SOLUTIONS TO EXERCISES

EXERCISE 8-1

(a) The target cost formula is: Target cost = Market price – Desired
profit.

In this case, the market price is $20 and the desired profit is $8
(40% X $20). Therefore the target cost is $12 ($20 – $8).

(b) Target costing is particularly helpful when a company faces a

competitive market. In this case, the price is affected by supply
and demand, so no company in the industry can affect price.
Therefore to earn a profit, companies must focus on controlling
costs.

EXERCISE 8-2

The following formula may be used to determine return on investment

Investment X ROI percentage = Return on investment

$8,000,000 X 20% = $1,600,000

Return on investment per unit is then $16 ($1,600,000 ÷ 100,000)

The target cost is therefore $74 computed as follows:

Target cost = Market price – Desired profit

$74 = $90 – $16

EXERCISE 8-3

(a) (1) In this case the selling price would be $125 ($100 + [$100 X
25%]). The problem with the $125 is that it is unlikely that Leno
will be able to sell any All-Body suits at that price. Market
research seems to indicate that it will sell for only $100. (2) One
way that Leno might consider manufacturing the All-Body
swimsuit is if it has excess capacity and therefore manufacturing
 the All-Body will not affect fixed costs. Thus if the company can
cover its variable costs, it might want to sell at the $100 level.

(b) In this case, the amount would be the selling price of $100.
EXERCISE 8-3 (Continued)

(c) The highest acceptable cost would be the target cost. The target
cost is $75 as shown below:

Target cost = Market price – Desired profit

$75 = $100 – $25

EXERCISE 8-4

(a) Total cost per unit:

Per Unit
Direct materials .......................................................................... $17
Direct labor ................................................................................. 8
Variable manufacturing overhead ............................................ 11
Fixed manufacturing overhead
($300,000/30,000) .................................................................... 10
Variable selling and administrative expenses ......................... 4
Fixed selling and administrative expenses
($150,000/30,000) .................................................................... 5
$55

(b) Target selling price = $55 + (40% X $55) = $77

EXERCISE 8-5

(a) Total cost per unit:

Per Unit
Direct materials .......................................................................... $ 7
Direct labor ................................................................................. 11
Variable manufacturing overhead ............................................ 15
Fixed manufacturing overhead
($3,000,000/500,000) ............................................................... 6
Variable selling and administrative expenses ......................... 14
Fixed selling and administrative expenses
($1,500,000/500,000) ............................................................... 3
$56
(b) Desired ROI per unit = (25% X $28,000,000)/500,000 = $14
EXERCISE 8-5 (Continued)

(c) Markup percentage using total cost per unit:

$14
= 25%
$56

(d) Target selling price = $56 + ($56 X 25%) = $70

EXERCISE 8-6

(a) Total cost per session:

Per Session
Direct materials .................................................. $ 20
Direct labor ......................................................... 400
Variable overhead .............................................. 50
Fixed overhead ($950,000 ÷ 1,000) ................... 950
Variable selling & administrative expenses .... 40
Fixed selling & administrative expenses
($500,000 ÷ 1,000) ........................................... 500
Total cost per session ............................... $1,960

(b) Desired ROI per session = (20% X $2,352,000) ÷ 1,000 = $470.40

(c) Mark-up percentage on total cost per session = $470.40 ÷ $1,960 =

24%

(d) Target price per session = $1,960 + ($1,960 X 24%) = $2,430.40

EXERCISE 8-7

$1,500,000
(a) Fixed manufacturing overhead per unit = = $500 per unit
3,000

Fixed selling and administrative = $324,000 = $108 per unit

expenses per unit 3,000

(b) Desired ROI per unit = 20% X $54,000,000 = $3,600 per unit
3,000
EXERCISE 8-7 (Continued)

(c) Per Unit

Direct materials .......................................................................... $ 380
Direct labor ................................................................................. 290
Variable manufacturing overhead ............................................ 72
Fixed manufacturing overhead ................................................. 500
Variable selling and administrative expenses ......................... 55
Fixed selling and administrative expenses ............................. 108
Total cost per unit ...................................................................... 1,405
Desired ROI per unit ................................................................... 3,600
Target selling price .................................................................... $5,005

