Chap 015

CHAPTER 15
Target Costing and Cost Analysis for Pricing

Decisions
ANSWERS TO REVIEW QUESTIONS
15.1 In the long run, every organization must price its product or service above the total
cost of production. While the market for the product also is critically important, costs
cannot be ignored.
15.2 The statement that prices are determined by production costs is too simplistic.
Although firms must price their products and services above their total costs in the
long run, management cannot ignore demand issues and the economic environment.
Setting prices generally is a balance between cost-related issues and economic
market forces.
15.3 Four major influences on pricing decisions are as follows:
(1) Customer demand: Management must consider customers demand for their
product, which reflects the price that customers are willing to pay for the
product.
(2) Actions of competitors: When pricing its product, management must consider
the likely pricing decisions and product design decisions of competing firms.
(3) Costs: No organization or industry can price its product below total production
costs indefinitely.
(4) Political, legal, and image-related issues: Management must consider the way the
public perceives the firm and must adhere to certain laws when setting prices.
15.4 It is crucial to define the firms product when considering the reaction of
competitors, so that the competitors can be identified. For example, is a firm that
produces glass bottles competing only with other firms that produce glass bottles,
or is the firm competing with all companies that produce containers? Defining the
product as glass bottles or containers is an important step in identifying who the
firms competitors are.
McGraw-Hill/Irwin 2009 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 8/e 15- 1
15.5 In most industries, both market forces and cost considerations heavily influence
prices. No organization can price its products below their production costs in the
long run. On the other hand, no company can set prices at cost plus a markup
without keeping an eye on the market. The product or service must be sold at a price
customers are willing to pay.
15.6 The profit-maximizing price is the price for which the associated quantity is
determined by the intersection of the marginal cost and marginal revenue curves.
This intersection is shown in Exhibit 15-3 in the text.
15.7 (a) Total revenue: Price multiplied by quantity sold.
(b) Marginal revenue: The amount by which total revenue increases when one
additional unit is sold.
(c) Demand curve: A graphical or mathematical expression of the relationship
between the price and the quantity sold.
(d) Price elasticity: The impact of price changes on sales volume.
(e) Cross-elasticity: The extent to which a change in a products price affects the
demand for substitute products.
15-8 (a) Total cost: Unit cost multiplied by quantity produced.
(b) Marginal cost: Additional cost when one more unit is produced.
15.9 Three limitations of the economic, profit-maximizing model of pricing are as follows:
(1) The firms demand and marginal revenue curves are difficult to determine with
precision.
(2) The marginal-cost, marginal-revenue paradigm, as described in the text, is not
valid for all forms of market organization.
(3) Cost-accounting systems are not designed to measure the marginal changes in
cost incurred as production and sales increase unit by unit. To measure marginal
cost would entail a very costly information system.
15.10 Determining the best approach to pricing requires a cost-benefit trade-off. While the
marginal-cost, marginal-revenue paradigm results in a profit-maximizing price, only a
sophisticated and costly information system can collect marginal-cost data. Thus,
the firm will incur greater cost in order to obtain information for better decisions.
Inc.
15-2 Solutions Manual
15.11 The general formula for cost-plus pricing is as follows:
Price = cost + (markup percentage cost)
The price is equal to cost plus a markup. Depending on how cost is defined, the
markup percentage may differ. Several different definitions of cost, each combined
with a different markup percentage, can result in the same price for a product or
service.
15-12 The four cost bases commonly used in cost-plus pricing are the following:
absorption manufacturing cost, total cost, variable manufacturing cost, and total
variable cost. Each of these cost bases can result in the same price under cost-
based pricing if the markup percentage used in the cost-plus pricing formula is
changed. For example, a lower markup percentage would be applied to total cost
than would be applied to total variable cost.
15.13 Four reasons often cited for the widespread use of absorption cost as the cost base
in cost-plus pricing formulas are as follows:
(1) In the long run, the price must cover all costs and a normal profit margin.
(2) Absorption-cost and total-cost pricing formulas provide a justifiable price that
tends to be perceived as equitable by all parties.
(3) When a companys competitors have similar operations and cost structures,
cost-plus pricing based on full costs gives management an idea of how
competitors may set prices.
(4) Absorption-cost information is provided by a firms cost-accounting system,
because it is required for external financial reporting under generally accepted
accounting principles. Since absorption-cost information already exists, it is
