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CHAPTER 25
DIFFERENTIAL ANALYSIS AND
PRODUCT PRICING
EYE OPENERS
1. a. Differential revenue is the amount of
increase or decrease in revenue expected from a particular course of action
compared with an alternative.
b. Differential cost is the amount of increase or decrease in cost expected
from a particular course of action compared with an alternative.
c. Differential income is the difference between differential revenue and differential cost.
2. This decision is an example of a make-vs.buy decision. Exabyte is focusing on its
comparative advantages, which include
marketing and distribution, while building
partnerships with others to actually manufacture key elements of the product.
3. The differential income and costs of the
lease option should be compared against
selling the building. The differential revenue
would be the lease revenue compared to the
proceeds from sale. The differential expenses would be the costs associated with leasing the building, including maintenance,
property tax, and insurance compared to the
expense of selling, such as sales commissions. The opportunity cost of money should
also be considered in the analysis.
4. Assuming there is demand for the premiumgrade product, this would assume the differential price (premium less commodity) exceeded the differential cost to process the
product to premium grade.
5. A business should only accept business at a
special price if the lower price will not contaminate the regular pricing for other customers or induce other customers to buy at
the special price. In addition, the business
must be careful not to violate the RobinsonPatman Act, which prohibits uncompetitive
price differences across different markets for
the same product. Lastly, the company may
only offer the special price once for an incremental order. Thus, the business must
consider the longer-term ramifications of of-
6.
7.
8.
9.
10.
11.
12.
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fering discount business to a customer that
may wish to order in the future.
It would be reasonable to purchase from the
supplier if the fixed cost per unit was less
than 50 cents. That is, if the fixed cost were
less than 50 cents per unit, then the variable
cost per unit would exceed the supplier’s
price, making the supplier price more attractive.
Some of the financial considerations include
the profitability of the store, including all the
revenues, variable and fixed costs associated with the store, since they would all be differential to the decision. In addition, any
costs of closing the store and preparing the
store for disposal would need to be considered (legal costs, demolition costs, employee severance costs). Lastly, the opportunity
cost of the value of the equipment and land
(either in cash or rental income) should be
considered. For example, if the opportunity
value of the assets were $500 per month,
then the store would need to have a profitability exceeding this amount to remain an attractive alternative.
In the long run, the normal selling price must
be set high enough to cover all costs (both
fixed and variable) and provide a reasonable
amount for profit.
The use of ideal standards might not allow
for such factors as normal spoilage or normal periods of idle time, with the result that
these costs might not be covered by the
product price. In such cases, the product
price could be too low to earn a desired profit.
In setting prices, managers should also
consider such factors as the prices of competing products and the general economic
conditions of the marketplace.
Activity-based costing can be used to determine the product cost in a complex manufacturing setting.
The target cost concept begins with a price
that can be sustained in the marketplace,
13.
then subtracts a target profit, thus determining the target cost. The cost is made to conform to the price required in the market. In
contrast, under cost plus, a markup is added
to the cost. The resulting price is assumed to
be acceptable in the market.
The target cost concept is most appropriate
in highly competitive product markets, where
margins are under pressure and prices are
falling.
14.
15.
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A production bottleneck is a point in the
production process where demand exceeds
the ability to produce (i.e., the segment is
operating at full capacity). As a result, the
complete production system output is limited
by the output of the bottleneck.
The proper measure of product value in a
bottlenecked process is the contribution
margin per bottleneck hour.
PRACTICE EXERCISES
PE 25–1A
Differential revenue from alternatives:
Revenue from lease .......................................................
Revenue from sale .........................................................
Differential revenue from lease ............................
Differential cost of alternatives:
Repair, insurance, and property tax expenses
from lease ..................................................................
Commission expense on sale (6% × $40,000) .............
Differential cost of lease .......................................
Net differential loss from the lease alternative ..................
$ 42,000
40,000
$ 2,000
$ 7,000
2,400
4,600
$(2,600)
PE 25–1B
Differential revenue from alternatives:
Revenue from lease .......................................................
Revenue from sale .........................................................
Differential revenue from lease ............................
Differential cost of alternatives:
Repair, insurance, and property tax expenses
from lease ..................................................................
Commission expense on sale (5% × $250,000)...........
Differential cost of lease .......................................
Net differential income from the lease alternative ............
$268,000
250,000
$ 18,000
$ 24,000
12,500
11,500
$ 6,500
PE 25–2A
a.
Differential revenue from annual sales of Product L:
Revenue from sales ...................................................
Differential cost of annual sales of Product L:
Variable cost of goods sold ......................................
Variable selling expenses .........................................
Annual differential income from sales of Product L ..
b. Product L should be continued.
367
$ 56,000
$ 29,000
12,000
41,000
$ 15,000
PE 25–2B
a.
Differential revenue from annual sales of Product V:
Revenue from sales ...................................................
Differential cost of annual sales of Product V:
Variable cost of goods sold ......................................
Variable selling expenses .........................................
Annual differential loss from sales of Product V .......
$204,000
$134,000
74,000
208,000
$ (4,000)
b. Product V should be discontinued.
PE 25–3A
Differential cost to purchase:
Purchase price of small bottles (per 1,000) .......................
Freight for bottles ................................................................
Differential cost to manufacture:
Variable manufacturing costs ($52 – $15 fixed costs) ......
Cost savings from manufacturing small bottles ......................
$32
7
$39
37
$ 2
PE 25–3B
Differential cost to purchase:
Purchase price of bread ...............................................
Delivery cost for bread .................................................
Differential cost to manufacture:
Variable baking costs ($160 – $38 fixed costs) ..........
Cost savings from purchasing bread .................................
$109
8
$117
122
$ (5)
PE 25–4A
Annual direct labor cost reduction .....................................
Number of years applicable ................................................
Total differential decrease in cost ......................................
Proceeds from sale of old equipment ................................
Cost of new equipment ........................................................
Net differential decrease in cost from replacing
equipment, five-year total .............................................
Annual net differential decrease in cost—new machine ..
368
$ 2,800
×
5
$ 14,000
50,000
$ 64,000
62,000
$ 2,000
$
400
PE 25–4B
Annual direct labor cost reduction .....................................
Number of years applicable ................................................
Total differential decrease in cost ......................................
Proceeds from sale of old equipment ................................
Cost of new equipment ........................................................
Net differential increase in cost from replacing
equipment, six-year total ..............................................
Annual net differential increase in cost—new machine ...
$ 12,000
×
6
$ 72,000
243,000
$315,000
320,000
$ (5,000)
$
(833)
(rounded)
PE 25–5A
Differential revenue from further processing per gallon:
Revenue per gallon from sale of Product E .......................
Revenue per gallon from sale of Product D .......................
Differential revenue ..............................................................
Differential cost per gallon:
Additional cost for producing Product E ($19 – $3) ..........
Differential income from further processing into Product E ...
$105
85
$20
16
$ 4
PE 25–5B
Differential revenue from further processing per pound:
Revenue per pound from sale of Product U .....................
