13-33

Cost-plus and target pricing

1. Investment Rs 18,00,000
Return on investment 20%
Operating income (20%  Rs 18,00,000) Rs 3,60,000
Operating income per unit of TB toy (Rs 3,60,000  15,000) Rs 24
Full cost per unit of TB toy Rs 200
Selling price (Rs 200 + Rs 24) Rs 224
Markup percentage on full cost (Rs 24  Rs 200) 12%

2. Selling price of TB toy = Variable costs per unit of TB toy  1.40

Hence, Variable costs per unit of TB toy = Selling price of TB toy = Rs 224 = Rs 160
1.40 1.40

3. Fixed costs are Rs 40 (Rs 200  Rs 160) per unit  15,000 units = Rs 6,00,000

Revenues (Rs 230  13,500) Rs 31,05,000

Variable costs (Rs 160  13,500) 21,60,000
Contribution margin (Rs 70  13,500) 9,45,000
Fixed costs 6,00,000
Operating income Rs 3,45,000

The operating income if Babloo Toys increases the selling price of TB toy to Rs 230 is Rs
3,45,000. This is less than the Rs 3,60,000 operating income Babloo Toys earns by selling 15,000
units at a price of Rs 224. The Rs 6 (Rs 230 – Rs 224) increase in price causes demand to
decrease by 1,500 units (15,000 – 13,500). The demand for TB toy is elastic—an increase in price
causes a significant decrease in demand. Babloo Toys should not increase the selling price to Rs
230.

4. Target investment in 2016 Rs 16,50,000

Target return on investment 20%
Target operating income in 2016, 20%  Rs 16,50,000 Rs 3,30,000

Target revenues in 2016, Rs 210  15,000 Rs 31,50,000

Less target operating income in 2016 3,30,000
Target costs in 2016 Rs 28,20,000

Target cost per unit in 2016, Rs 28,20,000  15,00 Rs 188

13-34
Relevant-cost approach to pricing decisions.
1. Revenues (1,000 packets at Rs 100 per packet) Rs 100,000
Variable costs:
Manufacturing Rs 40,000
Marketing 14,000
 Total variable costs 54,000
Contribution margin 46,000
Fixed costs:
Manufacturing Rs 20,000
Marketing 16,000
Total fixed costs 36,000
Operating income Rs 10,000

Normal markup percentage: Rs 46,000 ÷ Rs 54,000 = 85.19% of total variable costs.

2. Only the manufacturing-cost category is relevant to considering this special order; no additional marketing costs
will be incurred. The relevant manufacturing costs for the 200-packet special order are:

Variable manufacturing cost per unit

Rs 40  200 packets Rs 8,000
Special packaging 2,000
Rs 10,000

Any price above Rs 50 per packet (Rs 10,000 ÷ 200) will make a positive contribution to operating income. Hence,
based on financial considerations, Best should accept the 200-packet special order.
The reasoning based on a comparison of Rs 55 per packet price with the Rs 60 per packet
absorption cost ignores monthly cost-volume-profit relationships. The Rs 60 per packet
absorption cost includes a Rs 20 per packet cost component that is irrelevant to the special order.
The relevant range for the fixed manufacturing costs is from 500 to 1,500 packets per month; the
special order will increase production from 1,000 to 1,200 packets per month. Furthermore, the
special order requires no incremental marketing costs.
3. If the new customer is likely to remain in business, Best should consider whether a strictly short-run focus is
appropriate. For example, what is the likelihood of demand from other customers increasing over time? If Best
accepts the 200-packet special offer for more than one month, it may preclude accepting other customers at prices
exceeding Rs 55 per packet. Moreover, the existing customers may learn about Best’s willingness to set a price based
on variable cost plus a small contribution margin. The longer time frame over which Best keeps selling 200 packets at
Rs 55 a packet, the more likely that the existing customers will approach Best for their own special price reductions.
If the new customer wants the contract to extend over a longer time period, Best should negotiate a higher price.

13-35
Cost-plus and market-based pricing.

