QUESTIONS 6-1 The answer depends on the time frame considered. - PDF document

Chapter 6 Cost Information for Pricing and Product Planning QUESTIONS 6-1 The answer depends on the time frame considered. Short-run prices need only cover the costs that vary in the short run. However, in the long run, most costs become flexible (variable). In fact, in the long run, prices must cover both capacity-related (fixed) and flexible costs for the firm to survive. 6-2 Since capacities made available for many production and support activities cannot be altered easily in the short term, managers need to pay attention to whether surplus capacity is available for additional production or whether the available capacity limits production alternatives. In contrast, in the long term, managers have considerably more flexibility in adjusting the capacities of activity resources to match the demand that is placed on these resources by the actual production of different products. 6-3 In commodity-type businesses, prices are set by traders in the commodity markets based on industry supply and demand. Firms in commodity-type industries are price-takers, unable to influence the market prices. 6-4 The following two considerations complicate short-term product mix decisions: 1. Deciding what costs are relevant to the short-term product mix decision. 2. Recognizing that in the short term managers may not have the flexibility to alter the capacities of some activity resources. 6-5 A firm that is one of a large number of small firms in an industry in which there is little to distinguish the products of different firms from each other is likely to be a price-taker. A price-taker firm cannot influence prices significantly by its own decisions because the prices are set by overall industry supply and demand forces, or by a large dominant firm in its industry. – 251 –

Atkinson, Solutions Manual t/a Management Accounting, 5E 6-6 Firms in an industry with relatively few competing firms, and firms enjoying large market shares and exercising leadership in an industry are likely to behave as price setters or price leaders. Also, firms in industries in which products are highly customized or otherwise differentiated from each other because of special features, characteristics, or customer service, are able to set prices for their differentiated products. 6-7 No. Products should be ranked by the contribution margin per unit of the constrained resource rather than by the contribution margin per unit of the product. 6-8 Yes. When capacity is fixed in the short run, the firm may need to sacrifice the production of some profitable products to make capacity available for a new order. The contribution margin on the production of profitable products sacrificed for a new order is an opportunity cost that must be considered to evaluate the profitability of the new order. 6-9 When surplus capacity is not available and overtime, extra shift, subcontracting, or other means must be employed to augment the limited capacity, a short-term pricing decision must consider the additional costs of overtime wages, supervision, heating, lighting, cleaning, security, machine maintenance and engineering, along with human factors such as a decline in morale. 6-10 If facility-sustaining (business-sustaining) costs do not vary with the decision alternatives, such as when there is some idle capacity, then these costs should not be considered for a short-run pricing decision. However, if facility- sustaining costs vary with the decision, such as when heating, or lighting and security costs increase for overtime work, they must be considered for the short-run pricing decision. 6-11 Contracts for the development and production of new, customized products, including contracts with governmental agencies such as the Department of Defense, specify prices as full costs plus a markup. Prices set in regulated industries, such as electric utilities, are also based on full costs. Also, when a firm enters into a long-term contractual relationship with a customer to supply a product, it will price the product based on its full costs. This is because it has flexibility in adjusting the level of commitment for all activity resources and as a result most of its costs become flexible (variable) in the long run. Finally, prices based on full costs are used as benchmark prices to guide short-run price adjustments in response to fluctuations in short-run demand conditions. – 252 –