Revenue per pound from sale of Product T ......................
Differential revenue .............................................................
Differential cost per pound:
Additional cost for producing Product U ($0.50 – $0.12) .
Differential loss from further processing into Product U .......
$4.45
4.10
$ 0.35
0.38
$(0.03)
PE 25–6A
Differential revenue from export:
Revenue per unit from export sale ..............................
Differential cost from export:
Variable manufacturing costs ......................................
Export tariff (25% × $5.60) ............................................
Differential loss from accepting export sale ......................
369
$ 5.60
$4.50
1.40
5.90
$(0.30)
PE 25–6B
Differential revenue from export:
Revenue per unit from export sale ..............................
Differential cost from export:
Variable manufacturing costs ......................................
Export tariff (15% × $46) ...............................................
Differential income from accepting export sale ................
PE 25–7A
Markup percentage on total cost:
$30
= 20%
$150
PE 25–7B
Markup percentage on total cost:
$10
= 12.5%
$80
PE 25–8A
Markup percentage on product cost:
$30 + $50
= 80%
$100 *
*$150 – $50
PE 25–8B
Markup percentage on product cost:
$10 + $44
= 150%
$36 *
*$80 – $44
PE 25–9A
Markup percentage on variable cost:
$30 + $25 *
= 44%
$125
*$150 – $125
370
$46.00
$32.00
6.90
38.90
$ 7.10
PE 25–9B
Markup percentage on variable cost:
$10 + $50 *
= 200%
$30
*$80 – $30
PE 25–10A
Unit contribution margin .....................................................
Furnace hours per unit ........................................................
Unit contribution margin per production bottleneck hour
Product K
Product L
$240
÷ 8
$ 30
$200
÷ 5
$ 40
Product L is the most profitable in using bottleneck resources.
PE 25–10B
Product A
Unit contribution margin .....................................................
Testing hours per unit .........................................................
Unit contribution margin per production bottleneck hour
Product A is the most profitable in using bottleneck resources.
371
$45
÷ 3
$15
Product B
$60
÷ 5
$12
EXERCISES
Ex. 25–1
a.
Proposal to Lease or Sell Machinery
January 3, 2010
Differential revenue from alternatives:
Revenue from lease ...................................................
Proceeds from sale ...................................................
Differential revenue from lease ...........................
Differential cost of alternatives:
Repairs, insurance, and property tax expenses
from lease ................................................................
Commission on sale..................................................
Differential cost of lease ......................................
Net differential loss from lease alternative .................
$312,000
292,000
$ 20,000
$ 36,000
14,600*
21,400
$ (1,400)
*5% × $292,000
b. Sell the machinery. The net gain from selling is $1,400.
Ex. 25–2
a.
Proposal to Discontinue Royal Cola
March 3, 2010
Differential revenue from annual sales of Royal Cola:
Revenue from sales ......................................................
Differential cost of annual sales of Royal Cola:
Variable cost of goods sold .........................................
Variable operating expenses .......................................
Annual differential income from sales of Royal Cola....
$254,000
$102,480*
124,800**
227,280
$ 26,720
*(1 – 16%) × $122,000
**(1 – 20%) × $156,000
b. Royal Cola should be retained. As indicated by the differential analysis in part (a),
the income would decrease by $26,720 (excess of differential revenue over differential cost) if the product is discontinued.
372
Ex. 25–3
a.
SUFFOLK CHINA WARE COMPANY
Differential Product Analysis Report
For the Month Ended December 31, 2010
Differential revenue from annual sales:
Revenue from sales .................................
Differential costs of annual sales:
Variable cost of goods sold ....................
Variable selling and administrative
expenses ..............................................
Annual differential income from sales .......
Bowls
Plates
Cups
$54,000
$68,500
$24,500
$ 19,040
$ 26,945
$10,115
16,980
$ 36,020
15,180
$ 42,125
12,240
$22,355
$ 17,980
$ 26,375
$ 2,145
b. The Cups line should be retained. As indicated by the differential analysis in part
(a), the income would decrease by $2,145 (excess of differential revenue over differential cost) if the Cups line is discontinued.
373
Ex. 25–4
Note to Instructors: Many students may be unfamiliar with the financial services industry. This exercise provides an opportunity to introduce students to some basic
terms and concepts used within the industry.
a. The “Individual Investor” segment serves the retail customer, you and me. These
are the brokerage, Internet, and mutual fund services used by individual investors.
The “Institutional Investor” segment includes the same services provided for financial institutions, such as banks, mutual fund managers, insurance companies,
and pension plan administrators. Although not required by the question, the “Corporate and Retirement Services” segment provides wealth management services
for affluent individuals and families.
b. Variable costs in the “Individual Investor” segment include:
1.
2.
3.
4.
Commissions to brokers
Fees paid to exchanges for executing trades
Transaction fees incurred by Schwab mutual funds to purchase and sell shares
Advertising
Fixed costs in the “Individual Investor” segment include:
1. Depreciation on brokerage offices
2. Depreciation on brokerage office equipment, such as computers and computer
networks
3. Property taxes on brokerage offices
c.
Individual
Investor
Income from operations ..............................
Plus depreciation.........................................
Estimated contribution margin...................
$1,237
98
$1,335
Corporate
and
Institutional Retirement
Investor
Services
$482
25
$507
$139
15
$154
d. If one assumes that the fixed costs that serve institutional investors (computers,
servers, and facilities) would not be sold but would be used by the other two sectors, then the contribution margin of $507 million would be an estimate of the reduced profitability. If the fixed assets were sold, then the operating income decline
would approach $482 million. Since the institutional and retail investors use nearly
the same assets, the $507 million answer is probably the better estimate.
374
Ex. 25–5
The flaw in the decision was the failure to focus on the differential revenues and
costs, which indicate that operating income would be reduced by $40,000 if Children’s
Shoes is discontinued. This differential income from sales of Children’s Shoes can be
determined as follows:
Differential revenue from annual sales of Children’s
Shoes:
Revenue from sales ......................................................
Differential cost of annual sales of Children’s Shoes:
Variable cost of goods sold .........................................
Variable selling and administrative expenses ............
Annual differential income from sales of Children’s
Shoes .............................................................................
$170,000
$100,000
30,000
130,000
$ 40,000
Ex. 25–6
a.
Proposal to Manufacture Carrying Case
October 11, 2010
Purchase price of carrying case ..................................
Differential cost to manufacture carrying case:
Direct materials .........................................................
Direct labor ................................................................
Variable factory overhead (15% × $32) ....................
Cost savings from manufacturing carrying case .......
$68.00
$25.00
32.00
4.80
61.80
$ 6.20
b. It would be advisable to manufacture the carrying cases because the cost savings
would be $6.20 per unit. Fixed factory overhead is irrelevant, since it will continue
whether the carrying cases are purchased or manufactured.
375
Ex. 25–7
a.
