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Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

CHAPTER 15
Target Costing and Cost Analysis for Pricing
Decisions
ANSWERS TO REVIEW QUESTIONS
15.1

In the long run, every organization must price its product or service above the total
cost of production. While the market for the product also is critically important, costs
cannot be ignored.

15.2

The statement that prices are determined by production costs is too simplistic.
Although firms must price their products and services above their total costs in the
long run, management cannot ignore demand issues and the economic environment.
Setting prices generally is a balance between cost-related issues and economic
market forces.

15.3

Four major influences on pricing decisions are as follows:


(1) Customer demand: Management must consider customers demand for their
product, which reflects the price that customers are willing to pay for the
product.
(2) Actions of competitors: When pricing its product, management must consider
the likely pricing decisions and product design decisions of competing firms.
(3) Costs: No organization or industry can price its product below total production
costs indefinitely.
(4) Political, legal, and image-related issues: Management must consider the way the
public perceives the firm and must adhere to certain laws when setting prices.

15.4

It is crucial to define the firms product when considering the reaction of


competitors, so that the competitors can be identified. For example, is a firm that
produces glass bottles competing only with other firms that produce glass bottles,
or is the firm competing with all companies that produce containers? Defining the
product as glass bottles or containers is an important step in identifying who the
firms competitors are.

15-1
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

15.5

In most industries, both market forces and cost considerations heavily influence
prices. No organization can price its products below their production costs in the
long run. On the other hand, no company can set prices at cost plus a markup
without keeping an eye on the market. The product or service must be sold at a price
customers are willing to pay.

15.6

The profit-maximizing price is the price for which the associated quantity is
determined by the intersection of the marginal cost and marginal revenue curves.
This intersection is shown in Exhibit 15-3 in the text.

15.7

(a) Total revenue: Price multiplied by quantity sold.


(b) Marginal revenue: The amount by which total revenue increases when one
additional unit is sold.
(c) Demand curve: A graphical or mathematical expression of the relationship
between the price and the quantity sold.
(d) Price elasticity: The impact of price changes on sales volume.
(e) Cross-elasticity: The extent to which a change in a products price affects the
demand for substitute products.

15-8

(a) Total cost: Unit cost multiplied by quantity produced.


(b) Marginal cost: Additional cost when one more unit is produced.

15.9

Three limitations of the economic, profit-maximizing model of pricing are as follows:


(1) The firms demand and marginal revenue curves are difficult to determine with
precision.
(2) The marginal-cost, marginal-revenue paradigm, as described in the text, is not
valid for all forms of market organization.
(3) Cost-accounting systems are not designed to measure the marginal changes in
cost incurred as production and sales increase unit by unit. To measure marginal
cost would entail a very costly information system.

15.10 Determining the best approach to pricing requires a cost-benefit trade-off. While the
marginal-cost, marginal-revenue paradigm results in a profit-maximizing price, only a
sophisticated and costly information system can collect marginal-cost data. Thus,
the firm will incur greater cost in order to obtain information for better decisions.

15-2
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

15.11 The general formula for cost-plus pricing is as follows:


Price = cost + (markup percentage cost)
The price is equal to cost plus a markup. Depending on how cost is defined, the
markup percentage may differ. Several different definitions of cost, each combined
with a different markup percentage, can result in the same price for a product or
service.
15-12 The four cost bases commonly used in cost-plus pricing are the following:
absorption manufacturing cost, total cost, variable manufacturing cost, and total
variable cost. Each of these cost bases can result in the same price under costbased pricing if the markup percentage used in the cost-plus pricing formula is
changed. For example, a lower markup percentage would be applied to total cost
than would be applied to total variable cost.
15.13 Four reasons often cited for the widespread use of absorption cost as the cost base
in cost-plus pricing formulas are as follows:
(1) In the long run, the price must cover all costs and a normal profit margin.
(2) Absorption-cost and total-cost pricing formulas provide a justifiable price that
tends to be perceived as equitable by all parties.
(3) When a companys competitors have similar operations and cost structures,
cost-plus pricing based on full costs gives management an idea of how
competitors may set prices.
(4) Absorption-cost information is provided by a firms cost-accounting system,
because it is required for external financial reporting under generally accepted
accounting principles. Since absorption-cost information already exists, it is
cost-effective to use for pricing.
15.14 The primary disadvantage of absorption-cost or total-cost pricing formulas is that
they obscure the cost behavior pattern of the firm. Since absorption-cost and totalcost data include allocated fixed costs, it is not clear from these data how the firms
total costs will change as volume changes.
15.15 Three advantages of pricing based on variable cost are as follows:
(1) Variable-cost data do not obscure the cost behavior pattern by unitizing fixed
costs and making them appear variable.