Chapter 6: Cost Information for Pricing and Product Planning 6-12 The stronger the demand, the higher will be the markup. When demand is more elastic, markup will be lower because customers are sensitive to higher prices. Finally, when competition is more intense, a firm cannot sustain a high markup. 6-13 Short-run prices fluctuate over time because of changes in demand conditions. When the demand for products is low, firms adjust their prices downward. Conversely, when the demand is high, they adjust prices upward. 6-14 Several strategic factors may affect the level of markup. A firm may choose a low markup to penetrate the market and win market share from its competitors. In contrast, a firm may employ a high markup if it employs a skimming strategy for a market segment in which some customers are willing to pay higher prices. 6-15 If long-run market prices are lower than full costs, managers may consider reengineering the product to lower costs, raising prices by further differentiating the product, offering customer incentives such as quantity discounts, or dropping these unprofitable products. 6-16 In the long run, a firm has the flexibility to adjust most of its activity resources, and therefore, most costs are flexible (variable). Thus, full costs approximate long-run flexible costs that are relevant for long-run pricing decisions. EXERCISES 6-17 Healthy Hearth has sufficient excess capacity to handle the one-time order for 1000 meals next month. Consequently, the analysis focuses on incremental revenues and costs: Incremental revenue per meal $3.50 Incremental cost per meal 3.00 Incremental contribution margin per meal $0.50 × 1,000 Number of meals Increase in operating income $ 500 – 253 –

Atkinson, Solutions Manual t/a Management Accounting, 5E 6-18 In order to accept the new order for 1,500 modules next week, McGee must give up regular sales of 500 modules per week. Variable costs are $800 per module ($2,400,000/3,000 modules). The contribution margin per unit on regular sales is $900 – $800 = $100 per module. Therefore, the opportunity cost (lost CM) of accepting the new order is 500($100) = $50,000, and McGee will be indifferent between filling the special order and not filling the special order when the contribution margins of the two alternatives are equal (fixed costs will remain unchanged). That is, McGee will be indifferent at a price P where 1,500(P – $800) = $50,000, or P = $833.33. 6-19 This order will require 500 = 5 × (10,000 ÷ 100) machine hours. Since there is excess capacity of 800 = 4,000 × (100% − 80%) machine hours per month, Shorewood Shoes Company can accept this order without expanding its capacity. Therefore, Shorewood should charge at least as much as the incremental variable costs for this order. Direct material $6.00 Direct labor 4.00 Variable manufacturing support 2.00 Additional cost of embossing the private label 0.50 Minimum price to be charged for this order $12.50 Shorewood’s costs stated in the problem are average costs per pair of shoes. Shorewood should determine whether the costs are reasonably accurate for the discount store’s order. Shorewood should also consider how its regular customers might react to the lower price offered to the discount store. 6-20 (a) Superstore faces a problem of maximizing contribution margin per unit of scarce resource. Here, the scarce resource is shelf space. Superstore requires at least 24 square feet for each category. The store manager should assign additional available space to the category with the highest contribution margin per square foot, i.e., ice cream. After assigning a total of 100 square feet to ice cream, there is sufficient available shelf space to assign a total of 100 square feet to frozen dinners and 26 square feet to juices. The frozen vegetable receives the minimum required assignment of 24 square feet. – 254 –

Chapter 6: Cost Information for Pricing and Product Planning Frozen Frozen Ice Cream Juices Dinners Vegetables Selling price per unit (square-foot package) $12.00 $13.00 $24.00 $9.00 Variable costs per unit (square-foot package) $8.00 $10.00 $20.50 $7.00 Unit CM (square-foot package) $4.00 $3.00 $3.50 $2.00 Minimum required 24 24 24 24 Maximum allowed 100 100 100 100 Allocation to maximize total CM 100 26 100 24 (b) In setting the minimum required and maximum allowed square footage per category, the manager might consider seasonality (for example, permitting more ice cream space during the summer or more frozen vegetable space during the winter) and the effect on contribution margins of variability in costs and prices. The analysis does not take into account the rate at which products are sold within each category. The analysis should also consider the effect of the mix on other product sales. If the store offers only a limited selection of frozen vegetables, for example, shoppers may switch to another store for their regular grocery shopping. 6-21 Regular Deluxe Sale price per sq. yard $16 $25 Variable costs per sq. yard 10 15 Contribution margin per sq. yard $6 $10 DLH required per sq. yard 0.15 0.20 $40 a $50 b Contribution margin per DLH a $6 ÷ 0.15 = $40 b $10 ÷ 0.20 = $50 – 255 –