Proposal to Purchase Outside Page Layout Services
December 15, 2009
Differential revenue:
Salvage of computer equipment .................................
Differential expenses:
Purchase price of layout work:
Number of pages ......................................................
Price per page ...........................................................
Total ..................................................................................
Differential cost to perform internally:
Salaries..........................................................................
Benefits .........................................................................
Supplies ........................................................................
Office expenses ............................................................
Cost savings from purchasing layout services .............
Total benefit from using an outside service ..................
$
7,000
20,000
× $15.00
$300,000
$220,000
35,000
30,000
25,000
310,000
$ 10,000
$ 17,000
b. The benefit from using an outside service is shown to be $17,000 greater than performing the layout work internally. The fixed costs (depreciation expenses) in the
budget are irrelevant to the decision. Thus, the work should be purchased from
the outside on a strictly financial basis. In addition, the decision to purchase from
the outside would be further favored if the need for administrative expansion
space were great. If more administrative space were needed immediately, then any
avoided lease costs would become a differential benefit to the decision to outsource.
c. Before electing to terminate the five employees, the guild should consider the
long-run impact of the decision. Specifically, future page layout rates may grow
faster than the cost of internal salaries, thus favoring the use of employees over
the long term. This would especially be the case if the outside company provided
a low bid in order to win the initial business. In addition, the guild may wish to
consider noneconomic factors such as the ability to more directly control the
quality and timing of the layout work by internal employees.
376
Ex. 25–8
a.
Annual variable costs—present equipment................
Annual variable costs—new equipment .....................
Annual differential decrease in cost ............................
Number of years applicable .........................................
Total differential decrease in cost ...............................
Proceeds from sale of present equipment ..................
Cost of new equipment .................................................
Net differential income, eight-year total ......................
Annual differential income from new equipment
($40,000/8) ..................................................................
$165,000
112,750
$ 52,250
×
8
$418,000
72,000
$490,000
450,000
$ 40,000
$
5,000
b. The sunk cost is the $250,000 book value ($600,000 cost less $350,000 accumulated depreciation) of the present equipment. The original cost and
accumulated depreciation were incurred in the past and are irrelevant to the decision to replace the machine.
377
Ex. 25–9
a.
Proposal to Replace Machine
February 20, 2010
Annual costs and expenses—present machine ...............................
Annual costs and expenses—new machine .....................................
Annual differential decrease in costs and expenses .......................
Number of years applicable ...............................................................
Total differential decrease in costs and expenses ..........................
Cost of new equipment .......................................................................
Net differential increase in costs and expenses, five-year total .....
$203,000
188,000
$ 15,000*
×
5
$ 75,000
111,000
$ 36,000
Annual differential increase in costs and expenses—
new machine ($36,000/5 years) ......................................................
$
7,200
*The annual differential decrease in costs and expenses could be computed alternatively as follows:
Decrease in direct labor costs .........................................
Less: Increase in power and maintenance ....................
Increase in taxes, insurance, etc. .......................
Annual differential decrease in costs and expenses .....
$ 40,000
$22,000
3,000
25,000
$ 15,000
b. The proposal should not be accepted.
c. In addition to the factors given, consideration should be given to such factors as:
Do both present and proposed operations provide the same capacity? What are
the opportunity costs associated with alternative uses of the $111,000 outlay required to purchase the automatic machine? Is the product improved by using automatic machinery? Does the federal income tax have an effect on the decision?
Ex. 25–10
a. Differential revenue: $840 – $635 = $205
b. Differential cost: $565 – $490 = $75
c. Differential income: $205 – $75 = $130
378
Ex. 25–11
a.
Proposal to Process Columbian Coffee Further
Differential revenue from further processing per batch:
Revenue from sale of Decaf Columbian [(8,000
pounds – 400* pounds evaporation) × $12.50]....
Revenue from sale of Columbian coffee
(8,000 pounds × $10.80) ........................................
Differential revenue .......................................................
Differential cost per batch:
Additional cost of producing Decaf Columbian ......
Differential loss from further processing:
Decaf Columbian per batch ......................................
$95,000
86,400
$ 8,600
10,500
$ (1,900)
*5% × 8,000
b. The differential revenue from processing further to Decaf Columbian is less than
the differential cost of processing further. Thus, Seattle Roast Coffee Company
should sell Columbian coffee and not process further to Decaf Columbian.
c. The price of Decaf Columbian would need to increase to $12.75 per pound in order
for the differential analysis to yield neither an advantage or a disadvantage (indifference). This is determined as follows:
Net Disadvantage of Further Processing
$1,900
=
= $0.25 per lb.
7,600 lbs.
Volume of Decaf Columbian
The price of Decaf Columbian would need to be $0.25 higher, or $12.75, to yield no
net differential income or loss. This is verified by the following differential analysis:
Differential revenue from further processing per batch:
Revenue from sale of Decaf Columbian [(8,000
pounds – 400 pounds evaporation) × $12.75] ................
Revenue from sale of Columbian coffee
(8,000 pounds × $10.80) ...................................................
Differential revenue ..............................................................
Differential cost per batch:
Additional cost of producing Decaf Columbian .................
Differential income from further processing:
Decaf Columbian per batch .................................................
379
$96,900
86,400
$10,500
10,500
$
0
Ex. 25–12
a.
Proposal to Sell to Fields Company
March 18, 2010
Differential revenue from accepting the offer:
Revenue from sale of 18,000 additional units at $29 ..................
Differential cost of accepting the offer:
Variable costs from sale of 18,000 additional units at $22 .........
Differential income from accepting the offer ....................................
$522,000
396,000
$126,000
b. The additional units can be sold for $29 each, and since unused capacity is available, the only costs that would be added if this additional production were accepted are the variable costs of $22 per unit. The differential revenue is therefore $29
per unit, and the differential cost is $22 per unit. Thus, the net gain is $7 per unit ×
18,000 units, or $126,000.
c. $22.01. Any selling price above $22 (variable costs per unit) will produce a positive
contribution margin.
Ex. 25–13
Total costs
Less fixed costs
Total variable costs
$478,000
58,000
$420,000
Variable cost per unit:
$420,000/30,000 batteries = $14.00
The lowest bid should be sufficient to cover the variable cost of $14 per unit.
380
Ex. 25–14
a.
Proposal to Sell to Euro Motors
May 4, 2010
Per Unit
Total
Differential revenue from accepting special offer ....
Differential costs from accepting special offer:
Direct materials .......................................................
Direct labor ..............................................................
Variable factory overhead .......................................
Variable selling and administrative .......................
Less avoided sales commission ............................
Additional shipping costs .......................................
$75.00
$1,875,000*
Variable special offer product cost ........................
Incremental certification costs ..................................
Total differential costs ................................................
Differential income from accepting special order ....
$63.50
$32.00
8.00
15.00
7.00
(4.50)**
6.00
$1,587,500
125,000
$1,712,500
$ 162,500
*$75 × 25,000 units
**5% × $90. The avoided sales commission should not be computed on the basis
of the $75 price to Euro Motors, but on the existing domestic sales price of $90.
b.