EXERCISE 8-8

(a) Total Total Per Hour

Cost ÷ Hours = Charge
Hourly labor rate for repairs
Technician’s wages and benefits $228,000 ÷ 7,600 = $30
Overhead costs
Office employee’s salary and
benefits 38,000 ÷ 7,600 = 5
Other overhead 15,200 ÷ 7,600 = 2
$281,200 ÷ 7,600 = 37
Profit margin 30
Rate charged per hour of labor $67

(b) Total
Material Invoice Cost, Material
Loading Parts and Loading
Charges ÷ Materials = Percentage
Overhead costs
Parts manager’s salary and
benefits $42,500
Office employee’s salary
and benefits 9,000
51,500 ÷ $400,000 = 12.875%
Other overhead 24,000 ÷ $400,000 = 6.000%
$75,500 ÷ $400,000 = 18.875%
Profit margin 20.000%
Material loading percentage 38.875%
 EXERCISE 8-8 (Continued)

(c) Job: Pace Corporation—Rebuild spot welder

Labor charges
40 hours @ $67 ............................................ $2,680.00

Material charges
Cost of parts and materials ........................ $2,000.00
Material loading charge
(38.875% X $2,000) .................................... 777.50 2,777.50

Total price of labor and material .......... $5,457.50

EXERCISE 8-9

(a) Total Total Per Hour

Cost ÷ Hours = Charge
Hourly labor rate for repairs
Technician’s wages and benefits $150,000 ÷ 6,250 = $24.00
Overhead costs
Office employee’s salary and
benefits 30,000 ÷ 6,250 = 4.80
Other overhead 15,000 ÷ 6,250 = 2.40
$195,000 ÷ 6,250 = 31.20
Profit margin 38.00
Rate charged per hour of labor $69.20

(b) Total
Material Invoice Cost, Material
Loading Parts and Loading
Charges ÷ Materials = Percentage
Overhead costs
Parts manager’s salary and
benefits $34,000
Office employee’s salary
and benefits 15,000
49,000 ÷ $700,000 = 7.00%

Other overhead 42,000 ÷ $700,000 = 6.00%

$91,000 ÷ $700,000 13.00%
Profit margin 80.00%
Material loading percentage 93.00%
EXERCISE 8-9 (Continued)

(c) Job: Buil Builders

Labor charges
80 hours @ $69.20 ................................ $ 5,536
Material charges
Cost of parts and materials ................. $40,000
Material loading charge
(93% X $40,000) ................................. 37,200 77,200
Total price of labor and material ... $82,736

EXERCISE 8-10

(a) Total Total Hours Hourly

Cost ÷ = Charge
Hourly labor rate:
Restorers’ wages and $270,000 ÷ 12,000 = $22.50
fringes
Overhead costs:
Administrative salaries & 54,000 ÷ 12,000 = 4.50
fringes
Other overhead costs 24,000 ÷ 12,000 = 2.00
Total hourly cost $348,000 ÷ 12,000 = $29.00

Profit margin = Hourly rate – total hourly cost

= $70.00 –
$29.00
= $41.00
EXERCISE 8-10 (Continued)

(b)

Material Total Invoice Material

Loading Cost, Parts & Loading
Charges ÷ Materials = Percentage
Overhead costs:
Purchasing agent’s
salary and $ 67,500
fringes
Administrative
salaries and
fringes 21,960
89,460 ÷ $1,260,000 = 7.10%

Other overhead costs 77,490 ÷ $1,260,000 = 6.15%

Total $166,950 ÷ $1,260,000 = 13.25%

Material loading charge (with profit) 83.25%

Material loading charge (without profit) 13.25%
Profit margin on materials 70.00%

(c) Labor charges:

150 hours @ $70 $ 10,500
Material charges:
Cost of parts & materials $60,000
Material loading charge
($60,000 X 83.25%) 49,950 109,950
Total price of labor and materials $120,450

EXERCISE 8-11

(a) The minimum transfer price is:

Minimum transfer price = Variable cost + opportunity cost

Given that the Small Motor Division has excess capacity, the
minimum transfer price is the variable cost of $11 per unit.
(b) Given no excess capacity, the minimum transfer price is $35,
which is its variable cost plus the lost contribution margin.
EXERCISE 8-11 (Continued)

(c) The level of capacity plays a significant role in determining the

appropriate transfer price. If a division has no excess capacity,
why should it sell its product below a selling price it can obtain
in an outside market? Conversely, if it has excess capacity, as
long as it receives more than its variable cost, it has a net gain.

