Cost-Based Pricing

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CHAPTER
          Tactical
          Decision
          Making
                                                  17 -2


                 Objectives
                tactical decision-making model.
1. Describe theAfter studying this
               chapter, you resource
2. Explain how the activity should usage
                    assessing
   model is used inbe able to:relevancy.
3. Apply tactical decision-making concepts in a
   variety of business situations.
4. Choose the optimal product mix when faced
   with one constrained resource.
5. Explain the impact of cost of pricing
   decisions.
                                                   17 -3


                 Objectives
6. Use linear programming to find the optimal
   solution to a problem of multiple constrained
   resources. (Appendix)
                                                         17 -4

Model for Making Tactical Decisions
Step 1. Recognize and define the problem.
   Increase capacity for warehousing and production.
Step 2. Identify alternatives as possible solutions to
        the problem; eliminate alternatives that are
        clearly not feasible.
   1. Build new facility
   2. Lease larger facility; sublease current facility
   3. Lease additional facility
   4. Lease warehouse space
   5. Buy shafts and brushings; free up needed space

                      Continued
                                                            17 -5

Model for Making Tactical Decisions
Step 3. Identify the costs and benefits associated with
        each feasible alternative. Classify costs and
        benefits as relevant or irrelevant, and eliminate
        irrelevant ones from consideration.
   Lease warehouse space:
     Variable production costs               $345,000
     Warehouse lease                          135,000
   Buy shafts and bushings externally:
     Purchase price                          $460,000

                       Continued
                                                         17 -6

Model for Making Tactical Decisions
Step 4. Total the relevant costs and benefits for each
         alternative.
   Lease warehouse space:
     Variable production costs              $345,000
     Warehouse lease                          135,000
        Total                               $480,000
   Buy shafts and bushings externally:
     Purchase price                         $460,000
   Differential cost                        $ 20,000


                      Continued
                                                        17 -7

Model for Making Tactical Decisions
Step 5. Assess qualitative factors.     Quality of shafts
   1. Quality of external suppliers     and brushing is
   2. Reliability of external suppliers significantly lower
                                          Not reliable
   3. Price stability
   4. Labor relations and community image
Step 6. Make the decision.
  Continue to produce shafts and bushings internally;
  lease warehouse
                                              17 -8

       Relevant Costs Defined

Relevant costs are future costs that differ
across alternatives. A cost must not only
   be a future cost but most also differ
           between alternatives.
                                   17 -9



Flexible resources can be easily
purchased in the amount needed
 and at the time of use… like
           electricity.
                                  17 -10



   Committed resources are
purchased before they are used,
  such as salaried employees.
                                                  17 -11


Activity Resource Usage Model and
        Assessing Relevancy

              Flexible Resources



   a. Demand Changes               Relevant

   b. Demand Constant              Not Relevant
                                                        17 -12


  Activity Resource Usage Model and
          Assessing Relevancy
                  Committed Resources
                     (Short-Term)


             Supply – Demand = Unused Capacity
a.. Demand Increased < Unused Capacity       Not relevant
b. Demand Increased > Unused Capacity        Relevant
c. Demand Decease (Permanent)
    1. Activity Capacity Reduced             Relevant
    2. Activity Capacity Unchanged          Not Relevant
                                                       17 -13


  Activity Resource Usage Model and
          Assessing Relevancy
                 Committed Resources
                 (Multiperiod Capacity)


            Supply – Demand = Unused Capacity
a.. Demand Increased < Unused Capacity      Not relevant
b. Demand Decreased (Permanent)             Relevant
c. Demand Increase > Unused Capacity    Capital Decision
                                      17 -14

 Illustrative Examples of
Relevant Cost Applications
     Make or Buy

     Keep or Drop

     Special Order

     Sell or Process Further

     Product Mix

  Important: Short-term Perspective
                                                    17 -15

               Make or Buy
 Swasey Manufacturing currently produces an
electronic component used in one of its printers.
Swasey must produce 10,000 of these parts. The
  firm has been approached by a supplier who
   offers to build the component to Swasey’s
        specifications for $4.75 per unit.
                                                         17 -16

                  Make or Buy
The full absorption cost for the 10,000 parts is
computed as follows:
                                 Total Cost Unit Cost
 Rental of equipment               $12,000       $1.20
 Equipment depreciation              2,000        0.20
 Direct materials                   10,000        1.00
 Direct labor                       20,000        2.00
 Variable overhead                   8,000        0.80
 General fixed overhead             30,000        3.00
   Total                           $82,000       $8.20
   Enough material is on hand to make 5,000 parts.
                                                            17 -17