15-3
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

(2) Variable-cost data do not require allocation of common fixed costs to individual
product lines.
(3) Variable-cost data are exactly the type of information managers need when facing
certain decisions, such as whether to accept a special order.
15.16 The behavioral problem that can result from the use of a variable-cost pricing
formula is that managers may perceive the variable cost of a product or service as
the floor for the price. They may tend to set the price too low for the firm to cover its
fixed costs.
15.17 Return-on-investment pricing is an approach under which the price is set so that it
will cover costs and also earn a profit that will provide a target return on the invested
capital.
15.18 Price-led costing refers to the process under target costing of first determining the
acceptable market price for a product or service and then determining the cost at
which the product or service must be produced.
15.19 To be successful at target costing, management must listen to the companys
customers. By doing so, management will learn the products, features, and quality
that customers are willing to buy as well as the price they are willing to pay.
15.20 Value-engineering is a cost-reduction and process-improvement technique used to
help bring the cost of manufacturing a product or providing a service into line with
its target cost.
15.21 Tear-down methods can be used in a service-industry firm just as they are used in
the manufacturing industry. The various steps in providing a service can be
analyzed for cost improvements just as a products materials and manufacturing
operations can be analyzed for the same purpose.
15.22 Under time-and-material pricing, the price includes a cost-based charge for labor, a
cost-based charge for material, and generally a markup on one or both of these
production-cost factors.
15.23 When a firm has excess capacity, there is no opportunity cost in accepting an
additional production job. Therefore, it is not necessary to reflect such an
opportunity cost in setting a bid price. On the other hand, if the firm is already at full
capacity, there is an opportunity cost to accepting another production job. In this
case, it is appropriate to include in the price an estimate of the opportunity cost
associated with the job for which the bid is being prepared.

15-4
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

15.24 The decision to accept or reject a special order and the selection of a price for a
special order are similar decisions. If a price has been offered for a special order,
management can base its acceptance or rejection decision on whether or not that
price covers the incremental cost of producing the order. Another way of viewing the
problem is to set the minimum price for the special order at a level sufficient to cover
the incremental cost of producing the order.
15.25 (a) Skimming pricing: Setting a high initial price for a new product in order to reap
short-run profits. Over time, the price is reduced gradually.
(b) Penetration pricing: Setting a low initial price for a new product in order to
penetrate a market deeply and gain a large and broad market share.
(c) Target costing: Conducting market research to determine the price at which a
new product will sell and then, given the likely sales price, computing the cost for
which the product must be manufactured in order to provide the firm with an
acceptable profit margin. Then engineers and cost analysts work together to
design a product that can be manufactured for the allowable cost. This process
is used widely in the development stages of new products.
15-26 (a) Unlawful price discrimination: Quoting different prices to different customers for
the same product or service, even though the different prices cannot be justified
by differences in the cost incurred to produce, sell, and deliver the product or
service.
(b) Predatory pricing: Temporarily cutting a price to broaden demand for a product
with the intention of later restricting the supply and raising the price again.
15-27 Traditional, volume-based product-costing systems often overcost high-volume and
relatively simple products while undercosting low-volume and complex products.
This practice can result in overpricing high-volume and relatively simple products
and underpricing low-volume and complex products. Such strategic pricing errors
can have a disastrous impact on a firms competitive position.

15-5
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

SOLUTIONS TO EXERCISES
EXERCISE 15-28 (25 MINUTES)
Dollars
Total cost

Total revenue

Total profit at profit-maximizing quantity and price

Quantity sold per


month

q*
Dollars per unit

Marginal cost
p*

Demand (average revenue)


Marginal revenue
Quantity sold
per month

q*

15-6
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

15-7
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Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-29 (30 MINUTES)


1.

Tabulated price, quantity, and revenue data:


(1)

(2)

Quantity
Sold per
Month

Unit
Sales
Price

20
40
60
80
100

......................................
$500
......................................
475
......................................
450
......................................
425
......................................
400

(3)
Total
Revenue
per
Month*

(4)
Changes
in Total
Revenue

....................................................................................
$10,000
....................................................................................
19,000 } .................... $9,000
....................................................................................
27,000 } .................... 8,000
....................................................................................
34,000 } .................... 7,000
6,000
....................................................................................
40,000 } ....................

*Column (1) times column (2).

Differences between amounts in column (3).

15-8
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-29 (CONTINUED)


2.

Total revenue curve:


Dollars

Total revenue

$40,000

$35,000

$30,000

$25,000

$20,000

Curve is increasing
throughout its range,
but at a declining rate

$15,000

$10,000

$ 5,000

20

40

60

80

100

Quantity sold
per month

15-9
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-30 (30 MINUTES)


1.

Tabulated cost and quantity data:

(1)
(2)
Quantity
Produced
Average
and Sold per
Cost per
Month
Unit
20
......................................
$450
40
......................................
425
60
......................................
410
80
......................................
430
100
......................................
445

(3)

(4)

Total
Changes
Cost per
in Total
Month*
Cost
....................................................................................
$ 9,000
....................................................................................
17,000 } ..................... $ 8,000
....................................................................................
24,600 } ..................... 7,600
....................................................................................
34,400 } ..................... 9,800
} ..................... 10,100
....................................................................................
44,500

*Column (1) times column (2).

Differences between amounts in column (3).

15-10
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-30 (CONTINUED)


2.
Total cost curve:
Dollars
$45,000

Total cost

$40,000

$35,000

$30,000

$25,000

Total cost increases


at an increasing rate

$20,000

$15,000

$10,000

Total cost increases


at an declining rate

$ 5,000

20

40

60

80

100

Quantity sold
per month

15-11
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Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

15-12
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-31 (40 MINUTES)


1.

