Langfield-Smith7e IRM Ch20

CHAPTER 20
PRICING AND PRODUCT MIX DECISIONS

ANSWERS TO REVIEW QUESTIONS
20.1 In the long run, organisations need to price their products above the cost of producing and marketing those
products. While it is important for the price to be competitive with other available products, in the long run
costs cannot be ignored. Understanding product costs helps companies to determine whether they can
afford to be in that market or perhaps need to work at reducing costs to enable them to be both competitive
and profitable. The cost of a product, whether goods or services, should be the basis for setting the lower
limit of the price.
20.2 Some examples include:
Childcare. The government subsidises childcare places, which lowers the price. This is because
childcare is often used by families who find it difficult to afford the service. The media may level
criticisms at childcare organisations when fees are too high.
Petrol. Customers are very sensitive to the price of petrol, and the public and the government may
criticise the petrol companies when prices rise. Petrol companies need to consider this when setting
their prices.
Banks. Banks need to consider how customers and the government will react when they raise interest
rates (prices). High interest rates can have an impact on many aspects of the economy, including
household wealth and the share market.
20.3 The definition of the product and the market are vital to setting a price, as a company needs to strategically
position itself to appeal to the right customer group. If the strategy is to appeal to high-income consumers,
a price noticeably lower than the competitors in that market will suggest that this product is less desirable
for one reason or another (possibly because of the image of the consumer). On the other hand, a product
that has a reputation of being of lower quality will not sell if equivalent products in that market are lower
priced.
Defining the product or market is not as simple as it sounds. A market can be defined too narrowly or too
broadly. For example, a company that produces buttons may define the product and market as buttons
and closely watch the activities of other button manufacturers as they are the relevant competitors.
However, if the button manufacturer believes it is operating in the clothing fasteners market, then
competitors will also include manufacturers of zippers, velcro fasteners and other clothing fasteners.
Selling prices and marketing strategies will differ depending on which definition of market and product is
selected.
Discussions about this issue can consider the need to understand customer value as, defining the product
and the market are necessary when identifying who the customer is and what it is about the product that
makes it attractive to customers. It is important to consider customer value when setting prices to ensure
that the price is not higher than customers perceptions of the value of the product.
20.4 The Australian furniture industry has experienced fierce competition from furniture importers. The
furniture that is imported from Asia into Australia is usually cheaper than furniture manufactured in
Australia due to much lower wages in Asian countries. Some Australian manufacturers find that they have
to reduce prices to match the competition.
20.5 The economic models of pricing decisions are of limited use.

1 It is difficult to determine accurate predictions for the demand and marginal revenue curves and the
impact of factors other than demand are not included.
2 The assumptions of simple economic pricing models do not apply to all forms of markets.
3 It is difficult to measure marginal cost.
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e
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20.6 Value-based pricing is used to set product prices based on the customers perceptions of the value of the
product. The economic-value pricing method is used to set product prices based on the estimated costs and
benefits of the product to the customer that extend beyond the purchase price. The former pricing method
requires understanding of consumers perception of product value and the latter pricing method requires a
reference product as benchmark for comparison.
20.7 The reasons often cited for the widespread use of variable costing as the cost base in cost-plus formulas are
as follows:
(a) Variable cost data do not obscure the cost behaviour pattern by unitising fixed costs and making
them appear variable.
(b) Variable cost data do not require the allocation of fixed costs to individual product lines.
(c) Variable cost data are exactly the type of information managers need when facing certain tactical
short-term pricing decisions.
The primary disadvantage of variable cost is that in the long term price must be set to cover all costs and a
normal profit margin.
20.8 Three disadvantages of pricing based on absorption cost are as follows:

1 Absorption-cost data obscure the cost behaviour pattern by unitising fixed costs and making them
appear variable.
2 Absorption-cost data attempt to (inaccurately) allocate fixed costs to individual product lines.
3 Absorption-cost data are not useful for managers to make decisions, such as whether to accept a
special order.
20.9 The markup percentage is different depending on which product costing definition (absorption or total
variable costs) is adopted. The markup percentage is calculated as sum of the target profit and the total
annual costs not included in the cost base (denominator of the equation) divided by the total product costs
(cost base) derived from the costing method.
20.10 Under time and material pricing, the price includes a price for labour and a price for material. The labour
price is based on time and is calculated as a cost per hour plus a charge to cover some overheads and a
profit margin. The material price is based on the material costs incurred on the job plus a charge to cover
material-related overheads. By separating the time-based elements of the cost from the material costs it is
possible to use the method in industries where the material charges vary across jobs. This method assumes
that resources other than materials are consumed relatively steadily over time and can be costed to the
output on the basis of time. The need for profit to be earned steadily over time leads to adopting the
approach of marking up the hourly rate to generate the required profit. It is used in industries such as
construction, printing, repairs, legal and accounting offices.
20.11 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 and profitability.
20.12 (a) Skimming pricing: setting the initial price for a new product high in order to reap high short-term
profits. Over time, the price is reduced gradually. One example is the pricing of new technology
products such as MP4 players, Blu-ray recorders and portable video recorders.
(b) Penetration pricing: setting the initial price for a new product low in order to quickly attract a large
market share. For example, admission prices to a newly opened museum or art gallery, subscription
prices for newly launched magazines.