cost-effective to use for pricing.
15.14 The primary disadvantage of absorption-cost or total-cost pricing formulas is that
they obscure the cost behavior pattern of the firm. Since absorption-cost and total-
cost data include allocated fixed costs, it is not clear from these data how the firms
total costs will change as volume changes.
15.15 Three advantages of pricing based on variable cost are as follows:
(1) Variable-cost data do not obscure the cost behavior pattern by unitizing fixed
costs and making them appear variable.
(2) Variable-cost data do not require allocation of common fixed costs to individual
product lines.
Inc.
(3) Variable-cost data are exactly the type of information managers need when
facing certain decisions, such as whether to accept a special order.
15.16 The behavioral problem that can result from the use of a variable-cost pricing
formula is that managers may perceive the variable cost of a product or service as
the floor for the price. They may tend to set the price too low for the firm to cover its
fixed costs.
15.17 Return-on-investment pricing is an approach under which the price is set so that it
will cover costs and also earn a profit that will provide a target return on the invested
capital.
15.18 Price-led costing refers to the process under target costing of first determining the
acceptable market price for a product or service and then determining the cost at
which the product or service must be produced.
15.19 To be successful at target costing, management must listen to the companys
customers. By doing so, management will learn the products, features, and quality
that customers are willing to buy as well as the price they are willing to pay.
15.20 Value-engineering is a cost-reduction and process-improvement technique used to
help bring the cost of manufacturing a product or providing a service into line with
its target cost.
15.21 Tear-down methods can be used in a service-industry firm just as they are used in
the manufacturing industry. The various steps in providing a service can be
analyzed for cost improvements just as a products materials and manufacturing
operations can be analyzed for the same purpose.
15.22 Under time-and-material pricing, the price includes a cost-based charge for labor, a
cost-based charge for material, and generally a markup on one or both of these
production-cost factors.
15.23 When a firm has excess capacity, there is no opportunity cost in accepting an
additional production job. Therefore, it is not necessary to reflect such an
opportunity cost in setting a bid price. On the other hand, if the firm is already at full
capacity, there is an opportunity cost to accepting another production job. In this
case, it is appropriate to include in the price an estimate of the opportunity cost
associated with the job for which the bid is being prepared.
Inc.
15.24 The decision to accept or reject a special order and the selection of a price for a
special order are similar decisions. If a price has been offered for a special order,
management can base its acceptance or rejection decision on whether or not that
price covers the incremental cost of producing the order. Another way of viewing the
problem is to set the minimum price for the special order at a level sufficient to cover
the incremental cost of producing the order.
15.25 (a) Skimming pricing: Setting a high initial price for a new product in order to reap
short-run profits. Over time, the price is reduced gradually.
(b) Penetration pricing: Setting a low initial price for a new product in order to
penetrate a market deeply and gain a large and broad market share.
(c) Target costing: Conducting market research to determine the price at which a
new product will sell and then, given the likely sales price, computing the cost for
which the product must be manufactured in order to provide the firm with an
acceptable profit margin. Then engineers and cost analysts work together to
design a product that can be manufactured for the allowable cost. This process
is used widely in the development stages of new products.
15-26 (a) Unlawful price discrimination: Quoting different prices to different customers for
the same product or service, even though the different prices cannot be justified
by differences in the cost incurred to produce, sell, and deliver the product or
service.
(b) Predatory pricing: Temporarily cutting a price to broaden demand for a product
with the intention of later restricting the supply and raising the price again.
15-27 Traditional, volume-based product-costing systems often overcost high-volume and
relatively simple products while undercosting low-volume and complex products.
This practice can result in overpricing high-volume and relatively simple products
and underpricing low-volume and complex products. Such strategic pricing errors
can have a disastrous impact on a firms competitive position.
Inc.
SOLUTIONS TO EXERCISES
EXERCISE 15-28 (25 MINUTES)
Inc.
Dollars per unit
p*
Marginal cost
Demand (average revenue)
Marginal revenue
Quantity sold
per month q*
Dollars
Total cost
Total revenue
Total profit at profit-maximizing quantity and price
Quantity sold per
month q*
Inc.
1. Tabulated price, quantity, and revenue data:
(1)
Quantity
Sold per
Month
(2)
Unit
Sales
Price
(3)
Total
Revenue
per
Month*
(4)
Changes
in Total
Revenue
20 ..................... $500 ..................... $10,000