Tabulated revenue, cost, and profit data:

(1)
(2)
(3)
(4)
(5)
Quantity
Total
Total
Produced
Sales
Revenue
Cost
Profit
and Sold
Price
per
per
per

per Month
per Unit
Month*
Month
Month**
20
......................................
$500 ....................................................................................
$10,000
$ 9,000 ...........................................................
$1,000
40
......................................
475 ....................................................................................
19,000
17,000 ...........................................................
2,000
60
......................................
450 ....................................................................................
27,000
24,600 ...........................................................
2,400
80
......................................
425 ....................................................................................
34,000
34,400 ...........................................................
(400)
100
......................................
400 ....................................................................................
40,000
44,500 ...........................................................
(4,500)

*Column (1) times column (2).

Column (1) times average cost per unit given in the preceding exercise.

**Column (3) minus column (4).


2.

Total revenue and cost curves: see next page.

3.

Of the five candidate prices listed, $450 is the optimal price. This price produces a
monthly profit of $2,400, which is greater than the profit at the other four candidate
prices.

15-13
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-31 (CONTINUED)


2.

Total revenue and cost curves:


Dollars
$45,000

Total cost

$40,000

Total revenue

$35,000

$30,000

$25,000

$20,000

Total profit at the profitmaximizing quantity and


price.

$15,000

$10,000

$ 5,000

20

40

60

80

100

Quantity sold
per month

15-14
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-32 (30 MINUTES)


1.

Price =total unit cost + (markup percentage total unit cost)


$495 =total unit cost + (12.5% total unit cost)
$495 =total unit cost 1.125
Total unit cost =

$495
1.125

Allocated fixed
selling and
administrative cost

2.

= $440

total
unit
cost

all
manufacturing
costs

$440 ($275 + $55)

$44

variable
selling and
administrative cost

$66

a.

Cost-Plus Pricing Formula


Variable manufacturing cost ..................................................
$275 $495 = $275 + (80% $275)*
Applied fixed manufacturing cost .........................................
55

b.

Absorption manufacturing cost .............................................


$330 $495 = $330 + (50% $330)
Variable manufacturing cost ..................................................
$275
Variable selling and administrative
cost ........................................................................................
66

c.

Total variable cost ...................................................................


$341 $495 = $341 + (45.16% $341)**

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


($495 $330) $330 = 50%
**($495 $341) $341 = 45.16% (rounded)

15-15
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-33 (15 MINUTES)


1.

Profit on sales of 60,000 units:


Sales revenue (60,000 9.00p) ..............................................
Less: Variable costs:
Manufacturing and administrative (60,000 4.50p) .......
Sales commissions (60,000 9.00p 10%) ...................
Contribution margin ...............................................................
Less: Fixed costs (90,000p + 7,500p) ....................................
Profit ........................................................................................

540,000p
270,000p
54,000p

324,000p
216,000p
97,500p
118,500p

p denotes Argentinas peso


2.

Required price on special order:


Unit contribution margin
required on special order

target additional profit


unit sales volume in special order

=
Sales price required

30,000p
3.00 p per unit
10,000

unit variable cost + required unit


contribution margin

4.50p + 3.00p = 7.50p per unit

As an alternative approach, let X denote the price required in order to earn additional
profit of 30,000p on the special order:
10,000X 10,000(4.50p)

30,000p

10,000X

75,000p

7.50p per unit

15-16
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-34 (25 MINUTES)


(1)

Cost-Plus Pricing Formula


Variable manufacturing cost ..................................................
$300 $600 = $300 + (100% $300)a
Applied fixed manufacturing cost .........................................
105

(2)

Absorption manufacturing cost .............................................


$405 $600 = $405 + (48.15% $405)b
Variable selling and administrative cost ...............................
45
Allocated fixed selling and
administrative cost ...............................................................
75

(3)

Total cost

$525 $600 = $525 + (14.29% $525)c

Variable manufacturing cost ..................................................


$300
Variable selling and administrative cost ...............................
45
(4)

Total variable cost ...................................................................


$345 $600 = $345 + (73.91% $345)d
Explanatory Notes:
a

($600 $300) $300 = 100%


($600 $405) $405 = 48.15% (rounded)
c
($600 $525) $525 = 14.29% (rounded)
d
($600 $345) $345 = 73.91% (rounded)
b

EXERCISE 15-35 (30 MINUTES)


Markup percentage
applied to cost base in
cost-plus
pricing formula

profit required to
achieve target ROI

annual
volume

total annual costs not


included in cost base
cost base per unit
used in cost-plus
pricing formula

15-17
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

1.

Markup percentage

$60,000

total variable selling and total annual

administrative costs
fixed costs
480 $400

$60,000 (480 $50) [480 ($250 $100)]


480 $400

$60,000 $24,000 $168,000


$192,000

= 131.25%
Thus, the Wave Darters price would be set equal to $925, where
$925 = $400 + ($400 131.25%).

15-18
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-35 (CONTINUED)


In the preceding formula:
$60,000
480
$400
$50
$250
$100

2.