$1,712,500
= $68.50
25,000
or
$75 –
$162,500
= $68.50
25,000
381
Ex. 25–15
a. $100,000 ($400,000 × 25%)
b. Total costs:
Variable ($240 × 5,000 units) .........................................................
Fixed ($215,000 + $75,000) ............................................................
Total ......................................................................................................
$1,200,000
290,000
$1,490,000
Cost amount per unit: $1,490,000/5,000 units = $298
c.
Markup Percentage =
Markup Percentage =
Markup Percentage =
Desired Profit
Total Costs
$100,000
$1,490,000
6.71% (rounded)
d. Cost amount per unit...........................................................................
Markup ($298 × 6.71%) ........................................................................
Selling price .........................................................................................
$298
20
$318
Ex. 25–16
a.
Total manufacturing costs:
Variable ($210 × 5,000 units) .........................................................
Fixed factory overhead ..................................................................
Total ......................................................................................................
$1,050,000
215,000
$1,265,000
Cost amount per unit: $1,265,000/5,000 units = $253
b.
Markup
Percentage
=
Desired Profit + Total Selling and Administr ative Expenses
Total Manufactur ing Costs
Markup Percentage =
$100,000 + $75,000 + ($30 × 5,000)
$1,265,000
Markup Percentage =
$100,000 + $75,000 + $150,000
$1,265,000
Markup Percentage =
$325,000
$1,265,000
Markup Percentage = 25.69% (rounded)
c.
Cost amount per unit...........................................................................
Markup ($253 × 25.69%) ......................................................................
Selling price .........................................................................................
382
$253
65
$318
Ex. 25–17
a.
Total variable costs: $240 × 5,000 units ............................................
Cost amount per unit: $1,200,000/5,000 units = $240
b. Markup Percentage =
$1,200,000
Desired Profit + Total Fixed Costs
Total Variable Costs
Markup Percentage =
$100,000 + $215,000 + $75,000
$1,200,000
Markup Percentage =
$390,000
$1,200,000
Markup Percentage = 32.5%
c.
Cost amount per unit...........................................................................
Markup ($240 × 32.5%) ........................................................................
Selling price .........................................................................................
$240
78
$318
Ex. 25–18
a. The price will be set at the estimated market price required to remain competitive,
or $22,000. Under the target cost concept, the market dictates the price, not the
markup on cost.
b. The required profit margin of 20% of the estimated $22,000 price implies a $17,600
target product cost as follows:
Target Product Cost = $22,000 – ($22,000 × 20%)
Target Product Cost = $22,000 – $4,400
Target Product Cost = $17,600
Since the estimated manufacturing cost of $18,100 exceeds the target cost of
$17,600, Toyota will try to remove $500 from its total costs in order to maintain
competitive pricing within its profit objectives.
Note to Instructors: Target costing provides pressure to keep costs competitive.
The method assumes that the company may not be able to successfully add a
markup to its costs because the resulting price may be too high in the marketplace. For example, merely adding the 25% markup on the $18,100 product cost
would result in an uncompetitive price of $22,625. The target cost concept moves
backward by taking the price as given and then determining the cost that is required for a given profit objective.
383
Ex. 25–19
a. Historical markup percentage:
$400  $320
= 25%
$320
$80
= 20% markup on selling price
$400
$380 revised selling price × 20% markup = $76 amount of markup
$380 selling price – $76 markup = $304 target cost
b. Required cost reduction: $320 – $304 = $16
c.
1. Direct labor reduction:
9 min.
× $25 =
60 min.
2. Additional inspection:
6 min.
× $25 =
60 min.
Direct material reduction:
$ 3.75
$(2.50)
8.00
3. Injection molding productivity improvement:
Direct labor improvement (25%* × 30% × $60)
Factory overhead improvement (25%* × 42% × $30)
Total savings
$ 4.50
3.15
5.50
7.65
$16.90
*Improving the cycle time from four minutes to three minutes is a 25% reduction.
The total savings exceeds the required target cost reduction by $0.90. Thus, these
improvements are sufficient to meet the target cost.
384
Ex. 25–20
Determine the contribution margin per furnace hour as follows:
Type 5
Type 10
Type 20
Revenue ....................................................
Variable cost .............................................
Contribution margin .................................
Divide by number of units .......................
Unit contribution margin .........................
$36,000
22,500
$ 13,500
÷ 5,000 units
$ 2.70
$40,000
20,000
$ 20,000
÷ 5,000 units
$ 4.00
$ 22,000
15,000
$ 7,000
÷ 5,000 units
$ 1.40
*Contribution margin per furnace hour ..
$
$
$
0.54
0.40
0.28
*Calculated as follows:
Type 5:
$2.70
= $0.54 per furnace hour
5 hours
Type 10:
$4.00
= $0.40 per furnace hour
10 hours
Type 20:
$1.40
= $0.28 per furnace hour
5 hours
Emphasize Type 5. In a production-constrained environment, Type 5 generates the
most unit contribution margin per hour of furnace resource and, thus, is the most
profitable. While Type 10 has the largest profit per unit ($2.80) and unit contribution
margin ($4.00), these would not be the correct metrics for determining the product to
emphasize in the marketing campaign.
385
Ex. 25–21
a.
Large
Medium
Small
Units produced........................
3,000
3,000
3,000
Revenues .................................
Less variable costs .................
Contribution margin ...............
Less fixed costs ......................
Income from operations .........
$360,000
288,000
$ 72,000
$300,000
255,000
$ 45,000
$270,000
225,000
$ 45,000
Total
$930,000
768,000
$162,000
74,000
$ 88,000
b. The Small glass product is the most profitable in a bottleneck operation, demonstrated as follows:
Unit contribution margin ................................
Autoclave hours per unit ................................
Unit contribution margin per production
bottleneck hour ...........................................
386
Large
Medium
Small
$ 24
÷
4
$ 15
÷
2
$
÷
$ 6.00
$ 7.50
$15.00
15
1
Ex. 25–22
Small is the highest profit item, since it produces more contribution margin per autoclave hour. The prices of Large and Medium would need to be increased in order to
match Small’s profitability. The two calculations are as follows:
Revised price of Large:
=
Revised Price -- Unit Varia ble Cost
of Large
of Large
Bottleneck Hours per Unit of Large
$15.00
=
Revised Price of Large -- $96
4 hours
$60.00
=
Revised Price of Large – $96
$156.00
=
Revised Price of Large
Unit Contribution Margin
per Bottleneck Hour
of Small
Revised price of Medium:
Unit Contribution Margin
per Bottleneck Hour
=
of Small
Revised Price -Unit Varia ble Cost
of Medium
of Medium
Bottleneck Hours per Unit of Medium
$15.00
=
Revised Price of Medium -- $85
2 hours
$30.00
=
Revised Price of Medium – $85
$115.00
=
Revised Price of Medium
Thus, prices of $156 for Large and $115 for Medium both produce a unit contribution
margin per hour of bottleneck operation of $15.00. The price of Small would remain
unchanged. At these prices, the company should be indifferent about the product mix.