}
}
}
}
....................
....................
....................
....................
$9,000
8,000
7,000
6,000
40 ..................... 475 ..................... 19,000
60 ..................... 450 ..................... 27,000
80 ..................... 425 ..................... 34,000
100 ..................... 400 ..................... 40,000
*Column (1) times column (2).
Differences between amounts in column (3).

Inc.
EXERCISE 15-29 (CONTINUED)
2. Total revenue curve:
Inc.
Quantity sold
per month
Curve is increasing
throughout its range,
but at a declining rate
Dollars
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$ 5,000
20 40 60 80 100
Total revenue
1. Tabulated cost and quantity data:
(1)
Quantity
Produced
and Sold per
Month
(2)
Average
Cost per
Unit
(3)
Total
Cost per
Month*
(4)
Changes
in Total
Cost
20 ..................... $450 ..................... $ 9,000

}
}
}
}
.....................
.....................
.....................
.....................
$ 8,000
7,600
9,800
10,100
40 ..................... 425 ..................... 17,000
60 ..................... 410 ..................... 24,600
80 ..................... 430 ..................... 34,400
100 .....................
445
.....................
44,500
Differences between amounts in column (3).

Inc.
2. Total cost curve:
Inc.
Quantity sold
per month
Total cost increases
at an increasing rate
Dollars
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$ 5,000
20 40 60 80 100
Total cost
Total cost increases
at an declining rate
Inc.
1. Tabulated revenue, cost, and profit data:
(1)
Quantity
Produced
and Sold
per Month
(2)
Sales
Price
per Unit
(3)
Total
Revenue
per
Month*
(4)
Total
Cost
per
Month
(5)
Profit
per
Month**
20 ............... $500 ................ $10,000 $ 9,000 ................ $1,000
40 ............... 475 ................ 19,000 17,000 ................ 2,000
60 ............... 450 ................ 27,000 24,600 ................ 2,400
80 ............... 425 ................ 34,000 34,400 ................ (400)
100 ............... 400 ................ 40,000 44,500 ................ (4,500)
Column (1) times average cost per unit given in the preceding exercise.
**Column (3) minus column (4).
2. Total revenue and cost curves: see next page.
3. Of the five candidate prices listed, $450 is the optimal price. This price produces a
monthly profit of $2,400, which is greater than the profit at the other four candidate
prices.
Inc.
2. Total revenue and cost curves:
Inc.
Total revenue
Quantity sold
per month
Total profit at the profit-
maximizing quantity and
price.
Dollars
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$ 5,000
20 40 60 80 100
Total cost

1. Price = total unit cost + (markup percentage total unit cost)
$495 = total unit cost + (12.5% total unit cost)
$495 = total unit cost 1.125
Total unit cost =
1.125
$495
= $440
Allocated fixed
selling and
administrative cost
=
total
unit
cost
all
manufacturing
costs
variable
selling and
administrative cost
= $440 ($275 + $55) $66
= $44

Cost-Plus Pricing Formula
2. a. Variable manufacturing cost .................. $275 $495 = $275 + (80% $275)*
Applied fixed manufacturing cost ......... 55
b. Absorption manufacturing cost ............. $330 $495 = $330 + (50% $330)
Variable manufacturing cost .................. $275

Variable selling and administrative
cost ........................................................ 66
c. Total variable cost ................................... $341 $495 = $341 + (45.16% $341)**
*($495 $275) $275 = 80%
($495 $330) $330 = 50%

**($495 $341) $341 = 45.16% (rounded)
Inc.
1. Profit on sales of 60,000 units:
Sales revenue (60,000 9.00p) .............................................. 540,000p
Less: Variable costs:
Manufacturing and administrative (60,000 4.50p) .......
270,000p
Sales commissions (60,000 9.00p 10%) ...................
54,000 p
324,000 p
Contribution margin ............................................................... 216,000p
Less: Fixed costs (90,000p + 7,500p) .................................... 97,500 p
Profit ........................................................................................ 118,500 p
p denotes Argentinas peso
2. Required price on special order:
Unit contribution margin
required on special order = order special in volume sales unit
profit additional target
=
unit per 3.00
10,000
30,000
p
p
Sales price required = unit variable cost + required unit

contribution margin
= 4.50p + 3.00p = 7.50p per unit
As an alternative approach, let X denote the price required in order to earn additional
profit of 30,000p on the special order:
10,000X 10,000(4.50p) = 30,000p
10,000X = 75,000p
X = 7.50p per unit
Inc.

Cost-Plus Pricing Formula
(1) Variable manufacturing cost .............................. $300 $600 = $300 + (100% $300)
a
Applied fixed manufacturing cost ..................... 105
(2) Absorption manufacturing cost ......................... $405 $600 = $405 + (48.15% $405)
b
Variable selling and administrative cost ........... 45
Allocated fixed selling and
administrative cost ........................................... 75
(3) Total cost $525 $600 = $525 + (14.29% $525)
c
Variable manufacturing cost .............................. $300
Variable selling and administrative cost ........... 45
(4) Total variable cost ............................................... $345 $600 = $345 + (73.91% $345)
d
Explanatory Notes:
a
($600 $300) $300 = 100%
b
($600 $405) $405 = 48.15% (rounded)
c
($600 $525) $525 = 14.29% (rounded)
d
($600 $345) $345 = 73.91% (rounded)
Markup percentage
applied to cost base in
cost-plus
pricing formula
=
profit required to
achieve target ROI
+
total annual costs not
included in cost base
annual
volume
cost base per unit

used in cost-plus
pricing formula
Inc.
1. Markup percentage =
$400 480
costs fixed
annual total

costs tive administra
and selling variable total
$60,000
+ +
=
$400 480
$100)] ($250 [480 $50) (480 $60,000
+ + +
=
$192,000
$168,000 $24,000 $60,000 + +
= 131.25%
Thus the Wave Darters price would be set equal to $925, where
$925 = $400 + ($400 131.25%).
Inc.
In the preceding formula:
$60,000 = target profit (given)
480 = annual volume of Wave Darter production and sales (from Exhibit 15-5)
$400 = variable manufacturing cost per unit (from Exhibit 15-5)
$50 = variable selling and administrative cost per unit (from Exhibit 15-5)
$250 = applied fixed manufacturing cost per unit (from Exhibit 15-5)
$100 = allocated fixed selling and administrative cost per unit (from Exhibit 15-5)
2.
Markup percentage =
* $650 480
costs tive administra
and selling total
$60,000
+
=
$650 480
$100)] ($50 [480 $60,000
+ +
=
$312,000
$72,000 $60,000 +
= 42.31% (rounded)
Thus the Wave Darters price would be set equal to $925, where
$925 = $650 + ($650 42.31%) with rounding.
*$650 = absorption manufacturing cost (from Exhibit 15-5).
The other amounts used in this formula were defined in requirement (1).
Inc.
1. Material component of time and material pricing formula:
1.05
Department Repair in used
materials of cost annual
costs storage and
handling material