=
=
=
=
=
=

target profit (given)


annual volume of Wave Darter production and sales (from Exhibit 15-5)
variable manufacturing cost per unit (from Exhibit 15-5)
variable selling and administrative cost per unit (from Exhibit 15-5)
applied fixed manufacturing cost per unit (from Exhibit 15-5)
allocated fixed selling and administrative cost per unit (from Exhibit 15-5)

$60,000

Markup percentage =

total selling and


administrative costs
480 $650*

$60,000 [480 ($50 $100)]


480 $650

$60,000 $72,000
$312,000

= 42.31% (rounded)
Thus the Wave Darters price would be set equal to $925, where
$925 = $650 + ($650 42.31%) with rounding.
*$650 = absorption manufacturing cost (from Exhibit 15-5).
The other amounts used in this formula were defined in requirement (1).

15-19
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

EXERCISE 15-36 (15 MINUTES)


1.

Material component of time and material pricing formula:


material

cost

material handling

and storage costs

incurred
annual cost of materials
incurred

used in Repair Department


on job
on job

2.

material

cost

1.05

Material component of price, using formula developed in requirement (1):


[$8,000 + ($8,000 .04)] 1.05
= $8,320 1.05
= $8,736
New price to be quoted on yacht refurbishment:
Total price of job = time charges + material charges
= $9,000* + $8,736**
= $17,736
*From Exhibit 15-7.
**

From requirement (1).

EXERCISE 15-37 (30 MINUTES)


Answers will vary widely, depending on the company and the product chosen. The answer
should include a general discussion of the use of target costing in setting a price for a
new product. The target-costing approach includes the following key features: priceled costing; focus on the customer; focus on product design; focus on process
design; use of cross-functional teams; analysis of life-cycle costs; and a value-chain
orientation. Target costing makes extensive use of value engineering to reduce
production costs and bring them into line with the target cost.

15-20
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

SOLUTIONS TO PROBLEMS
PROBLEM 15-38 (45 MINUTES)
1.

The order will boost Heartlands net income by $13,950, as the following calculations
show.
Sales revenue......................................................
Less: Sales commissions (10%)........................
Less manufacturing costs:
Direct material...............................................
Direct labor....................................................
Variable manufacturing overhead*...........................
Total manufacturing costs
Income before taxes...........................................
Income taxes (40%).............................................
Net income ......................................................

$82,500
8,250

$74,250

$14,600
28,000
8,400
51,000
$ 23,250
9,300
$ 13,950

*Based on an analysis of the year just ended, variable overhead is 30 percent of


direct labor ($1,125 $3,750). For Premier Foods order:
Direct-labor cost x .30 = $28,000 x .30 = $8,400.
2.

Yes. Although this amount is below the $82,500 full-cost price, the order is still
profitable. Heartland can afford to pick up some additional business, because the
company is operating at 75 percent of practical capacity.
Sales revenue............................................................
Less: Sales commissions (10%)..............................
Less manufacturing costs:
Direct material
Direct labor

$63,500
6,350

$57,150

$14,600
28,000

Variable manufacturing overhead


Total manufacturing costs
Income before taxes.................................................
Income taxes (40%)...................................................
Net income ............................................................

8,400
51,000
$ 6,150
2,460
$ 3,690

Note that the fixed manufacturing overhead and fixed corporate administration costs
are not relevant in this decision, because these amounts will remain the same
regardless of what Heartlands management decides about the order.
15-21
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Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-38 (CONTINUED)


3.

The break-even price is $56,667, computed as follows:


Let P = break-even bid price
P 0.1P - $51,000 = 0
0.9P = $51,000
P = $56,667 (rounded)
Income taxes can be ignored, because there is no tax at the break-even point.

4.

Profits will probably decline. Heartland originally used a full-cost pricing formula to
derive the $82,500 bid price. A drop in the selling price to $63,500 signifies that the
firm is now pricing its orders at less than full cost, which would decrease
profitability.
Reduced prices could lead to an increase in income if the company were able to
generate additional volume. This situation will not occur here, because the problem
states that Heartland has operated, and will continue to operate, at 75 percent of
practical capacity.

5. In the electronic version of the solutions manual, press the CTRL key and click on the
following link: 10E - BUILD A SPREADSHEET 15-38.XLS

15-22
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-39 (30 MINUTES)


1.

(a) Time charges:


Hourly labor cost +

annual overhead (excluding


material handling and storage)
annual labor hours

= $20.00 +

$135,000
12,000

hourly charge to
cover profit magin

+ $5.00

= $36.25 per labor hour


(b) Material charges:

Material cost material cost material handling and storage costs

incurred on job incurred on job annual cost of materials used


Material cost

material cost

$31,250

= incurred on job incurred on job


$312,500

2.

PRICE QUOTATION
Time charges:

Labor time ...................................................................................................


400 hours
Rate ..........................................................................................................
$36.25 per hour
Total .............................................................................................................
$14,500

Material charges: Cost of materials for job ............................................................................


$75,000
+ Charge for material handling and storage ............................................
7,500*
Total .............................................................................................................
$82,500
Total price of job: Time .............................................................................................................
$14,500
Material ........................................................................................................
82,500
Total .............................................................................................................
$97,000
*Charge for material handling and storage):
10% = $31,250 $312,500; 10% $75,000 = $7,500
15-23
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Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-39 (CONTINUED)


3.

Price of job without markup on material costs (from requirement 2) ....