EXERCISE 8-12

(a) As indicated, FrameBody has excess capacity and therefore

should be willing to accept any price that equals or exceeds its
variable cost.

1. The effect on Cycle Division is as follows:

Purchase
Present from
Situation FrameBody
Selling price $2,200 $2,200
Variable cost of goods
sold $300 $280
Body frame 900 1,200 900 1,180
Other variable costs $1,000 $1,020
Contribution margin
In this case, Cycle Division makes $20 ($1,020 – $1,000) more
per cycle sold and therefore if it sells 1,000 cycles, it makes an
additional $20,000.

2. The effect on FrameBody is that it makes $10 on each frame

sold as shown below:

Selling price to Cycle Division $280

Variable cost 270
$ 10

Thus the FrameBody Division gains $10,000 ($10 X 1,000).

3. As a result, the overall income for Ayala increases $30,000
($20,000 from Cycle Division and $10,000 from FrameBody).
EXERCISE 8-12 (Continued)

(b) 1. The answer would not change from (a)(1). Cycle Division
would
gain $20,000 if it purchased the frames from FrameBody.
2. However, FrameBody would incur a loss of $70,000 as
computed
below:

Selling price to outside buyer $ 350

Selling price to Cycle Division 280
Lost contribution margin per cycle $ 70
Number of cycles X 1,000
Lost contribution margin $70,000
3. The effect on the overall income to Ayala is a net loss of
$50,000 as shown below:

Cycle Division gain $20,000

Frame Body loss (70,000)
Overall loss ($50,000)

EXERCISE 8-13

(a) The minimum transfer price that Benson should accept is:

Minimum transfer price = ($37 – $3) + ($86 – $37) = $83

(b) The lost contribution margin per unit to the company is:
Contribution margin lost by Benson
[($86 – $37) – ($35 – $34)] ...................................................... $48
Increased contribution margin to
vehicle division ($80 – $35) ................................................... 45
Net loss in contribution margin ................................................ $ 3

Total lost contribution margin is $3 X 200,000 units = $600,000

(c) If management insists that it wants Benson to provide the stereo

units, and Benson is operating at full capacity, then it must be
willing to pay the minimum transfer price for those units.
Otherwise it will be penalizing the managers of Benson by not
giving them adequate credit for their contribution to the
corporation’s contribution margin.
EXERCISE 8-14

The minimum transfer price on this special order would be:

Minimum transfer price = ($140 – $6) + ($50 – $29) = $155.

Since the $160 price offered by the Bathtub Division exceeds this
minimum price, the offer should probably be accepted. However,
given that the division is operating at full capacity, it should give
some consideration to the chance that it may anger existing
customers if it has to turn away
business.

EXERCISE 8-15

(a) Minimum transfer price = ($130 – $8) + $0 = $122

(b) Minimum transfer price = ($130 – $8) + ($160 – $130) = $152

(c) No. By forcing the Appraisal Department to accept the $150 per
appraisal price, management is penalizing the Appraisal
department. If the department was allowed to sell its services to
outside customers,
it could earn $30 ($160 – $130) in contribution margin per
appraisal. Forcing them to sell their services internally would
allow them to earn only $28 ($150 – $122) in contribution margin. A
loss of $2 per appraisal or a total of $2,400 (1,200 X $2) would
result.

EXERCISE 8-16

(a) The minimum transfer price for Division B would be variable

costs, which are $6 per unit ($7, variable cost – $1, variable
selling expense).
The maximum price would be the external price paid by Division
A, which is $10 per unit.