job on
incurred
cost
material

job on
incurred
cost
material
1
1
1
1
1
]
1
,
_
+
2. Material component of price, using formula developed in requirement (1):
[$8,000 + ($8,000 .04)] 1.05
= $8,320 1.05
= $8,736
New price to be quoted on yacht refurbishment:
Total price of job = time charges + material charges
= $9,000* + $8,736
**
= $17,736
*From Exhibit 15-7.
**
From requirement (1).
Answers will vary widely, depending on the company and the product chosen. The answer
should include a general discussion of the use of target costing in setting a price for a
new product. The target-costing approach includes the following key features: price-
led costing; focus on the customer; focus on product design; focus on process
design; use of cross-functional teams; analysis of life-cycle costs; and a value-chain
orientation. Target costing makes extensive use of value engineering to reduce
production costs and bring them into line with the target cost.
Inc.
SOLUTIONS TO PROBLEMS
PROBLEM 15-38 (45 MINUTES)
1. The order will boost Heartlands net income by $13,950, as the following calculations
show.
Sales revenue...................................................... $82,500
Less: Sales commissions (10%)........................ 8,250 $74,250
Less manufacturing costs:
Direct material............................................... $14,600
Direct labor.................................................... 28,000
Variable manufacturing overhead
*..........................
8,400
Total manufacturing costs 51,000
Income before taxes........................................... $ 23,250
Income taxes (40%)............................................. 9,300
Net income ...................................................... $ 13,950
*Based on an analysis of the year just ended, variable overhead is 30 percent of
direct labor ($1,125 $3,750). For Premiers Foods order:
Direct-labor cost x .30 = $28,000 x .30 = $8,400.
2. Yes. Although this amount is below the $82,500 full-cost price, the order is still
profitable. Heartland can afford to pick up some additional business, because the
company is operating at 75 percent of practical capacity.
Sales revenue............................................................ $63,500
Less: Sales commissions (10%).............................. 6,350 $57,150
Less manufacturing costs:
Direct material $14,600
Direct labor 28,000
Variable manufacturing overhead 8,400
Total manufacturing costs 51,000
Income before taxes................................................. $ 6,150
Income taxes (40%)................................................... 2,460
Net income ............................................................ $ 3,690
Note that the fixed manufacturing overhead and fixed corporate administration costs
are not relevant in this decision, because these amounts will remain the same
regardless of what Heartlands management decides about the order.
Inc.
PROBLEM 15-38 (CONTINUED)
3. The break-even price is $56,667, computed as follows:
Let P = break-even bid price
P 0.1P - $51,000 = 0
0.9P = $51,000
P = $56,667 (rounded)
Income taxes can be ignored, because there is no tax at the break-even point.
4. Profits will probably decline. Heartland originally used a full-cost pricing formula
to derive a $82,500 bid price. A drop in the selling price to $63,500 signifies that
the firm is now pricing its orders at less than full cost, which would decrease
profitability.
Reduced prices could lead to an increase in income if the company were able to
generate additional volume. This situation will not occur here, because the problem
states that Heartland has operated, and will continue to operate, at 75 percent of
practical capacity.
5. The electronic version of the Solutions Manual BUILD A SPREADSHEET SOLUTIONS
is available on your Instructors CD and on the Hilton, 8e website:
WWW.MHHE.COM/HILTON8E.
Inc.
1. (a) Time charges:
Hourly labor cost +
hours labor annual
storage) and handling material
(excluding overhead annual
+
magin profit cover
to charge hourly
= $20.00 +
12,000
$135,000
+ $5.00
= $36.25 per labor hour
(b) Material charges:
,
_
+
used materials of cost annual
costs storage and handling l materia