                    Make or Buy
The cost to make or buy 5,000 units follows:
                           Alternatives      Differential
                          Make        Buy Cost to Make
Rental of equipment     $12,000       -------    $12,000
Direct materials          5,000       -------       5,000
Direct labor             20,000       -------     20,000
Variable overhead         8,000       -------       8,000
Purchase cost             -------   $47,500      -47,500
Receiving Dept. labor     -------     8,500       - 8,500
  Total                 $45,000     $56,000     $-11,000
                          Make
                                                                  17 -18

             Keep-or-Drop Decisions
Norton Materials, Inc. produces concrete blocks, bricks, and roofing
tile. The controller prepared the following income statements:
                                 Blocks Bricks Tile           Total
    Sales revenue                  $500      $800 $150 $1,450
    Less: Variable expenses         250       480     140       870
    Contribution margin            $250      $320 $ 30 $ 580
    Less direct fixed expenses:
      Advertising                  $ 10      $ 10 $ 10 $ 30
      Salaries                        37       40      35       112
      Depreciation                    53       40      10       103
         Total                     $100      $ 90 $ 55 $ 245
    Segment margin                 $150      $230 $- 45 $ 335
    Less: Common fixed exp.                                     125
      Operating income                                       $ 210
                                                       17 -19

         Keep-or-Drop Decisions
                                           Differential
                          Keep    Drop    Amount to Keep
Sales                     $150     ----        $150
Less: Variable expenses 140        ----         140
Contribution margin       $ 10     ----        $ 10
Less: Advertising           -10    ----         -10
       Cost of supervision -35     ----         -35
Total relevant benefit
 (loss)                   $- 35    $ 0        $- 35

       Preliminary figures indicate that the tile
             segment should be dropped!
                                                            17 -20

          Keep-or-Drop Decisions
Tom Blackburn determines that dropping the tile section will
reduce sales in all sections as follows: $50,000 for blocks,
$64,000 for bricks, and $150,000 for roofing tile. His
summary in thousands is shown below:
                                                 Differential
                             Keep        Drop Amount to Keep
 Sales                      $1,450 $1,186.0          $264.0
 Less: Variable expenses       870       666.6        203.4
 Contribution margin        $ 580 $ 519.4            $ 60.6
 Less: Advertising              -30       -20.0       -10.0
       Cost of supervision -112           -77.0       -35.0
 Total                      $ 438 $ 422.4            $ 15.6

                 Keep roofing tile segment!
                                                               17 -21

          Keep-or-Drop Decisions
                 Alternate Use of Facilities

The marketing manager sees the market for floor tile as
stronger and less competitive than roof tile. He submits the
following figures for floor tile sales:
   Sales                           $100,000
   Less: Variable expenses           40,000
   Contribution margin             $ 60,000
   Less: Direct fixed expenses       55,000
    Segment margin                 $ 5,000
                                                      17 -22

        Keep-or-Drop Decisions
              Alternate Use of Facilities

                               Drop and    Differential
                         Keep Replace Amount to Keep
Sales                   $1,450 $1,286.00    $164.00
Less: Variable expenses    870    706.60     163.40
                             $1,450 – $150 $ 0.60
 Contribution margin $ 580 $ 579.40
                          –$50 – $64 –
                         $870 – $140+
                              $100
                         $25 – $38.40 +
          Decision: Continue making roof tile!
                              $40
                                          17 -23

Special-Order Decisions

         An ice cream company is
       operating at 80 percent of its
      productive capacity (20 million
     half gallon units). The unit costs
      associated with producing and
    selling 16 million units are shown
              on the next slide.
                                                17 -24

        Special-Order Decisions
            Variable costs:
              Dairy ingredients        $ 0.70
              Sugar                      0.10
              Flavoring                  0.15
              Direct labor               0.25
              Packaging                  0.20
              Commissions                0.02
              Distribution               0.03
              Other                      0.05
Wholesale       Total variable costs   $ 1.50
 price =    Total fixed costs           0.097
  $2.00     Total costs                $1.597
                                            17 -25

Special-Order Decisions

       An ice cream distributor from a
       geographic region not normally
     served by the company has offered
    to buy two million units at $1.55 per
     unit, provided its own label can be
        attached to the product. The
      distributor has agreed to pay the
             transportation cost.
                                                      17 -26

            Special-Order Decisions
                  Variable costs:
                    Dairy ingredients        $0.70
                    Sugar                      0.10
                    Flavoring                  0.15
                    Direct labor               0.25
                    Packaging                  0.20
                    Commissions                0.02
                    Distribution               0.03
                    Other                      0.05
 Which costs          Total variable costs   $1.50
                                              $1.45
are irrelevant?   Total fixed costs           0.097
                  Total costs                $1.597
                                              $1.45
                                                       17 -27