387
Appendix Ex. 25–23
=
Activity
Cost
Stationary Bicycle
Fabrication
1,950 machine hours
× $24 per mh
Assembly
436 direct labor hours
× $12 per dlh
Setup
48 setups
× $40 per setup
Inspecting
725 inspections
× $22 per inspection
Production scheduling 68 production orders
× $14 per prod. order
Purchasing
166 purchase orders
× $6 per purch. order
Total..................................................................................................................
Number of units ...............................................................................................
Activity costs per unit .....................................................................................
$ 46,800
5,232
1,920
15,950
952
996
$ 71,850
÷ 1,000
$ 71.85
Rowing Machine
Fabrication
975 machine hours
× $24 per mh
Assembly
162 direct labor hours
× $12 per dlh
Setup
15 setups
× $40 per setup
Inspecting
375 inspections
× $22 per inspection
Production scheduling 20 production orders
× $14 per prod. order
Purchasing
126 purchase orders
× $6 per purch. order
Total..................................................................................................................
Number of units ...............................................................................................
Activity costs per unit .....................................................................................
$ 23,400
1,944
600
8,250
280
756
$ 35,230
÷ 1,000
$ 35.23
Activity-Base Usage
388
×
Activity
Rate
Appendix Ex. 25–24
a.
Production
Quality
Materials
Activity Rates
Setup
Procurement
Control
Management
Overhead cost... $
54,000 $ 122,000 $
170,000 $
125,000
Activity base...... ÷
500 ÷
1,000 ÷
2,000 ÷
500
Activity rate ....... $ 108/setup $ 122/PO $ 85/inspection $250/component
b.
Number of setups .....................
Rate per setup ..........................
Custom
375
× $108
Standard
125
× $108
$ 40,500
Number of purchase orders ....
Rate per purchase order ..........
900
× $122
Number of inspections ............
Rate per inspection ..................
1,800
× $85
$ 13,500
100
× $122
109,800
12,200
200
× $85
153,000
Number of components ...........
Rate per component ................
300
× $250
200
× $250
75,000
$378,300
÷ 3,000
$ 126.10
Total product cost ....................
Unit volume ...............................
Unit cost ...............................
17,000
50,000
$ 92,700
÷ 3,000
$ 30.90
c. The factory overhead allocated to each product on the basis of direct labor hours
would be 50%, since each product has the same 3,000 direct labor hours. The factory overhead per direct labor hour for each product is computed as follows:
$471,000
= $78.50 per hour
6,000 hours
Since each product requires one direct labor hour, the cost per unit is also $78.50
for each product.
d. The factory overhead allocated to the custom power unit is much higher under the
activity-based approach, compared to the direct labor method. The reason is that
the setup, procurement, and quality control activities are not directly related to the
number of direct labor hours but are instead related to the number of setups, purchase orders, and inspections. In addition, the custom product has a more complex design (more components) than does the standard product. As a result, the
custom product will consume more materials management activities than will the
standard product.
389
PROBLEMS
Prob. 25–1A
1.
Proposal to Operate Warehouse
March 1, 2010
Differential revenue from alternatives:
Revenue from operating warehouse........................ $4,270,0001
Revenue from investment in bonds .........................
735,0002
Differential revenue from operating warehouse .
$3,535,000
Differential cost of alternatives:
Costs to operate warehouse .................................... $2,730,0003
Cost of equipment less residual value ....................
674,000
Differential cost of operating warehouse ............
3,404,000
Differential income from operating warehouse ..........
$ 131,000
1
(7 yrs. × $330,000) + (7 yrs. × $280,000)
2
7% × $750,000 × 14 yrs.
3
$195,000 × 14 yrs.
2. The proposal should be accepted.
3.
Total estimated revenue from operating
warehouse..................................................................
Total estimated expenses to operate warehouse:
Costs to operate warehouse, excluding
depreciation ........................................................... $2,730,000
Cost of equipment less residual value ....................
674,000
Total estimated income from operating
warehouse..................................................................
$4,270,000
3,404,000
$
866,000*
*The $866,000 income from operations could also be determined by adding the
$131,000 income from operating the warehouse as derived in part (1) to the
$735,000 of investment income forgone by electing to operate the warehouse.
390
Prob. 25–2A
1.
Proposal to Replace Machine
May 22, 2010
Annual manufacturing costs associated with present machine ......
Annual manufacturing costs associated with proposed
new machine ...................................................................................
Annual reduction in manufacturing costs ..........................................
Number of years applicable .................................................................
Cost reduction attributable to difference in manufacturing costs ...
Proceeds from sale of present machine.............................................
Cost of new machine ............................................................................
Differential income anticipated from replacement, six-year total ....
$ 14,500
5,200
$ 9,300
×
6
$ 55,800
18,000
$ 73,800
58,500
$ 15,300
2. Other factors to be considered include the following:
a. Are there any improvements in the quality of work turned out by the new machine?
b. What effect does the federal income tax have on the decision?
c. What opportunities are available for the use of the $40,500 of funds ($58,500
less $18,000 sales price of old machine) that are required to purchase the new
machine?
After considering such factors as those listed above, the net cost reduction anticipated over the six-year period may not be sufficient to justify the replacement. For
example, if there is an opportunity to invest the $40,500 ($58,500 – $18,000) of additional funds required for the replacement in a project that earns a return of 6%, the
amount of the return over the six-year period would be $14,580 ($40,500 × 6% × 6).
However, this is less than the differential income determined in part (1), suggesting
the proposal to replace is preferred.
391
Prob. 25–3A
1.
Proposals for Sales Promotion Campaign
May 13, 2010
Tennis Shoe
Differential revenue from proposals ..................
Differential cost of proposals:
Direct materials ...............................................
Direct labor ......................................................
Variable factory overhead ...............................
Variable selling expenses ...............................
Sales promotion expenses .............................
Differential cost of proposals .....................
Differential income from proposed sales
promotion campaign .......................................
1
2
Walking Shoe
$550,0001
$600,0002
$100,000
40,000
25,000
35,000
125,000
$325,000
$132,000
54,000
36,000
30,000
125,000
$377,000
$225,000
$223,000
5,000 shoes × $110
6,000 shoes × $100
2. The sales manager’s tentative decision should be opposed. The sales manager erroneously considered the full unit costs instead of the differential (additional) revenue and differential (additional) costs. An analysis similar to that presented in part
(1) would lead to the selection of tennis shoes for the promotional campaign, since
this alternative will contribute $2,000 ($225,000 – $223,000) more to operating income than would be contributed by promoting walking shoes.
392
Prob. 25–4A
1.
Proposal to Process Aluminum Ingot Further
December 20, 2010
Differential revenue from further processing per batch:
Revenue from sale of rolled aluminum
[(66 tons/1.2 tons) × $1,600] .................................