Markup on total material costs ($82,500 10%) ......................................
Total price of job .........................................................................................

$ 97,000
8,250
$105,250

PROBLEM 15-40 (25 MINUTES)


1.

Direct-labor hours (DLH) required for job =

1,000,000 doses to be packaged


2,000 doses/DLH

= 500 DLH
Traceable out-of-pocket costs:
Direct labor ($16.00 500) .....................................................................
Variable overhead ($12.00 500) ..........................................................
Administrative cost ................................................................................
Total traceable out-of-pocket costs...................................................
Minimum price per dose =
=
2.

$ 8,000
6,000
2,000
$16,000

total traceable out -of -pocket costs


1,000,000 doses

$16,000
1,000,000

= $.016

As in requirement (1), 500 direct-labor hours are required for the job.
Direct labor ($16.00 500) .........................................................................
Variable overhead ($12.00 500) ..............................................................
Fixed overhead ($20.00 500) ..................................................................
Administrative cost ....................................................................................
Total cost .................................................................................................
Maximum allowable return (15%) ..............................................................
Total bid price .........................................................................................

Bid price per dose

total bid price

$ 8,000
6,000
10,000
2,000
$26,000
3,900
$29,900

$29,900

= 1,000,000 =$.0299 per dose

= 1,000,000 doses

15-24
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-40 (CONTINUED)


3.

Under the supposition that the price computed by Manhattan Pharmaceuticals, Inc.
using Wyants criterion is greater than $0.03, the factors that Manhattans
management should consider before deciding whether or not to submit a bid at the
maximum allowable price include whether Manhattan Pharmaceuticals has excess
capacity, whether there are available jobs on which earnings might be greater, and
whether the maximum bid of $0.03 contributes toward covering fixed costs.

PROBLEM 15-41 (25 MINUTES)


1.

The manufacturing overhead rate is $27.00 per direct-labor hour, and the product
cost includes $13.50 of manufacturing overhead per pressure valve. Accordingly, the
direct-labor hours per finished valve is 1/2 hour ($13.50 $27.00). Therefore, 30,000
units per month would require 15,000 direct-labor hours.

2.

The analysis of accepting the Glasgow Industries order of 120,000 units is as


follows:
Totals for
Per Unit 120,000 Units
Incremental revenue ............................................................... $28.50
$3,420,000
Incremental costs:
Variable costs:
Direct material ................................................................. $7.50
Direct labor ......................................................................
9.00
Variable overhead ........................................................... 4.50
Total variable costs ..................................................... $21.00

$ 900,000
1,080,000
540,000
$2,520,000

Fixed overhead:
Supervisory and clerical costs
(4 months @ $18,000) .......................................................
Total incremental costs ..........................................................
Total incremental profit ..........................................................

72,000
$2,592,000
$ 828,000

The following costs are irrelevant to the analysis:


Shipping
Sales commission
Fixed manufacturing overhead (both traceable and allocated)
15-25
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-41 (CONTINUED)


3.

The minimum unit price that Wolverine Valve and Fitting Company could accept
without reducing net income must cover the variable unit cost plus the additional
fixed costs.
Variable unit cost:
Direct material ..................................................................... $ 7.50
Direct labor ..........................................................................
9.00
Variable overhead ............................................................... 4.50
Additional fixed cost ($72,000 120,000) .............................
Minimum unit price .................................................................

4.

$21.00
.60
$21.60

Wolverines management should consider the following factors before accepting the
Glasgow Industries order:
The effect of the special order on Wolverines sales at regular prices.
The possibility of future sales to Glasgow Industries and the effects of
participating in the international marketplace.
The companys relevant range of activity and whether or not the special order will
cause volume to exceed this range.
The effect on machinery or the scheduled maintenance of equipment.
Other possible production orders that could come in and require the capacity
allocated to the Glasgow job.

5. In the electronic version of the solutions manual, press the CTRL key and click on the
following link: 10E - BUILD A SPREADSHEET 15-41.XLS

15-26
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-42 (30 MINUTES)


1.

Cost-plus pricing begins by computing an items cost and then adds an appropriate
markup. The result is the items selling price. In contrast, target costing begins by
determining an appropriate selling price. A target profit is next subtracted from that
price to yield the cost (i.e., the target cost) that must be achieved.
Target costing could be labeled price-led costing because it begins by determining a
target selling price. In contrast, cost-plus pricing methods begin with the cost and
culminate in determination of the selling price.

2.

The current selling price is $675:


Direct material...
Direct labor
Manufacturing overhead
Selling and administrative expenses.
Total cost.
Markup ($540 x 25%)...
Selling price...

3.

$ 90
225
150
75
$540
135
$675

Lehighs markup is $135, which is 20% of the current $675 selling price ($135
$675). To achieve a 20% markup on a $585 selling price, the company must reduce
its costs by $72.
Selling price..
Less: 20% markup ($585 x 20%).
Target cost

$585
117
$468

Current cost..
Less: Target cost.
Required cost reduction

$540
468
$ 72

15-27
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-42 (CONTINUED)


4.

Yes. The company should focus its efforts on trimming non-value-added costs.
These costs are associated with non-value-added activities (i.e., activities that are
either (a) unnecessary and dispensable or (b) necessary, but inefficient and
improvable).