job on incurred
cost material

job on incurred
cost Material
=
,
_
+
$312,500
$31,250

job on incurred
cost material

job on incurred
cost Material
2. PRICE QUOTATION
Time charges: Labor time ......................................................... 400 hours
Rate ................................................................ $36.25 per hour
Total ................................................................... $14,500
Material changes: Cost of materials for job .................................. $75,000
+ Charge for material handling and storage ... 7,500 *
Total ................................................................... $82,500
Total price of job: Time ................................................................... $14,500
Material .............................................................. 82,500
Total ................................................................... $97,000
*Charge for material handling and storage):
10% = $31,250 $312,500; 10% $75,000 = $7,500
Inc.
3. Price of job without markup on material costs (from requirement 2) .... $ 97,000
Markup on total material costs ($82,500 10%) ...................................... 8,250
Total price of job ........................................................................................ $105,250
1. Direct-labor hours (DLH) required for job =
doses/DLH 2,000
packaged be to doses 1,000,000
= 500 DLH
Traceable out-of-pocket costs:
Direct labor ($16.00 500) .................................................................... $ 8,000
Variable overhead ($12.00 500) ......................................................... 6,000
Administrative cost ................................................................................ 2,000
Total traceable out-of-pocket costs.................................................. $16,000
Minimum price per dose =
doses 1,000,000
costs pocket - of - out e traceabl total
=
1,000,000
$16,000
= $.016
2. As in requirement (1), 500 direct-labor hours are required for the job.
Direct labor ($16.00 500) ......................................................................... $ 8,000
Variable overhead ($12.00 500) .............................................................. 6,000
Fixed overhead ($20.00 500) .................................................................. 10,000
Administrative cost .................................................................................... 2,000
Total cost ................................................................................................ $26,000
Maximum allowable return (15%) .............................................................. 3,900
Total bid price ........................................................................................ $29,900
Bid price per dose =
doses 1,000,000
price bid total
=
1,000,000
$29,900
= $.0299 per dose
Inc.
3. Under the supposition that the price computed by Manhattan Pharmaceuticals, Inc.
using Wyants criterion is greater than $0.03, the factors that Manhattans
management should consider before deciding whether or not to submit a bid at the
maximum allowable price include whether Manhattan Pharmaceuticals has excess
capacity, whether there are available jobs on which earnings might be greater, and
whether the maximum bid of $0.03 contributes toward covering fixed costs.
1. The manufacturing overhead rate is $27.00 per direct-labor hour, and the product
cost includes $13.50 of manufacturing overhead per pressure valve. Accordingly, the
direct-labor hours per finished valve is 1/2 hour ($13.50 $27.00). Therefore, 30,000
units per month would require 15,000 direct-labor hours.
2. The analysis of accepting the Glasgow Industries order of 120,000 units is as
follows:
Per Unit
Totals for
120,000 Units
Incremental revenue .............................................................. $28 .50 $3,420,000
Incremental costs:
Variable costs:
Direct material ................................................................ $ 7.50 $ 900,000
Direct labor ..................................................................... 9.00 1,080,000
Variable overhead .......................................................... 4 .50 540,000
Total variable costs ................................................... $21 .00 $2,520,000
Fixed overhead:
Supervisory and clerical costs
(4 months @ $18,000) ...................................................... 72,000
Total incremental costs ......................................................... $2,592,000
Total incremental profit ......................................................... $ 828,000
The following costs are irrelevant to the analysis:
Shipping
Sales commission
Fixed manufacturing overhead (both traceable and allocated)
Inc.
3. The minimum unit price that Wolverine Valve and Fitting Company could accept
without reducing net income must cover the variable unit cost plus the additional
fixed costs.
Variable unit cost:
Direct material .................................................................... $ 7.50
Direct labor ......................................................................... 9.00
Variable overhead .............................................................. 4 .50 $21.00
Additional fixed cost ($72,000 120,000) ............................. .60
Minimum unit price ................................................................ $21.60
4. Wolverines management should consider the following factors before accepting the
Glasgow Industries order:
The effect of the special order on Wolverines sales at regular prices.
The possibility of future sales to Glasgow Industries and the effects of
participating in the international marketplace.
The companys relevant range of activity and whether or not the special order will
cause volume to exceed this range.
The effect on machinery or the scheduled maintenance of equipment.
Other possible production orders that could come in and require the capacity
allocated to the Glasgow job.
5. The electronic version of the Solutions Manual BUILD A SPREADSHEET SOLUTIONS
is available on your Instructors CD and on the Hilton, 8e website:
Inc.
1. Cost-plus pricing begins by computing an items cost and then adds an appropriate
markup. The result is the items selling price. In contrast, target costing begins by
determining an appropriate selling price. A target profit is next subtracted from that
price to yield the cost (i.e., the target cost) that must be achieved.
Target costing could be labeled price-led costing because it begins by determining a
target selling price. In contrast, cost-plus pricing methods begin with the cost and
culminate in determination of the selling price.
2. The current selling price is $675:
Direct material... $ 90
Direct labor 225
Manufacturing overhead 150
Selling and administrative expenses. 75
Total cost. $540
Markup ($540 x 25%)... 135
Selling price... $675
3. Lehighs markup is $135, which is 20% of the current $675 selling price ($135
$675). To achieve a 20% markup on a $585 selling price, the company must reduce
its costs by $72.
Selling price.. $585
Less: 20% markup ($585 x 20%). 117
Target cost $468
Current cost.. $540
Less: Target cost. 468