            Special-Order Decisions
                   Accept costs:
                  Variable the offer ($0.10 x
                    2,000,000 = $200,000
                    Dairy ingredients         $ 0.70
                    Sugar more profit).         0.10
                    Flavoring                   0.15
                    Direct labor                0.25
                    Packaging                   0.20
                    Commissions                 0.02
                    Distribution                0.03
                    Other                       0.05
 Which costs          Total variable costs      1.50
                                              $$1.45
are irrelevant?   Total fixed costs            0.097
                  Total cost                  $1.597
                                               $1.45
                                                       17 -28


                Sell or Further Process
             Yield at Split-Off   Further Processing
              Grade A
              800 lb
              Sell for $0.40 lb

                                  Bagged
Joint Cost
              Grade B             120 Bags
$300
              600 lb              Cost $0.05/Bag
                                  Sell for $1.30/Bag

                                  Applesauce
              Grade C             500 16-oz Cans
              600 lb              Cost $0.10/lb
                                  Sell for $0.75 can
                                                       17 -29


              Sell or Further Process

                  Process            Differential Amount
                  Further    Sell     to Process Further
Revenues           $450     $150             $300
Processing cost     120      ----              120
Total              $330     $150             $180


                  Further process!
                                17 -30
    Two Approaches to Pricing

1. Cost-Based Pricing
2. Target Costing and
   Pricing
                                                            17 -31
              Cost-Based Pricing

Revenues                                         $856,500
Cost of goods sold:
    Direct materials                  $489,750
    Direct labor                       140,000
    Overhead                            84,000    713,750
Gross profit                                     $142,750
Selling and administrative expenses                25,000
    Operating income                             $117,750
                                                              17 -32
   Determining Markup Percentages
Markup on COGS =
      (S & A expenses + Operating income) ÷ COGS
                   = ($25,000 + $117,750) ÷ $713,750
                   = 0.20
Markup on direct materials =
(DL + OH + S & A expenses + Oper. income) ÷ Direct mater. =
($140,000 + $84,000 + $25,000 + $117,750) ÷$489,750 = 0.749
                                                          17 -33
  Determining Markup Percentages
Direct materials (computer components, etc.)   $100,000
Direct labor (100 x 6 hours x $15)                9,000
Overhead (60 percent of direct labor cost)        5,400
Estimated cost of goods sold                   $114,400
Plus 20 percent markup of COGS                   22,880
  Bid price                                    $137,280
                                                            17 -34
       Target Costing and Pricing
Target costing is a method of determining the cost of a
product or service based on the price (target price) that
customers are willing to pay.




This is referred to as price-driven costing.
                                                      17 -35


       Legal Aspects of Pricing
Predatory pricing. The practice of setting prices
below cost for the purpose of injuring or
eliminating competitors.
Price discrimination. Charging different prices to
different customers for essentially the same
product.
  The Robinson-Patman Act is the most potent
weapon against price discrimination, but it doesn’t
        cover services and intangibles.
                                                       17 -36


           Linear Programming

The maximum demand for Gear X is 15,000 units and
the maximum demand for Gear Y is 40,000 units. The
  contribution margin for X is $25 and for Y is $10.
                 Z = $25X x $10Y
 Two machine hours are used for each unit of Gear X,
  and 0.5 machine hour is used for a unit of Gear Y.

               2X + 0.5Y  40,000
                                     17 -37


        Linear Programming

              Max. Z = $25X x $10Y
Subject to:
               2X + 0.5Y  40,000
                       X  15,000
                       Y  40,000
                       X0
                       Y0
                                         17 -38


80 –
75 – Machine Hours Constraint
70 –     2X + 0.5Y  40,000
65 –
60 –                Demand Constraint
55 –                   X  15,000
50 –
45 –
   E           D
40 –
35 –                 Demand Constraint
30 –                     Y  40,000
25 –
                    C
20 – Feasibility
15 – Region
10 –
5–
   A |       |    B
                  |     |     |
0–
      5    10    15    20    25
                                                      17 -39


           Linear Programming

Corner Point   X-Value   Y-Value   Z = $25X + $10Y

    A              0          0            $ 0
    B             15          0            375
    C             15         20            575
    D             10         40            650
    E              0         40            400

   Manufacture 10,000 units of Gear X and 40,000 of
   Gear Y.
                    17 -40




Chapter Seventeen

        The End
17 -41

				
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