5.

If costs cannot be reduced below $540, Lehigh will have to reduce its markup to
remain competitive. Assuming a desire to achieve the going market price of $585,
the markup must equal $45 ($585 - $540), or 8.33% of cost ($45 $540). Given that
the current markup on cost is 25%, a reduction of 16.67% is needed (25.00% - 8.33%).

6.

The statement means that selling prices are a function of market conditions;
however, the selling prices must cover a companys costs in the long run. Also, in a
number of industries, prices are based on costs. Yet, the prices are subject to the
reaction of customers and competitors.

7.

In the electronic version of the solutions manual, press the CTRL key and click on
the following link: 10E - BUILD A SPREADSHEET 15-42.XLS

15-28
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-43 (30 MINUTES)


1.

The minimum price per blanket that Detroit Synthetic Fibers, Inc. could bid without
reducing the companys net income is $48 calculated as follows:
Raw material (6 lbs. @ $3.00 per lb.) .........................................................
Direct labor (.25 hrs. @ $14.00 per hr.) .....................................................
Machine time ($20.00 per blanket) ............................................................
Variable overhead (.25 hrs. @ $6.00 per hr.) .............................................
Administrative costs ($5,000 1,000) .......................................................
Minimum bid price ..................................................................................

2.

Using the full cost criteria and the maximum allowable return specified, Detroit
Synthetic Fibers, Inc.s bid price per blanket would be $59.80 calculated as follows:
Relevant costs from requirement (1) ........................................................
Fixed overhead (.25 hrs. @ $16.00 per hr.) ...............................................
Subtotal ...................................................................................................
Allowable return (.15 $52.00) .................................................................
Bid price ..................................................................................................

3.

$18.00
3.50
20.00
1.50
5.00
$48.00

$48.00
4.00
$52.00
7.80
$59.80

Factors that management should consider before deciding whether to submit a bid
at the maximum acceptable price of $50 per blanket include the following:
The company should be sure there is sufficient excess capacity to fill the order
and that no additional investment is necessary in facilities or equipment that
would increase fixed costs.
If the order is accepted at $50 per blanket, there will be a $2 contribution per
blanket to cover fixed costs. However, the company should consider whether
there are other jobs that would make a greater contribution.
Acceptance of the order at a low price could cause problems with current
customers who might demand a similar pricing arrangement.

15-29
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-44 (25 MINUTES)


1.

Target costing is more appropriate. MSC is limited in terms of what price it can
charge due to market conditions. A cost-plus-markup approach will use the desired
markup for the company; however, the resulting price may too high and not
competitive. In such an environment it makes more sense to use target costing,
which begins with the price to be charged and works backward to determine the
allowable cost.

2.

Target profit = asset investment x rate of return


= $27,000,000 x 12%
= $3,240,000

3.

Revenue = target profit + variable cost + fixed cost


= $3,240,000 + (25,000 hours x $33) + $2,850,000
= $6,915,000
Since total revenue must equal $6,915,000, the revenue per hour must be $276.60
($6,915,000 25,000 hours).

4.

Target profit = asset investment x rate of return


= $27,000,000 x 14%
= $3,780,000
Revenue = target profit + variable cost + fixed cost
= $3,780,000 + (25,000 hours x $33) + $2,850,000
= $7,455,000
No. A 14% return requires that MSC generate revenue per service hour of $298.20
($7,455,000 25,000 hours), which is clearly in excess of the $265 market price.

5.

To achieve a 14% return and a $265 revenue-per-hour figure, the company must trim
its costs. MSC could use value engineering, a technique that utilizes information
collected about a services design and associated production process. The goal is
to examine the design and process and then identify improvements that would
produce cost savings.

15-30
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-45 (40 MINUTES)


1.

Target costing is the design of a product, and the processes used to produce it, so
that ultimately the product can be manufactured at a cost that will enable a firm to
make a profit when the product is sold at an estimated market-driven price. This
estimated price is called the target price, the desired profit margin is called the target
profit, and the cost at which the product must be manufactured is called the target
cost.

2.

Value engineering (or value analysis) refers to a cost-reduction and process


improvement technique that utilizes information collected about a product's design
and production processes and then examines various attributes of the design and
processes to identify candidates for improvement efforts.
Value engineering focuses on improving those qualities that the customer desires,
while reducing or eliminating unnecessary moves, queues, setups, and other such
activities that the customer will not pay for. The process is reengineered to eliminate
non-value-added work and thereby enhance the value of the process to the customer.

15-31
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-45 (CONTINUED)


3.

Portland Electronics' current profit on sales is 10 percent [($700$630)/$700].


Therefore, the target cost for the new product must be $600 less 10 percent, or $540
[$600 ($600 10%)].

4.

The proposed changes to the just-in-time cell manufacturing process at Portland


Electronics will bring costs down to $532 per unit, which is below the $540 target cost
limit. Revised costs under the JIT cell manufacturing process are calculated as follows:

Current

Increase/
(Decrease)

Revised

Material:
Purchased components..................................
All other............................................................

$215
85

Labor:
Manufacturing, direct......................................
Setups...............................................................
Material handling.............................................
Inspection.........................................................