Required cost reduction $ 72
Inc.
4. Yes. The company should focus its efforts on trimming non-value-added costs.
These costs are associated with non-value-added activities (i.e., activities that are
either (a) unnecessary and dispensable or (b) necessary, but inefficient and
improvable).
5. If costs cannot be reduced below $540, Lehigh will have to reduce its markup to
remain competitive. Assuming a desire to achieve the going market price of $585,
the markup must equal $45 ($585 - $540), or 8.33% of cost ($45 $540). Given that
the current markup on cost is 25%, a reduction of 16.67% is needed (25.00% - 8.33%).
6. The statement means that selling prices are a function of market conditions;
however, the selling prices must cover a companys costs in the long run. Also, in a
number of industries, prices are based on costs. Yet, the prices are subject to the
reaction of customers and competitors.
7. The electronic version of the Solutions Manual BUILD A SPREADSHEET
SOLUTIONS is available on your Instructors CD and on the Hilton, 8e website:
Inc.
1. The minimum price per blanket that Detroit Synthetic Fibers, Inc. could bid without
reducing the companys net income is $48 calculated as follows:
Raw material (6 lbs. @ $3.00 per lb.) ......................................................... $18.00
Direct labor (.25 hrs. @ $14.00 per hr.) ..................................................... 3.50
Machine time ($20.00 per blanket) ............................................................ 20.00
Variable overhead (.25 hrs. @ $6.00 per hr.) ............................................ 1.50
Administrative costs ($5,000 1,000) ....................................................... 5 .00
Minimum bid price ................................................................................. $48 .00
2. Using the full cost criteria and the maximum allowable return specified, Detroit
Synthetic Fibers, Inc.s bid price per blanket would be $59.80 calculated as follows:
Relevant costs from requirement (1) ........................................................ $48.00
Fixed overhead (.25 hrs. @ $16.00 per hr.) ............................................... 4 .00
Subtotal .................................................................................................. $52.00
Allowable return (.15 $52.00) ................................................................. 7 .80
Bid price ................................................................................................. $59 .80
3. Factors that management should consider before deciding whether to submit a bid
at the maximum acceptable price of $50 per blanket include the following:
The company should be sure there is sufficient excess capacity to fill the order
and that no additional investment is necessary in facilities or equipment that
would increase fixed costs.
If the order is accepted at $50 per blanket, there will be a $2 contribution per
blanket to cover fixed costs. However, the company should consider whether
there are other jobs that would make a greater contribution.
Acceptance of the order at a low price could cause problems with current
customers who might demand a similar pricing arrangement.
Inc.
1. Target costing is more appropriate. MSC is limited in terms of what price it can
charge due to market conditions. A cost-plus-markup approach will use the desired
markup for the company; however, the resulting price may too high and not
competitive. In such an environment it makes more sense to use target costing,
which begins with the price to be charged and works backward to determine the
allowable cost.
2. Target profit = asset investment x rate of return
= $27,000,000 x 12%
= $3,240,000
3. Revenue = target profit + variable cost + fixed cost
= $3,240,000 + (25,000 hours x $33) + $2,850,000
= $6,915,000
Since total revenue must equal $6,915,000, the revenue per hour must be $276.60
($6,915,000 25,000 hours).
4. Target profit = asset investment x rate of return
= $27,000,000 x 14%
= $3,780,000
Revenue = target profit + variable cost + fixed cost
= $3,780,000 + (25,000 hours x $33) + $2,850,000
= $7,455,000
No. A 14% return requires that MSC generate revenue per service hour of $298.20
($7,455,000 25,000 hours), which is clearly in excess of the $265 market price.
5. To achieve a 14% return and a $265 revenue-per-hour figure, the company must trim
its costs. MSC could use value engineering, a technique that utilizes information
collected about a services design and associated production process. The goal is
to examine the design and process and then identify improvements that would
produce cost savings.
Inc.
1. Target costing is the design of a product, and the processes used to produce it, so
that ultimately the product can be manufactured at a cost that will enable a firm to
make a profit when the product is sold at an estimated market-driven price. This
estimated price is called the target price, the desired profit margin is called the target
profit, and the cost at which the product must be manufactured is called the target
cost.
2. Value engineering (or value analysis) refers to a cost-reduction and process
improvement technique that utilizes information collected about a product's design
and production processes and then examines various attributes of the design and
processes to identify candidates for improvement efforts.
Value engineering focuses on improving those qualities that the customer desires,
while reducing or eliminating unnecessary moves, queues, setups, and other such
activities that the customer will not pay for. The process is reengineered to eliminate
non-value-added work and thereby enhance the value of the process to the customer.
Inc.
3. Portland Electronics' current profit on sales is 10 percent [($700$630)/$700].
Therefore, the target cost for the new product must be $600 less 10 percent, or $540
[$600 ($600 10%)].
4. The proposed changes to the just-in-time cell manufacturing process at Portland
Electronics will bring costs down to $532 per unit, which is below the $540 target cost
limit. Revised costs under the JIT cell manufacturing process are calculated as follows:
Current
Increase/
(Decrease) Revised
Material:
Purchased components.................................. $215 $215
All other............................................................ 85 85
Labor:
Manufacturing, direct...................................... 130 $ 30
160
Setups............................................................... 18 (18) 0
Material handling............................................. 36 (36) 0
Inspection......................................................... 46 (46) 0
Machining:
All...................................................................... 70 (10) 60
Other:
Finished-goods warehousing......................... 10 (10) 0
Warranty*.......................................................... 20 (8) 12
Total cost................................................................ $630 $(98) $532
*40% reduction
Inc.
1. Budgeted overhead costs:
Department I Department II
Variable overhead
Department I: 37,500 $12 ....................................... $450,000