(b) Minimum transfer price = variable costs + opportunity cost

Variable costs = $6 (as in (a))
Opportunity cost = (($7 – $5) X 15,000) ÷ 10,000 = $3
Therefore the minimum transfer price should be $9 ($6 + $3)

The maximum price would still be the external price paid by

Division A, which is $10 per unit.
EXERCISE 8-16 (Continued)

(c) Minimum transfer price = variable costs + opportunity cost

Variable costs = $6.00 (as in (a))
Opportunity cost = (($12 – $7) X 5,000) ÷ 15,000 = $1.67
Therefore the minimum transfer price should be $7.67 ($6 + $1.67)

The maximum price would still be the external price paid by

Division A, which is $10 per unit.

EXERCISE 8-17

(a) Division Division Total

A B Company
Sales $1,500 $2,400 $3,900
Less: Costs
Variable costs $1,100 $1,200 $2,300
Transfer costs 0 1,500 1,500
Total costs $1,100 $2,700 $3,800
Contribution to income $ 400 $ (300) $ 100

(b) The opportunity cost is the market price. Transfers should be

made at market prices less any avoidable costs. In the current
situation, it would appear that no transfers would be made.

(c) (i) Maintain price, no transfers

(500 X $1,500) – (500 X $1,100) = $200,000
(ii) Cut price, no transfers
(1,000 X $1,200) – (1,000 X $1,100) = $100,000

(iii) Maintain price and transfers

(500 X $2,400) + (500 X $1,500) – $1,700,000* = $250,000
*(500 X $2,300) + (500 X $1,100)

The firm is better off by maintaining the current market price for
Division A’s product and transferring 500 units to Division B. A
transfer price within the range of $1,100 to $1,200 would be
needed to motivate both divisional managers to engage in the
transfers. An optimal transfer price cannot be determined from
the information given (even with full information, the best
transfer price in the range may not be determinable).
*EXERCISE 8-18

(a) Cost per unit:

Per Unit
Direct materials .......................................................................... $ 7
Direct labor ................................................................................. 11
Variable manufacturing overhead ............................................ 15
Fixed manufacturing overhead ($3,000,000/500,000) .............. 6
Variable selling and administrative expenses ......................... 14
Fixed selling and administrative expenses
($1,500,000/500,000) ............................................................... 3
$56

(b) Desired ROI per unit = (25% X $28,000,000)/500,000 = $14

(c) Absorption-cost pricing $14 + ($14 + $3)

= = 79.49%
markup percentage ($7 + $11 + $15 + $6)

(d) Variable-cost pricing $14 + ($6 + $3)

= = 48.94%
markup percentage ($7 + $11 + $15 + $14)

*EXERCISE 8-19

(a) The cost base of absorption-cost pricing includes only

manufacturing costs. All selling and administrative costs are
excluded from the cost base and are added back in the
numerator of the markup percentage.

Absorption-cost pricing $24 + ($9 + $11)

= = 55%
markup percentage ($20 + $25 + $14 + $21)

(b) The cost base of variable-cost pricing includes only variable

costs. All fixed costs are excluded from the cost base and are
added back in the numerator of the markup percentage.

Variable-cost pricing $24 + ($21 + $11)

= = 82.35%
markup percentage ($20 + $25 + $14 + $9)
*EXERCISE 8-20

(a) Fixed manufacturing $1,500,000

= = $500 per unit
overhead per unit 3,000

Fixed selling and administrative $324,000

= = $108 per unit
expenses per unit 3,000

20% X $54,000,000
(b) Desired ROI per unit = = $3,600 per unit
3,000

(c) Absorption-cost pricing $3,600 + ($55 + $108)

= = 302.979%
markup percentage $380 + $290 + $72 + $500

Target selling price = $1,242 + ($1,242 X 302.979%) = $5,005

(d) Variable-cost pricing $3,600 + ($500 + $108)

= = 527.980%
markup percentage $380 + $290 + $72 + $55

Target selling price = $797 + ($797 X 527.980%) = $5,005