1. Reliable Labour Supplying Company’s full cost per hour of supplying contract labor is:

Variable costs Rs 12
Fixed costs (Rs 240,000 ÷ 80,000 hours) 3
Full cost per hour Rs 15

Price per hour at full cost plus 20% = Rs 15  1.20 = Rs 18 per hour.
2. Contribution margins for different prices and demand realizations are as follows:
Contribution
Variable Cost per Margin per Hour Demand in Hours Total Contribution
Price per Hour Hour (3)=(1)–(2) (4) (5)=(3)×(4)
(1) (2)
Rs 16 Rs 12 Rs 4 1,20,000 Rs 4,80,000
5,00,000
17 12 5 1,00,000
18 12 6 80,000 4,80,000
19 12 7 70,000 4,90,000
20 12 8 60,000 4,80,000

Fixed costs will remain the same regardless of the demand realizations. Fixed costs are, therefore, irrelevant since
they do not differ among the alternatives.

The table above indicates that Reliable Labour Supplying Company can maximize contribution margin and,
hence, operating income by charging a price of Rs 17 per hour.

3. The cost-plus approach to pricing in requirement 1 does not explicitly consider the effect of prices on demand.
The approach in requirement 2 models the interaction between price and demand and determines the optimal level of
profitability using concepts of relevant costs. The two different approaches lead to two different prices in
requirements 1 and 2. As the chapter describes, pricing decisions should consider both demand or market
considerations and supply or cost factors. The approach in requirement 2 is the more balanced approach. In most
cases, of course, managers use the cost-plus method of requirement 1 as only a starting point. They then modify the
cost-plus price on the basis of market considerations—anticipated customer reaction to alternative price levels and the
prices charged by competitors for similar products.

13-36
Product costs, activity-based costing.

The problem illustrates how both product designers and manufacturing personnel can play key roles in a company
manufacturing competitively priced products. The following table presents the manufacturing cost per unit for different
cost categories for P-41 and P-63.
Cost Categories P-41 P-63
Direct manufacturing product costs
Direct materials Rs 4,075 Rs 2,921
Indirect manufacturing product costs
Materials handling
(85  Rs 12; 46  Rs 12) 1020 552
Assembly management
(32  Rs 400; 19  Rs 400) 1280 760
Machine insertion of parts
(49  Rs 7; 31  Rs 7) 343 217
Manual insertion of parts
(36  Rs 21; 15  Rs 21) 756 315
Quality testing
(14  Rs 250; 11  Rs 250) 350 275
Total indirect manufacturing product costs Rs 3,749 Rs 2,119
Total manufacturing product costs Rs 7,824 Rs 5,040

Overview of Product Costing at Executive Power

INDIRECT Machine Manual

Materials Assembly Quality
COST Insertion Insertion
Handling Management Testing
POOLS of Parts of Parts

COST Hours of Number of Number of Hours of

Number of
ALLOCATION Assembly Machine- Manually- Quality-
Parts
BASES Time Inserted Parts Inserted Parts Testing Time

COST OBJECT: INDIRECT COSTS

PRODUCT DIRECT COSTS

DIRECT
PRODUCT
COSTS Direct
Materials
13-37

Target cost, activity-based costing

1. A target cost per unit is the estimated long-run cost per unit of a product or service that, when
sold at the target price, enables the company to achieve the target operating income per unit. A
target cost per unit is the estimated unit long-run cost of a product that will enable a company to
enter or to remain in the market and compete profitably against its competitors.

2. The following table presents the manufacturing cost per unit for different cost categories for P-41REV and P-63
REV.
Cost Categories P-41 REV P-63 REV
Direct manufacturing product costs:
Direct materials Rs 3,812 Rs 2,631
Indirect manufacturing product costs:
Materials handling (71  Rs 12; 39  Rs 12) 852 468
Assembly management (21  Rs 400; 16  Rs 400) 840 640
Machine insertion of parts (59  Rs 7; 29  Rs 7) 413 203
Manual insertion of parts (12  Rs 21; 10  Rs 21) 252 210
Quality testing (12  Rs 250; 09  Rs 250) 300 225
Total indirect manufacturing costs 2,657 1,746
Total manufacturing costs Rs 6,469 Rs 4,377
Target cost Rs 6,800 Rs 3,900

P-41 REV is Rs 331 (Rs 6,800 – Rs 6,469) below its target cost However, P-63 REV is Rs 477 (Rs 4,377 – Rs 3,900)
above its target cost It appears Executive Power will have major problems competing with the foreign printer costing
Rs 3,900