Department II: 37,500 $6 ......................................... $ 225,000
Fixed overhead ................................................................ 225,000 225,000
Total overhead ................................................................ $675,000 $ 450,000
Total budgeted overhead for both
departments ($675,000 + $450,000) ............................. $1,125,000
Total expected direct-labor hours for
both departments (37,500 + 37,500) ............................ 75,000
Predetermined overhead rate =
hours labor - direct budgeted
overhead budgeted
=
75,000
$1,125,000
= $15.00 per direct-labor hour
2. Standard Deluxe
Total cost .............................................................................. $600.00 $750.00
Markup (15% of cost)
Standard: $600 .15 ...................................................... 90.00
Deluxe: $750 .15 ........................................................... ______ 112.50
Price ...................................................................................... $690.00 $862.50
3. Department I Department II
Budgeted overhead (from requirement 1)...................... $675,000 $450,000
Budgeted direct-labor hours .......................................... 37,500 37,500
Calculation of predetermined overhead rate ................
500 , 37
000 , 675 $
500 , 37
000 , 450 $
Predetermined overhead rate ......................................... $18.00 $12.00
Inc.
4. Standard Deluxe
Direct material ...................................................................... $240 $390
Direct labor ........................................................................... 210 210
Manufacturing overhead:
Department I:
Standard: 2 $18 ........................................................ 36
Deluxe: 8 $18 ............................................................ 144
Department II:
Standard: 8 $12 ........................................................ 96
Deluxe: 2 $12 ............................................................ 24
Total cost .............................................................................. $582 $768
5. Standard Deluxe
Total cost (from requirement 4)........................................... $582.00 $768.00
Markup (15% of cost)
Standard: $582 .15 ....................................................... 87.30
Deluxe: $768 .15 ........................................................... ______ 115 .20
Price ...................................................................................... $669 .30 $883 .20
6. The management of Super Sounds, Inc. should use departmental overhead rates. The
overhead cost structures in the two production departments are quite different, and
departmental rates more accurately assign overhead costs to products. When the
company used a plantwide overhead rate, the Standard speakers were overcosted and
the Deluxe speakers were undercosted. This in turn resulted in the Standard model
being overpriced and the Deluxe model being underpriced. The cost and price
distortion resulted from the following facts: (1) the Standard speakers spend most of
their production time in Department II, which is the least costly of the two
departments; and (2) the Deluxe speakers spend most of their production time in
Department I, which is more costly than Department II.
Inc.
1. Target costing is market driven, beginning with a determination of the selling price
that customers are willing to pay. That price is dependent on the product they
purchase and the products features. It is only natural that a marketing team
becomes heavily involved in this process, since customer feedback is crucial to the
design process.
2. Add cabinet doors: [(10 x 1) + (20 x 2) + (30 x 3) + (60 x 4) + (80 x 5)] = 780; 780 200
= 3.900
Expand storage area: [(10 x 1) + (40 x 2) + (70 x 3) + (50 x 4) + (30 x 5)] = 650; 650
200 = 3.250
Add security lock: [(30 x 1) + (60 x 2) + (50 x 3) + (40 x 4) + (20 x 5)] = 560; 560 200 =
2.800
New appearance for table top: [(10 x 1) + (20 x 2) + (50 x 3) + (60 x 4) + (60 x 5)] = 740;
740 200 = 3.700
Extend warranty: [(40 x 1) + (70 x 2) + (30 x 3) + (35 x 4) + (25 x 5)] = 535; 535 200 =
2.675
Inc.
Ranking (from strongest to weakest):
1Add cabinet doors (3.900)
2New appearance for table top (3.700)
3Expand storage area (3.250)
4Add security lock (2.800)
5Extend warranty (2.675)
3. (a) Danish Interiors currently earns a $48 profit on each table sold ($240 - $192),
which translates into a 20% markup on sales ($48 $240). The current
competitive market price is $285, which means that if the company maintains
the 20% markup, it will earn $57 ($285 x 20%) per unit. The maximum
allowable cost is therefore $228 ($285 - $57).
(b) Customers feel most strongly about adding cabinet doors and giving the
table top a new appearance. Both of these features can be added, and Danish
Interiors will be able to earn its 20% markup. The third and fifth most
desirable features (the expanded storage area and extended warranty) are too
costly. If it desires, management could also add a lock to the storage area.
Supporting calculations follow.
Maximum allowable cost... $228.00
Less: Current cost... 192.00
Cost of additional features $ 36.00
1Add cabinet doors. $ 18.00
2New appearance for table top 12.75
Subtotal $ 30.75
4Add security lock.. __ 4.95
Total.. $ 35.70
4. An expanded storage area would be the most logical additional feature in view of its
no. 3 ranking. Danish Interiors might use value engineering to study the design and
production process of both the table as currently manufactured as well as the
proposed new features. The goal is to identify improvements and associated
reductions in cost that may allow the company to add previously rejected options.
Inc.
SOLUTIONS TO CASES
CASE 15-48 (40 MINUTES)
1. Bid based on standard pricing policy:
Direct material ........................................................................................... $307,200
Direct labor (11,000 DLH @ $18.00) ......................................................... 198,000
Manufacturing overhead (11,000 DLH @ $10.80) ................................... 118,800
Full manufacturing costs ..................................................................... $624,000
Markup (50% of full cost) ......................................................................... 312,000
Standard pricing policy bid ...................................................................... $936,000
2. Minimum bid acceptable to Bair Company:
Direct material ........................................................................................... $307,200
Direct labor (11,000 DLH @ $18.00) ......................................................... 198,000
Variable manufacturing overhead (11,000 @ $6.48
a
) .............................. 71,280
Opportunity cost of lost sales
b
................................................................. 42,240
Minimum bid .............................................................................................. $618,720
a
Proportion of variable overhead =
overhead total budgeted
overhead variable budgeted
=
$1,944,000
$1,166,400
= 60%
Variable overhead rate =
,
_
,
_
proportion overhead
variable

