + 
$1,900,000 + ($22× 25,000 hours)=$2,160,000 + $1,900,000 + $550,000=
$4,610,000
Where: TP = Target Profit TFC = Fixed Costs TVC = Variable Costs

Thus, the target total revenue of MPE should be set to $4,610,000.

Step 7
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Step 2: Compute the target revenue per hour using the formula:

Target Revenue Per Hour=Target Total RevenueTotal Service Hours To 
Be Provided=$4,610,00025,000 hours=$184.40 per hourTarget Revenue 
Per Hour=Total Service Hours To Be ProvidedTarget Total Revenue
=25,000 hours$4,610,000=$184.40 per hour
Thus, the revenue per hour MPE Inc. should gain in order to achieve their 12%
return of investment in the first year of operation is 184.40 per hour.
Step 8
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Step 2: Compute the target total revenue for second year using the formula:
Target Total Revenue (Second Year)=TP + TFC + TVC=$2,520,000 + $1
,900,000 + ($22× 25,000 hours)=$2,520,000 + $1,900,000 + $550,000=$4
,970,000Target Total Revenue (Second Year)=TP + TFC + TVC=$2,520,
000 + $1,900,000 + ($22× 25,000 hours)=$2,520,000 + $1,900,000 + $55
0,000=$4,970,000
Where: TP = Target Profit TFC = Fixed Costs TVC = Variable Costs

Thus, the target total revenue of MPE in their second year of operation
is $4,970,000.
Step 9
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Step 3: Compute the revenue per hour in the second year operation of the
company. Computation is as follow:

Target Revenue Per Hour=Target Total RevenueTotal Service Hours To 
Be Provided=$4,970,00025,000 hours=$198.80 per hourTarget Revenue 
Per Hour=Total Service Hours To Be ProvidedTarget Total Revenue
=25,000 hours$4,970,000=$198.80 per hour
Thus, the revenue per hour in the second year operation with 14% target return
is $198.80.
Step 10
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Based on the computation above, the answer to the question is no. The company
will not achieve their 14% target return on the second year if the maximum selling
price is set to $175 per service hour and the number of service hours and
variable costs are the same as the amounts in the first year. The company needs
to generate $198.80 per service hour to achieve the goal.
Step 11
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Requirement 5:

In order for MPE Inc. to reach their target return of 12% on their asset
investment, the company must take advantage of target costing. Target costing is
a new product cost management process that helps engineers and company
management to prevent unneeded costs in the early stages of design.
Step 12
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This new approach also allows flexibility for making changes during production
on components, manufacturing processes or even customer produced parts.
Step 13
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The main goal of target costing is to create a competitive advantage by
producing quality products at lower prices. No other apparent goals exist, except
perhaps retaining market share through better pricing strategies compared with
competitors.
 2. Sumeer Ltd. has identified a market for a new product D for which the
following estimated information is available:
a. Sales turnover for the years 2002, 2003 and 2004 of Rs.60 lacs, 70 lacs
and 60 lacs respectively. No further sales are expected beyond 2004.
b. Contribution to sales % of 60% each year
c. Product specific fixed costs in the years 2002, 2003 and 2004 of Rs.25
lacs, Rs.22 lacs, Rs.18 lacs.
d. Capital investment of Rs.45 lacs on 1st January 2002 with nil residual
value at 31 December 2004. The cost of capital from 1 January 2002 is
expected to be 10% per annum.

Assume all cash flows(other than the initial investment) are taking place on 31st
December every year.

Required:
 Determine whether the new product is viable on financial grounds.
 Calculate the minimum target contribution to sales ratio(%) at which product D
will be viable in financial terms where all other factors remain unchanged.
 Suggest actions which should allow the investigation of variable cost in order that
the target contribution to sales ratio(%) calculated above may be achieved.