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20.13 The bid price may vary significantly in competitive bidding depending on whether or not the organisation
has spare capacity. Where an organisation has spare manufacturing capacity, only the incremental costs of
producing the extra order need to be covered to make a contribution to profits. For organisations with no
spare capacity, the opportunity costs forgone by taking the extra order need also to be covered by the bid
price. For this reason, an organisation with no spare manufacturing capacity may submit a higher bid than
an organisation with spare capacity.
20.14 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 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 price for the special order at a level sufficient to cover the incremental cost of producing the order.
20.15 Predatory pricing is a temporary cut in price to broaden demand for a product with the intention of later
restricting the supply and raising the price again. Resale price maintenance occurs when a supplier dictates
the minimum price at which a product or service is to be resold to a buyer or retailer.
20.16 The Australian Competition and Consumer Commission has wide-reaching responsibilities for surveillance
and enforcement of Commonwealth anti-competitive restrictive trade practices law and consumer law. In
regulating prices, there are certain practices that are restricted. These include the use of price-fixing
contracts, price discrimination and resale price maintenance.
For Qantas price fixing and cartels see: www.accc.gov.au/media-release/court-orders-qantas-to-pay-20-
million-for-price-fixing (viewed 1 February 2014).
For being guilty while ignorant of the law see: www.accc.gov.au/media-release/price-fixing-no-childs-play
(viewed 1 February 2014).
Students may need to be advised to access the ACCC web site and then put price fixing in the box in the
top right hand corner.
20.17 Short term product mix decisions involve changing the product mix temporarily, often because of some
constraint on the resources available, or because of unusual customer demands. A decision to be made in
situations where there is a resource shortage is based on using the scarce resource so that profitability is
maximised. This entails identifying the contribution per unit of scarce resource. Fluctuating customer
demands may create excess capacity for a brief period and the decision to utilise this for a one-off special
order may be based on exceeding the incremental cost of production (usually the variable cost only).
Long-term product mix decisions may entail whether new products should be adopted or existing products
discontinued. These decisions must consider costs that would have remained unchanged in the short term
product mix decisions. Fixed costs may change due to changing production requirements and there could
be an impact on market share. These issues must be considered when evaluating any investment required
to facilitate the long term change in mix.
20.18 The term contribution margin per unit of scarce resource is a products unit contribution margin divided by
the number of units of the scarce resource required to produce one unit of the product. For example, if a
products contribution margin per unit is $5 and it requires two hours of direct labour to produce one unit,
the contribution margin per direct labour hour is $2.50. In a short-term product mix decision, products are
produced in order of the highest contribution margin per unit of limited resource.
20.19 Linear programming (LP) is designed to help management to determine the optimum product mix that
would maximise the firms profit, where there are multiple limited resources. LP takes into account the
use that each product makes of each limited resource and considers the profitability of each product to
arrive at the optimum production mix.
20.20 Constraints: the limitations faced by an organisation, including limited production resources.
Decision variables: the variables about which a decision must be made.
Feasible region: the space between the axes and constraints within which lies the solution to a linear
programming problem.
Objective function: an algebraic expression of the firms goal that is used in linear programming.
These terms are used in linear programming. Linear programming is a method for identifying linear
relationships between decision variables to determine the optimal solution given a number of constraints.
Linear programming can be use to calculated the optimal product mix.