Revenue from sale of aluminum ingot
(66 tons × $950) .....................................................
Differential revenue ...............................................
Differential cost per batch:
Additional cost of processing rolled aluminum
(66 tons × $425) .....................................................
Differential loss from further processing aluminum
ingot, per batch..........................................................
$88,000
62,700
$25,300
28,050
$ (2,750)
2. Allegheny Valley Aluminum Co. should decide not to further process aluminum ingot to produce rolled aluminum, since profits would be decreased by $2,750 per
batch.
393
Prob. 25–5A
1. $60,000 ($500,000 × 12%)
2.
a. Total costs:
Variable ($44.00 × 12,000 units) ....................................................
Fixed ($120,000 + $60,000) ............................................................
Total ................................................................................................
Cost amount per unit: $708,000/12,000 units ..............................
b. Markup Percentage =
Markup Percentage =
$528,000
180,000
$708,000
$ 59.00
Desired Profit
Total Costs
$60,000
$708,000
Markup Percentage = 8.48% (rounded)
3.
c. Cost amount per unit .....................................................................
Markup ($59.00 × 8.48%) ................................................................
Selling price ....................................................................................
$59.00
5.00
$64.00
a. Total manufacturing costs:
Variable ($40 × 12,000 units) .........................................................
Fixed factory overhead ..................................................................
Total ................................................................................................
Cost amount per unit: $600,000/12,000 units ..............................
$480,000
120,000
$600,000
$ 50.00
b. Markup Percentage =
Desired Profit + Total Selling and Administr ative Expenses
Total Manufacturing Costs
Markup Percentage =
$60,000 + $60,000 + ($4 × 12,000 )
$600,000
Markup Percentage =
$60,000 + $60,000 + $48,000
$600,000
Markup Percentage =
$168,000
$600,000
Markup Percentage = 28%
c. Cost amount per unit .....................................................................
Markup ($50.00 × 28%) ...................................................................
Selling price ....................................................................................
394
$50.00
14.00
$64.00
Prob. 25–5A
4.
Concluded
a. Variable cost amount per unit: $44.00
Total variable costs: $44 × 12,000 units = $528,000
b. Markup Percentage =
Desired Profit + Total Fixed Costs
Total Variable Costs
Markup Percentage =
$60,000 + $120,000 + $60,000
$528,000
Markup Percentage =
$240,000
$528,000
Markup Percentage = 45.45% (rounded)
c. Cost amount per unit .....................................................................
Markup ($44.00 × 45.45%) ..............................................................
Selling price ....................................................................................
$44.00
20.00
$64.00
5. The cost-plus approach price of $64.00 should be viewed as a general guideline
for establishing long-run normal prices. Other considerations, such as the price of
competing products and general economic conditions of the marketplace, could
lead management to establish a short-run price more or less than $64.00.
6.
a.
Proposal to Sell to Forever Glow Inc.
September 5, 2010
Differential revenue from accepting offer:
Revenue from sale of 2,000 additional units at $45.00 ...........
Differential cost of accepting offer:
Variable costs of 2,000 additional units at $40.00* .................
Differential income from accepting offer .....................................
*$44 – $4 (Excluding variable selling and administrative expenses)
b. The proposal should be accepted.
395
$90,000
80,000
$10,000
Prob. 25–6A
1.
Ethylene
Selling price ...................................................
Variable conversion cost per unit*...............
Direct materials cost per unit .......................
Contribution margin per unit ....................
$165
$ 21
110
$131
$ 34
Butane
Ester
$128
$ 21
75
$ 96
$ 32
$115
$ 14
85
$ 99
$ 16
*$7 × 3 process hours = $21
$7 × 2 process hours = $14
2. The contribution margin per unit may give false signals when an organization has
production bottlenecks. Instead, Delaware Bay Chemical Company should use the
contribution margin per bottleneck hour to determine relative product profitability
as follows:
Ethylene
Contribution margin per unit ........................
Reactor (bottleneck) hours per unit .............
Contribution margin per reactor hour .........
$ 34
÷1.0
$ 34
Butane
Ester
$ 32
÷0.8
$ 40
$ 16
÷0.5
$ 32
Unlike the analysis in part (1), this analysis shows butane to be the most profitable
product, rather than ethylene. The reason is that butane delivers more contribution margin per bottleneck hour than does ethylene or ester ($40 vs. $34 and $32).
396
Prob. 25–6A
Concluded
3. One way to revise the pricing would be to increase the price to the point where all
three products produce profitability equal to the highest profit product. This would
be determined as follows:
Revised Price of Ethylene:
Revised Price _ Unit Varia ble Cost
Unit Contribution
of Ethylene
of Ethylene
Margin per Reactor
=
Hour for Butane
Reactor Hours of Ethylene per Unit
$40 = (Revised Price of Ethylene – $131)/1.0 hr.
$40 = (Revised Price of Ethylene – $131)
$171 = Revised Price of Ethylene
Ethylene would require a revised price of $171 in order to deliver the same unit
contribution margin per bottleneck hour as does butane.
Revised Price of Ester:
Revised Price _ Unit Varia ble Cost
Unit Contribution
of Ester
of Ester
Margin per Reactor
=
Hour for Butane
Reactor Hours of Ester per Unit
$40 = (Revised Price of Ester – $99)/0.5 hr.
$20 = (Revised Price of Ester – $99)
$119 = Revised Price of Ester
Ester would require a revised price of $119 in order to deliver the same unit contribution margin per bottleneck hour as does butane.
397
Prob. 25–1B
1.
Proposal to Operate Retail Store
November 1, 2010
Differential revenue from alternatives:
Revenue from operating store ................................ $1,200,0001
Revenue from investment bonds ............................
112,0002
Differential revenue from operating store ........
$1,088,000
Differential cost of alternatives:
Costs to operate store ............................................. $ 992,0003
Cost of store equipment less residual value .........
125,000
Differential cost of operating store ...................
1,117,000
Differential loss from operating store ..........................
$ (29,000)
1
(8 yrs. × $78,000) + (8 yrs. × $72,000)
2
5% × $140,000 × 16
3
$62,000 × 16
2. The proposal should be rejected.
3.
Total estimated revenue from operating store ............
Total estimated expenses to operate store:
Costs to operate store, excluding depreciation ....
Cost of store equipment less residual value .........
Total estimated income from operating store .............
$1,200,000
$992,000
125,000
1,117,000
$ 83,000*
*The $83,000 income could also be determined by subtracting the $29,000 loss
from operating the store as derived in part (1) from the $112,000 of investment income forgone by electing to operate the store.
398
Prob. 25–2B
1.
Proposal to Replace Machine
August 13, 2010
Annual manufacturing costs associated with present machine .....
Annual manufacturing costs associated with proposed
new machine ..................................................................................
Annual reduction in manufacturing costs .........................................
Number of years applicable ................................................................
Cost reduction attributable to difference in manufacturing costs ..