3 P-41 = Rs 7,824 P-63 = Rs 5,040

P-41 REV= 6,469 P-63 REV = 4,377
Difference= Rs 1,355 Difference = Rs 663

The sources of the cost reductions in the redesigned products are:

P-41 P-63

(a) Reduction in direct materials costs Rs 263 Rs 290

(b) Changes in design:
Reduced materials handling
costs due to fewer parts
(85 – 71); (46 – 39)  Rs 12 168 84
Reduced assembly time
(3.2 – 2.1); (1.9 – 1.6)  Rs 400 440 120
1
Reduced insertion of parts
(49 – 59)  Rs 7 + (36 – 12)  Rs 21 434
(31 – 29)  Rs 7 + (15 – 10)  Rs 21 119
Reduced quality testing
(1.4 – 1.2); (1.1 – 0.9)  Rs 250 50 50
Rs 1,355 Rs 663

1
Note that the reduced costs for insertion of parts comes from two sources: (a) a reduction in total number of parts to
be inserted, and (b) an increase in the percentage of parts inserted by the lower-cost machine method.
4. The Rs 120 reduction in cost per hour of assembly time (from Rs 400 to Rs 280) reduces product costs as
follows:

P-41 REV: Rs 120  2.1 hours = Rs 252. The new total manufacturing product cost is Rs 6,217 (Rs 6,469 – Rs 252)

P-63 REV: Rs 120  1.6 hours = Rs 192. The new total manufacturing product cost is Rs 4,185 (Rs 4,377 – Rs 192)

The reduction in the assembly management activity rate further reduces the cost of P-41 REV below the target cost. It
also moves P-63 REV closer toward its target cost.

13-38
Target prices, target costs, value engineering, cost incurrence, locked-in cost, activity-based
costing.
1.
Old New
CE100 Cost Change CE100
Direct materials costs Rs 18,20,000 Rs 22  7,000 = Rs 1,54,000 less Rs 16,66,000
Direct manufacturing labor costs 2,80,000 Rs 5  7,000 = Rs 35,000 less 2,45,000
Machining costs 3,15,000 Unchanged because capacity same 3,15,000
(20%  2.5  7,000)  Rs 20 = Rs
Testing costs 3,50,000 70,000 less 2,80,000
Rework costs 1,40,000 (See Note 1) 56,000
Ordering costs 33,600 (See Note 2) 21,000
Engineering costs 2,11,400 Unchanged because capacity same 2,11,400
Total manufacturing costs Rs 31,50, 000 Rs 27,94,400

Note 1:
10% of old CE100s are reworked. That is, 700 (10% of 7,000) CE100s made are reworked. Rework costs = Rs 200
per unit reworked  700 = Rs 1,40,000. If rework falls to 4% of New CE100s manufactured, 280 (4% of 7,000) New
CE100s manufactured will require rework. Rework costs = Rs 200 per unit  280 = Rs 56,000.
Note 2 :
Ordering costs for New CE100 = 2 orders/month  50 components  Rs 210/order = Rs 21,000

Unit manufacturing costs of New CE100 = Rs 27,94,400 ÷ 7,000 = Rs 399.2

2. Total manufacturing cost reductions based on new design = Rs 31,50,000 – Rs 27,94,400

= Rs 3,55,600

Reduction in unit manufacturing costs based on new design = Rs 3,55,600 ÷ 7,000

= Rs 50.8 per unit.

The reduction in unit manufacturing costs based on the new design can also be calculated as:
Unit cost of old design, Rs 450 (Rs 31,50,000 ÷ 7,000 units) – Unit cost of new design, Rs 399.2 = Rs 50.8

Hence, the target cost reduction of Rs 60 per unit is not achieved by the redesign.

3. Changes in design have a considerably larger impact on costs per unit relative to improvements in manufacturing
efficiency (Rs 50.8 versus Rs 15). One explanation is that many costs are locked in once the design of the radio-
cassette is completed. Improvements in manufacturing efficiency cannot reduce many of these costs. Design choices
can influence many direct and overhead cost categories, for example, by reducing direct materials requirements, by
reducing defects requiring rework, and by designing in fewer components that translate into fewer orders placed and
lower ordering costs.