130
18
36
46

$ 30
(18)
(36)
(46)

160
0
0
0

Machining:
All......................................................................

70

(10)

60

Other:
Finished-goods warehousing.........................
Warranty*..........................................................

10
20

(10)
(8)

0
12

Total cost................................................................

$630

$(98)

$532

$215
85

*40% reduction

15-32
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-46 (50 MINUTES)


1.

Budgeted overhead costs:


Department I Department II
Variable overhead
$450,000
Department I: 37,500 $12 ...................................................................
Department II: 37,500 $6 .....................................................................
Fixed overhead ...........................................................................................
225,000
Total overhead ............................................................................................
$675,000
Total budgeted overhead for both
departments ($675,000 + $450,000) .........................................................
Total expected direct-labor hours for
both departments (37,500 + 37,500) ........................................................
Predetermined overhead rate =
=

$ 225,000
225,000
$ 450,000
$1,125,000
75,000

budgeted overhead
budgeted direct -labor hours

$1,125,000
75,000

= $15.00 per direct-labor hour


2.

3.

Standard
Total cost ....................................................................................................
$600.00
Markup (15% of cost)
90.00
Standard: $600 .15 .............................................................................
______
Deluxe: $750 .15 ..................................................................................
Price ............................................................................................................
$690.00

Deluxe
$750.00
112.50
$862.50

Department I Department II
Budgeted overhead (from requirement 1).................................................
$675,000
$450,000
Budgeted direct-labor hours .....................................................................
37,500
37,500
Calculation of predetermined overhead rate ............................................
37,500

$675,000

$450,000
37,500

Predetermined overhead rate ....................................................................


$18.00

$12.00

15-33
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-46 (CONTINUED)


4.

5.

6.

Standard
Direct material ............................................................................................
$240
Direct labor .................................................................................................
210
Manufacturing overhead:
Department I:
36
Standard: 2 $18 ...............................................................................
Deluxe: 8 $18 ...................................................................................
Department II:
96
Standard: 8 $12 ...............................................................................
Deluxe: 2 $12 ...................................................................................
Total cost ....................................................................................................
$582

Deluxe
$390
210

Standard
Total cost (from requirement 4)..................................................................
$582.00
Markup (15% of cost)
87.30
Standard: $582 .15 ..............................................................................
______
Deluxe: $768 .15 ..................................................................................
Price ............................................................................................................
$669.30

Deluxe
$768.00

144

24
$768

115.20
$883.20

The management of Super Sounds, Inc. should use departmental overhead rates. The
overhead cost structures in the two production departments are quite different, and
departmental rates more accurately assign overhead costs to products. When the
company used a plantwide overhead rate, the Standard speakers were overcosted and
the Deluxe speakers were undercosted. This in turn resulted in the Standard model
being overpriced and the Deluxe model being underpriced. The cost and price
distortion resulted from the following facts: (1) the Standard speakers spend most of
their production time in Department II, which is the least costly of the two
departments; and (2) the Deluxe speakers spend most of their production time in
Department I, which is more costly than Department II.

15-34
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-47 (35 MINUTES)


1.

Target costing is market driven, beginning with a determination of the selling price
that customers are willing to pay. That price is dependent on the product they
purchase and the products features. It is only natural that a marketing team
becomes heavily involved in this process, since customer feedback is crucial to the
design process.

2.

Add cabinet doors: [(10 x 1) + (20 x 2) + (30 x 3) + (60 x 4) + (80 x 5)] = 780; 780 200
= 3.900
Expand storage area: [(10 x 1) + (40 x 2) + (70 x 3) + (50 x 4) + (30 x 5)] = 650; 650
200 = 3.250
Add security lock: [(30 x 1) + (60 x 2) + (50 x 3) + (40 x 4) + (20 x 5)] = 560; 560 200 =
2.800
New appearance for table top: [(10 x 1) + (20 x 2) + (50 x 3) + (60 x 4) + (60 x 5)] = 740;
740 200 = 3.700
Extend warranty: [(40 x 1) + (70 x 2) + (30 x 3) + (35 x 4) + (25 x 5)] = 535; 535 200 =
2.675

15-35
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

PROBLEM 15-47 (CONTINUED)


Ranking (from strongest to weakest):
1Add cabinet doors (3.900)
2New appearance for table top (3.700)
3Expand storage area (3.250)
4Add security lock (2.800)
5Extend warranty (2.675)
3.

4.

(a)

Danish Interiors currently earns a $48 profit on each table sold ($240 - $192),
which translates into a 20% markup on sales ($48 $240). The current
competitive market price is $285, which means that if the company maintains
the 20% markup, it will earn $57 ($285 x 20%) per unit. The maximum
allowable cost is therefore $228 ($285 - $57).

(b)

Customers feel most strongly about adding cabinet doors and giving the
table top a new appearance. Both of these features can be added, and Danish
Interiors will be able to earn its 20% markup. The third and fifth most
desirable features (the expanded storage area and extended warranty) are too
costly. If it desires, management could also add a lock to the storage area.
Supporting calculations follow.
Maximum allowable cost...
Less: Current cost...
Cost of additional features

$228.00
192.00
$ 36.00

1Add cabinet doors.


2New appearance for table top
Subtotal
4Add security lock..
Total..