rate
overhead total
= ($10.80) (.6)
= $6.48
Inc.
CASE 15-48 (CONTINUED)
b
Selling price per unit of standard product......................... $14,400
Variable costs per unit
Direct material ............................................................. $3,000
Direct labor (250 DLH @ $18.00) ................................ 4,500
Variable overhead (250 DLH @ $6.48) ....................... 1,620 9,120
Net contribution per unit ..................................................... $ 5,280
Standard product requirements (12,000 DLH 3) ............ 36,000 DLH
Special order requirements ................................................. 11,000 DLH
Total hours required ............................................................ 47,000 DLH
Plant capacity per quarter (15,000 DLH 3) ...................... 45,000 DLH
Shortage in hours ................................................................ 2,000 DLH
Lost unit sales (2,000 DLH 250 DLH) ............................... 8
Lost contribution ................................................................. $42,240
3. Lyan Companys assistant purchasing manager is not acting ethically. The details of
the bid submitted by Bair Company are confidential between Bair Company and Lyan
Company. It is unfair and unethical to give this information to Bairs competitor. If
Lyan Company had wanted competing bids on the specialized equipment, the bids
should have been solicited at the same time from the relevant set of manufacturers.
Each competing firm should receive the same specifications on the customized
equipment and be given the same time frame in which to complete the bid. Moreover,
the competing firms should be made aware that more than one bid is being solicited.
Inc.
CASE 15-49 (50 MINUTES)
1. Handy Household Products, Inc. should price the standard compound at $44 per
case and the commercial compound at $60 per case. The contribution margin is the
highest at these prices as shown in the following calculations:
Standard Compound
Selling price per case .............................................. $ 38 $ 40 $ 42 $ 44 $ 46
Variable cost per case ............................................. 32 32 32 32 32
Contribution margin per case ................................. $ 6 $ 8 $ 10 $ 12 $ 14
Volume in cases (in thousands) ............................. 120 100 90 80 50
Total contribution margin (in thousands) .............. $ 720 $ 800 $ 900 $ 960 $ 700
Commercial Compound
Selling price per case .............................................. $ 52 $ 54 $ 60 $ 64 $ 70
Variable cost per case ............................................. 42 42 42 42 42
Contribution margin per case ................................. $ 10 $ 12 $ 18 $ 22 $ 28
Volume in cases (in thousands) ............................. 175 140 100 55 35
Total contribution margin (in thousands) .............. $1,750 $1,680 $1,800 $1,210 $ 980
Inc.
CASE 15-49 (CONTINUED)
2. a. Management should continue to operate during the final six months of the
current year because any shutdown would be temporary. The company intends
to remain in the business and expects a profitable operation during the next year.
This is a short-run decision problem. Therefore, the fixed costs are irrelevant to
the decision, because they cannot be avoided in the short run. The products do
have a positive contribution margin so operations should continue.
HANDY HOUSEHOLD PRODUCTS, INC.
SHREVEPORT PLANT
PROJECTED CONTRIBUTION MARGIN
FOR THE SIX-MONTH PERIOD ENDING DECEMBER 31
(IN THOUSANDS)
Standard Commercial Total
Sales ......................................................................... $2,300 $2,450 $4,750
Variable costs:
Selling and administrative .................................. $ 400 $ 490 $ 890
Manufacturing ...................................................... 1,200 980 2,180
Total variable costs ......................................... $1,600 $1,470 $3,070
Contribution margin ................................................ $ 700 $ 980 $1,680
b. Management should consider the following qualitative factors when making the
decision about the Shreveport Plant.
The effect on employee morale.
The effect on market share.
The disruption of production and sales due to a shutdown.
The effect on the local community.
Inc.

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CHAPTER 15

Target Costing and Cost Analysis for Pricing

20 ..................... $500 ..................... $10,000

Differences between amounts in column (3).

20 ..................... $450 ..................... $ 9,000

Differences between amounts in column (3).

*Column (1) times column (2).

EXERCISE 15-32 (30 MINUTES)

Variable manufacturing cost .................. $275

*($495 $275) $275 = 80%

($495 $330) $330 = 50%

Sales price required = unit variable cost + required unit

cost base per unit

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