Whether the new product is viable

2002 2003 2004
Revenue 60 70 60

Contribution 36 42 36
Fixed cost 25 22 18
Cost of capital 4.5 4.5 4.5

Net Profit 6.5 15.5 13.5

Total return 35.5
Total Outflow -45

There is a net outflow of 9.5 lacs. So it is not viable

Minimum contribution at which it will be viable

 Required contribution= 36+42+36+9.5

123.5/(60+70+60)*100=65%

Actions which will allow investigation into the variable cost:

1. Value Engineering
2. Target Costing

Faculty must goad the students towards discussion about value engineering and
also link it to the product life cycle.

Why value engineering should be a continuous process and should be done at

various stages of the product life cycle.

3. Starcom Communication Technologies,Inc., has introduced a new phone so

small that it can be carried in a wallet. Starcom invested $400,000 in research
and development for the technology and another $800,000 to design and test
the prototypes. It predicts a four year life cycle for this phone and has gathered
this cost data for it:
Monthly fixed costs Variable costs
Manufacturing costs $25,000 $20
Marketing costs 20,000 5
Customer service costs 3,000 8
Distribution costs 5,000 15

Sales Predictions:
For a price of $150-average annual sales of 20,000 units
For a price of $180-average annual sales of 15,000 units
For a price of $225-Average annual sales of 12,000 units

If a price of a wallet phone is to be $225, Starcom must increase its research and
development costs by $100,000 and the prototyping costs by $400,000 to improve the
model for the higher price. Fixed customer service costs would also increase by $500
per month and the variable distribution costs would increase by $5 per unit to
improve the customer service and distribution at the $225 level. At the lowest price of
$150 fixed marketing costs would be reduced by $5,000 per month because the low
price would be the principal selling feature.
Required:
a. Determine the life cycle costs for each pricing decision
b. What price for the wallet phone’s life cycle will produce the most profit for
Starcom?

a. Life cycle cost

Selling price 150 180 225
Variable cost 48 48 53
Contribution 102 132 172
No of units sold 20000 15000 12000
Total Cont(annual) 2040000 1980000 2064000
Fixed expense 5,76,000 636000 642000
Profit(annual) 2304000 2544000 2568000
Other development cost 1200000 1200000 1700000
Life cycle profit 1104000 1344000 868000

b. Other than just discussing the obvious, that is 180 being the best
option, this problem can also be used to discuss the relationship
between product positioning and life cycle cost..

4. Johnson Supply, a wholesaler, has determined that its operations have three
primary activities-purchasing, warehousing, and distributing. The firm reports
the following pertinent operating data for the year just completed:

Activity Cost Driver Quantity of Cost Cost per Unit of Cost

Driver Driver
Purchasing Number of purchasing 1,000 $100 per order
orders
Warehousing Number of moves 8,000 20 per move
Distributing Number of shipments 500 80 per shipment

Johnson buys 100,000 units at an average unit cost of $5 and sells them at an average
unit price of $10.The firm also has a fixed operating cost of $50,000 for the year.

Johnson’s customers are demanding a 10% discount for the coming year. The
company expects to sell the same amount if demand for price reduction can be met.
Johnson’s suppliers, however, are willing to give only a 2% discount.

Required: Johnson has estimated that it can reduce the number of purchasing orders
to 800 and can decrease the shipment $5 with minor changes in its operations. Any
further cost savings must come from reengineering the warehousing processes. What
is the maximum cost for warehousing if the firm desires to earn the same amount of
profit next year.

Soln

Per se this problem is not heavy on calculations. Again we can use this to
demonstrate how the value engineering process is actually done and how value
engineering is used to achieve target cost.
Also how Activity Based Costing helps data mining and consequently is useful at
all levels of cost control.
Exisitng Revised(target)
Selling price 10 9
Variable cost 5 4.9
Contribution 5 4.1
No of units 100000 100000
Total Contribution 500000 410000

Purchasing 100000 80000

Warehousing 160000 92500
Distributing 40000 37500
 200000 200000

The warehousing costs should be 92500.