$ 18.00
12.75
$ 30.75
__ 4.95
$ 35.70

An expanded storage area would be the most logical additional feature in view of its
no. 3 ranking. Danish Interiors might use value engineering to study the design and
production process of both the table as currently manufactured as well as the
proposed new features. The goal is to identify improvements and associated
reductions in cost that may allow the company to add previously rejected options.

15-36
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

SOLUTIONS TO CASES
CASE 15-48 (40 MINUTES)
1.

Bid based on standard pricing policy:


Direct material ...........................................................................................
Direct labor (11,000 DLH @ $18.00) .........................................................
Manufacturing overhead (11,000 DLH @ $10.80) ....................................
Full manufacturing costs .....................................................................
Markup (50% of full cost) .........................................................................
Standard pricing policy bid ......................................................................

2.

$307,200
198,000
118,800
$624,000
312,000
$936,000

Minimum bid acceptable to Bair Company:


Direct material ...........................................................................................
Direct labor (11,000 DLH @ $18.00) .........................................................
Variable manufacturing overhead (11,000 @ $6.48a) ..............................
Opportunity cost of lost salesb .................................................................
Minimum bid ..............................................................................................
a

Proportion of variable overhead

budgeted variable overhead


budgeted total overhead

$1,166,400
$1,944,000

$307,200
198,000
71,280
42,240
$618,720

= 60%
variable
total overhead

rate

overhead proportion

Variable overhead rate =

= ($10.80) (.6)
= $6.48

15-37
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

CASE 15-48 (CONTINUED)


b

Selling price per unit of standard product...............................................


Variable costs per unit
Direct material .....................................................................................
$3,000
Direct labor (250 DLH @ $18.00) ........................................................
4,500
Variable overhead (250 DLH @ $6.48) ...............................................
1,620
Net contribution per unit ............................................................................
36,000 DLH
Standard product requirements (12,000 DLH 3) ...................................
Special order requirements .......................................................................
11,000 DLH
Total hours required ...................................................................................
47,000 DLH
45,000 DLH
Plant capacity per quarter (15,000 DLH 3) ............................................
Shortage in hours .......................................................................................
2,000 DLH
Lost unit sales (2,000 DLH 250 DLH) .....................................................
Lost contribution ........................................................................................

3.

$14,400

9,120
$5,280

8
$42,240

Lyan Companys assistant purchasing manager is not acting ethically. The details of
the bid submitted by Bair Company are confidential between Bair Company and Lyan
Company. It is unfair and unethical to give this information to Bairs competitor. If
Lyan Company had wanted competing bids on the specialized equipment, the bids
should have been solicited at the same time from the relevant set of manufacturers.
Each competing firm should receive the same specifications on the customized
equipment and be given the same time frame in which to complete the bid. Moreover,
the competing firms should be made aware that more than one bid is being solicited.

15-38
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

CASE 15-49 (50 MINUTES)


1.

Handy Household Products, Inc. should price the standard compound at $44 per
case and the commercial compound at $60 per case. The contribution margin is the
highest at these prices as shown in the following calculations:
Standard Compound
Selling price per case ................................................................................
$ 38 $ 40 $ 42
Variable cost per case ................................................................................
32 32 32
Contribution margin per case ...................................................................
$ 6 $ 8 $ 10
Volume in cases (in thousands) ................................................................
120 100 90
Total contribution margin (in thousands) .................................................
$ 720 $ 800 $ 900

$ 44
32
$ 12
80
$ 960

Commercial Compound
Selling price per case ................................................................................
$ 52 $ 54 $ 60 $ 64
Variable cost per case ................................................................................
42 42 42 42
Contribution margin per case ...................................................................
$ 10 $12 $ 18 $ 22
Volume in cases (in thousands) ................................................................
175 140 100 55
Total contribution margin (in thousands) .................................................
$1,750 $1,680 $1,800 $1,210

$ 46
32
$ 14
50
$ 700

70
42
28
35
980

15-39
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Education.

Chapter 15 - Target Costing and Cost Analysis for Pricing Decisions

CASE 15-49 (CONTINUED)


2.

a. Management should continue to operate during the final six months of the
current year because any shutdown would be temporary. The company intends to
remain in the business and expects a profitable operation during the next year.
This is a short-run decision problem. Therefore, the fixed costs are irrelevant to
the decision, because they cannot be avoided in the short run. The products do
have a positive contribution margin so operations should continue.
HANDY HOUSEHOLD PRODUCTS, INC.
SHREVEPORT PLANT
PROJECTED CONTRIBUTION MARGIN
FOR THE SIX-MONTH PERIOD ENDING DECEMBER 31
(IN THOUSANDS)
Standard Commercial
Sales ............................................................................................................
$2,300
$2,450
Variable costs:
Selling and administrative .....................................................................
$ 400
$ 490
Manufacturing .........................................................................................
1,200
980
Total variable costs ............................................................................
$1,600
$1,470
Contribution margin ...................................................................................
$ 700
$ 980

Total
$4,750
$ 890
2,180
$3,070
$1,680

b. Management should consider the following qualitative factors when making the
decision about the Shreveport Plant.
The effect on employee morale.
The effect on market share.

The disruption of production and sales due to a shutdown.

The effect on the local community.

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