Proceeds from sale of present machine............................................
Cost of new machine ...........................................................................
Differential income anticipated from replacement, six-year total ...
$ 42,500
18,900
$ 23,600
×
6
$141,600
32,400
$174,000
144,000
$ 30,000
2. Other factors to be considered include:
a. Are there any improvements in the quality of work turned out by the new machine?
b. What effect does the federal income tax have on the decision?
c. What opportunities are available for the use of the $111,600 of funds ($144,000
less $32,400 sales price of old machine) that are required to purchase the new
machine?
After considering such factors as those listed above, the net cost reduction anticipated over the six-year period may not be sufficient to justify the replacement. For
example, if there is an opportunity to invest the $111,600 ($144,000 – $32,400) of
additional funds required for the replacement in a project that earns a return of
5%, the amount of the return over the six-year period would be $33,480 ($111,600 ×
5% × 6), which is more advantageous than the replacement, other factors being
equal.
399
Prob. 25–3B
1.
Proposals for Sales Promotion Campaign
June 15, 2010
Moisturizer
Differential revenue from proposals ............................
Differential cost of proposals:
Direct materials .........................................................
Direct labor ................................................................
Variable factory overhead .........................................
Variable selling expenses .........................................
Sales promotion expenses .......................................
Differential cost of proposals ...............................
Differential income from proposed sales
promotion campaign .................................................
Perfume
$572,0001
$612,0002
$ 99,000
22,000
33,000
121,000
120,000
$395,000
$ 99,000
27,000
36,000
135,000
120,000
$417,000
$177,000
$195,000
11,000 units × $52
1
9,000 units × $68
2
2. The sales manager’s tentative decision should be opposed. The sales manager
erroneously considered the full unit costs instead of the differential (additional)
revenue and differential (additional) costs. An analysis similar to that presented in
part (1) would lead to the selection of perfume for the promotional campaign,
since this alternative will contribute $18,000 ($195,000 – $177,000) more to operating income than would be contributed by promoting moisturizer.
400
Prob. 25–4B
1.
Proposal to Process Raw Sugar Further
January 30, 2010
Differential revenue from further processing per batch:
Revenue from sale of refined sugar
[(27,000 lbs./1.2 lbs.) × $1.90] ...............................
Revenue from sale of raw sugar
(27,000 lbs. × $1.10) ...............................................
Differential revenue ...............................................
Differential cost per batch:
Additional cost of processing refined sugar
(27,000 lbs. × $0.35) ...............................................
Differential income from further processing raw
sugar per batch..........................................................
$42,750
29,700
$ 13,050
9,450
$ 3,600
2. Caribbean Sugar Company should decide to further process raw sugar to produce
refined sugar, since profits would be increased by $3,600 per batch.
401
Prob. 25–5B
1. $300,000 ($1,500,000 × 20%)
2.
a. Total costs:
Variable ($245 × 12,000 units) .......................................................
Fixed ($960,000 + $480,000) ..........................................................
Total ................................................................................................
Cost amount per unit: $4,380,000/12,000 units ...........................
$2,940,000
1,440,000
$4,380,000
$
365
Desired Profit
Total Costs
$300,000
Markup Percentage =
$4,380,000
b. Markup Percentage =
Markup Percentage = 6.85% (rounded)
c. Cost amount per unit .....................................................................
Markup ($365 × 6.85%) ...................................................................
Selling price ....................................................................................
3.
$365
25
$390
a. Total manufacturing costs:
Variable ($220 × 12,000 units) ....................................................... $2,640,000
Fixed factory overhead ..................................................................
960,000
Total ................................................................................................ $3,600,000
Cost amount per unit: $3,600,000/12,000 units ........................... $
b. Markup Percentage =
300
Desired Profit + Total Selling and Administra tive Expenses
Total Manufacturing Costs
Markup Percentage =
$300,000 + $480,000 + ($25 × 12,000 units)
$3,600,000
Markup Percentage =
$300,000 + $480,000 + $300,000
$3,600,000
Markup Percentage =
$1,080,000
$3,600,000
Markup Percentage = 30%
c. Cost amount per unit .....................................................................
Markup ($300 × 30%) ......................................................................
Selling price ....................................................................................
402
$300
90
$390
Prob. 25–5B
Concluded
4. a. Variable cost amount per unit: $245
Total variable costs: $245 × 12,000 units = $2,940,000
b. Markup Percentage =
Desired Profit + Total Fixed Costs
Total Variable Costs
Markup Percentage =
$300,000 + $960,000 + $480,000
$2,940,000
Markup Percentage =
$1,740,000
$2,940,000
Markup Percentage = 59.18%
c. Cost amount per unit ......................................................................
Markup ($245 × 59.18%) ..................................................................
Selling price .....................................................................................
$245
145
$390
5. The cost-plus approach price of $390 should be viewed as a general guideline for
establishing long-run normal prices. Other considerations, such as the price of
competing products and general economic conditions of the marketplace, could
lead management to establish a short-run price more or less than $390.
6.
a.
Proposal to Sell to Vision Systems Inc.
August 3, 2010
Differential revenue from accepting offer:
Revenue from sale of 1,500 additional units at $235 ..............
Differential cost of accepting offer:
Variable costs of 1,500 additional units at $220* ....................
Differential income from accepting offer .....................................
$352,500
330,000
$ 22,500
*$245 – $25 (Excluding variable selling and administrative expenses)
b. The proposal should be accepted.
403
Prob. 25–6B
1.
Selling price .............................................
Variable conversion cost per unit*.........
Direct materials cost per unit .................
Contribution margin per unit ..............
High
Grade
Good
Grade
Regular
Grade
$270
$120
120
$240
$ 30
$250
$120
100
$220
$ 30
$210
$ 96
78
$174
$ 36
*$8 × 15 process hours = $120
$8 × 12 process hours = $96
2. The contribution margin per unit may give false signals when an organization has
production bottlenecks. Instead, Gemini should use the contribution margin per
bottleneck hour to determine relative product profitability, as follows:
Contribution margin per unit ......................
Furnace (bottleneck) hours per unit ..........
Contribution margin per furnace hour .......
High
Grade
Good
Grade
Regular
Grade
$ 30
÷
5
$ 6.00
$ 30
÷
4
$ 7.50
$ 36
÷
3
$12.00
The Regular Grade steel has the largest contribution margin per unit ($36) and the
largest contribution margin per furnace hour ($12). Both Good Grade and High
Grade have the same contribution margin per unit of $30. However, using production bottleneck analysis indicates that the Good Grade is actually more profitable
at $7.50 contribution margin per furnace hour than High Grade’s $6.00 contribution margin per furnace hour. Thus, the company would want to sell product in the
following preference order:
1. Regular Grade
2. Good Grade
3. High Grade
404
Prob. 25–6B
Concluded
3. One way to revise the pricing would be to increase the price to the point where all
three products produce profitability equal to the highest profit product. This would
be determined as follows:
Revised Price of High Grade Steel:
Revised Price _
Unit
Unit Contribution Margin
of High Grade
Variable Cost
per Furnace Hour for
=
Regular Grade
Furnace Hours of High Grade per Unit
$12
=
(Revised Price of High Grade – $240)/5 hrs.
$60
=
(Revised Price of High Grade – $240)
$300
=
Revised Price of High Grade
High Grade steel would require a revised price of $300 in order to deliver the same
unit contribution margin per bottleneck hour as does Regular Grade steel.
Revised Price of Good Grade Steel:
Contribution Margin
per Furnace Hour for
=
Regular Grade
Revised Price _
Unit
of Good Grade
Variable Cost
Furnace Hours of Good Grade per Unit
$12
=
(Revised Price of Good Grade – $220)/4 hrs.
$48
=
(Revised Price of Good Grade – $220)
$268
=
Revised Price of Good Grade
Good Grade steel would require a revised price of $268 in order to deliver the
same unit contribution margin per bottleneck hour as does Regular Grade steel.
405
SPECIAL ACTIVITIES
Activity 25–1
No, it would be unethical for Lucinda to attend the meeting. Such a meeting would be
considered price fixing and would be a violation of federal law. Thus, Lucinda’s attendance would be a criminal act. Her actions would also discredit her reputation and
that of the profession.
Activity 25–2
The contribution margin is $6 ($24 – $18) per dozen on the special order. Thus, Fairways and Greens’ manager can contribute to fixed costs by accepting the order. However, there are some additional considerations the manager must consider before accepting this order.
1. Have we ever done business overseas? Exports require additional administrative
activities. Have these additional administrative costs been considered in the differential analysis?
2. Will the customer sell the golf balls overseas, or will they relabel the golf balls and
have them imported back into the United States? Such a situation would cause
Fairways and Greens to be competing against itself.
3. Is it likely that other customers will learn of the “special deal” the overseas company received and demand equal treatment? That is, is there a risk that we’ll spoil
the pricing structure in the domestic market?
4. Will the overseas customer want to do business in the future, or is this just a single sale? If the overseas customer is expected to purchase more golf balls in the
future, then it is likely that the customer will come to expect the $24 price in the future.
5. Is there a possibility of another customer being willing to purchase the golf balls
at the $34 price? If so, Fairways and Greens may not want to commit capacity to
the overseas customer. Once the capacity is committed, it will be difficult to sell to
anyone else.
6. Will we help the overseas customer establish a presence in the overseas golf ball
market where we may wish to compete in the future?
406
Activity 25–3
First, Marriott has excess capacity for this day. Thus, it should not be concerned
about using its capacity to accept business from the Priceline.com customer. The
Priceline.com customer is incremental revenue that will not crowd out other business.
Given this, however, the price must at least cover variable cost, or else Marriott would
lose money. The variable cost per room night is shown below.
Housekeeping labor cost...........................................................................
Cost of room supplies (soap, paper, etc.) ................................................
Laundry labor and material cost ...............................................................
Utility cost (mostly air conditioning) ........................................................
Total variable cost per day per room........................................................
$34
6
10
4
$54
These costs are mostly avoidable, or variable to room nights. This answer assumes
that the maid and laundry staff hours are highly flexible and can be staffed to demand.
Likewise, the air conditioning and lights can be turned off if the room is not rented for
the night, saving most of the utility cost. The desk staff and hotel depreciation are either sunk (depreciation) or mostly fixed to the number of room nights. Therefore, they
are not variable to accepting this business. The total variable costs are $54 per night,
so the $70 customer bid should be accepted.
Note to Instructors: There could be some discussion about the degree that some of
these costs are fully variable. For example, it’s likely that some utility cost must be incurred for the room, whether it is occupied or not. Likewise, the housekeeping and
laundry staff hours may not be as flexible to demand as assumed here. There should
be very little question about the room supplies (full variable) or the hotel depreciation
(sunk). Regardless of the assumptions, the decision would remain the same.
407
Activity 25–4
a. Cam believes that the fixed costs should be treated as a sunk cost and ignored in
the pricing decision. In essence, Cam is suggesting that the new computer model
be treated as an incremental decision. However, the new model is not a special incremental decision. It is a core product that must contribute to covering fixed
costs. If the product price does not cover fixed costs and provide a profit, then Digi-Comp Computer Company will not be competitive in the long term. In the long
term, the price must cover all costs, plus a profit markup. Thus, Cam’s solution to
the pricing decision is not a good one.
b. Target costing provides a different perspective to the pricing issue. Under target
costing, Digi-Comp Computer Company should begin with the price the market is
willing to pay, which is $1,250. This price should then be reduced by the required
profit markup. This would yield a target cost of $1,000 ($1,250/1.25), which is $200
lower than the present product cost. The new target cost should be established as
a cost reduction target. The company should vigorously improve the product design and processes in order to achieve a $1,000 product cost. In this way, the
company can compete profitably.
Target costing takes the market price as given and adjusts the cost in order to
yield the required profitability. This approach is best used in highly competitive
product markets where declining prices require cost reduction in order to compete.
408
Activity 25–5
a. This activity is designed to have students access a number of products and services on the Internet to see their commercial potential. Each of the listed sites will
provide product descriptions and pricing.
The list of costs in the products will not be determined at the Internet site but
must be assumed. Some examples include:
Delta Air Lines—Airline tickets
Fixed or Variable?
Fuel .................................................................................
Crew salaries .................................................................
Plane depreciation.........................................................
Landing fees ..................................................................
Travel agent commissions............................................
Lease costs (gates) .......................................................
Ground salaries .............................................................
Equipment depreciation ................................................
V
F
F
V
V
F
F
F
Assume that the activity base is the number of passenger miles for determining
fixed and variable costs. Employee salaries for an airline are relatively fixed, and
only become variable when there are significant changes to the flight schedule.
Amazon.com—Books
Fixed or Variable?
Cost of books (purchased for resale) ..........................
Web page design and programming............................
Computer depreciation .................................................
Order handling and packing wages .............................
Freight ............................................................................
V
F
F
V
V
Assume that the activity base is the number of books sold for determining fixed
and variable costs.
Dell Inc.—Personal computers
Fixed or Variable?
Cost of computers (dl, dm, and foh) ............................
Web page design and programming............................
Advertising .....................................................................
Order handling and packing wages .............................
Freight ............................................................................
Bundled software ..........................................................
V (mostly)
F
F
V
V
V (depends on
contract terms with
software vendor)
Assume that the activity base is the number of PCs sold for determining fixed and
variable costs. One could argue that advertising might be variable.
409
Activity 25–5
Concluded
b. The product with the largest markup on variable cost is the airline ticket. The portion of variable cost to total cost for an airline flight will be much smaller (more
fixed cost) than the other two products. Thus, the markup on variable cost will be
a greater percent. As a result, the airline product has a larger contribution margin,
but it also has a larger fixed cost to cover. This creates larger operating leverage
(and risk) than the other two products.
410