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SOLUTIONS TO EXERCISES
EXERCISE 20.21 (30 minutes) Demand and revenue data: manufacturer
1 Tabulated price, quantity and revenue data:
Quantity sold Unit sales Total revenue Changes in

per month price per month total revenue
20 $500 $10 000
40 475 19 000 } $9 000

} 8 000
60 450 27 000 } 7 000
} 6 000
80 425 34 000
100 400 40 000
2 Total revenue curve:

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EXERCISE 20.22 (30 minutes) Continuation of Exercise 20.30; cost data: manufacturer
1 Tabulated cost and quantity data:
Quantity
produced and Average cost Total cost per Changes in
sold per month per unit month total cost
20 $450 $ 9 000
Dollars
40 425 17 000 } $ 8 000
Total cost } 7 600
60 410 24 600
} 9 800
80 430 34 400 } 10 100
100 445 44 500

45 000
Total cost increasesTotal revenue rate

at an increasing
2 Total cost curve:
Total cost increases at a declining rate

Curve is increasing throughout its rang
Quantity sold per month
Quantity s

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EXERCISE 20.23 (30 minutes) Profit maximising price: manufacturer
1 Tabulated revenue, cost, and profit data:
Quantity Total
produced and Sales price revenue per Total cost per Profit per
sold 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)
2 Total revenue and cost curves: see below.

3 Of the five possible prices listed, $450 is the optimal price. This price produces a monthly profit of $2400,
which is greater than the profit at the other four prices.

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4 Total revenue and cost curves
Total revenue

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EXERCISE 20.24 (30 minutes) Determining markup percentage; target ROI:
manufacturer
Markup percentage applied to cost base in cost - plus pricing formula
profit required to achieve target ROI + total annual costs not included in cost base
= annual volume cost base per unit used in cost - plus pricing formula
1 Variable manufacturing cost

Markup percentage
$100 000 + total variable selling and administrative costs + total annual fixed costs
= 480 $400
$100 000 $24 000 $168 000
= 480 $400
= 152.08%
Thus, the Wave Darters price would be set equal to $1008.32, where $1008.32= $400 + ($400 1.5208).
2 Absorption cost:
$100 000 + total selling and administrative costs
Markup percentage = 480 $650 *
$100 000 $72 000
= $312 000
= 55.13% (rounded)
Thus, the Wave Darters price would be set equal to $1008.35*, where $1008.35= $650 + ($650 0.5513).
* the selling prices for parts 1 and 2 should be identical. The slight difference is due to rounding errors.

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EXERCISE 20.25 (30 minutes) Cost-plus pricing formulas; missing data: manufacturer
1 Price =total unit cost + (mark-up percentage total unit cost)
$495 =total unit cost + (12.5% total unit cost)
$495 =total unit cost 1.125
$495
Total unit cost = 1.125 = $440
Allocated fixed selling total unit all manufacturing variable selling and
=
and administrative cost cost costs administrative cost
= $440 ($275 + $55) $66
= $44
Cost-plus pricing formula
2 (a) Variable manufacturing cost $275 $495 = $275 + (80% $275)*
Applied fixed manufacturing cost 55
(b) Absorption manufacturing cost $330 $495 = $330 + (50% $330)
(c) Variable manufacturing cost $275
Variable selling and administrative

cost 66
Total variable cost $341 $495 = $341 + (45.16% $341)**

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

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

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EXERCISE 20.26 (25 minutes) Cost-plus pricing formulas: manufacturer
Cost-plus pricing formula
1 Variable manufacturing cost $200 $400 = $200 + (100% $200)a
Applied fixed manufacturing cost 70
2 Absorption manufacturing cost $270 $400= $270 + (48.15% $270)b
Variable selling and administrative cost 30
Allocated fixed selling and administrative cost 50
3 Total cost $350 $400= $350 + (14.29% $350)c
Variable manufacturing cost $200
Variable selling and administrative cost 30
4 Total variable cost $230 $400= $230 + (73.91% $230)d

a
($400 $200) $200 = 100%
b
($400 $270) $270 = 48.15% (rounded)
c
($400 $350) $350 = 14.29% (rounded)
d
($400 $230) $230 = 73.91% (rounded)
EXERCISE 20.27 (15 minutes) Time and material pricing: manufacturer

1 Material component of time and material pricing formula:
annual material handling and storage costs
material cost incurred on job + material cost incurred on job annual cost of materials used in Repair Dept 1.20

2 Material component of price, using formula developed in requirement 1:
[$8000 + ($8000 0.04)] 1.20 = $8320 1.20
= $9984
New price to be quoted on yacht refurbishment:
Total price of job = time charges + material charges
= $10 400* + $9984
= $20 384
* from Exhibit 20.5

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EXERCISE 20.28 (20 minutes) Pricing; advertising; special order decisions:
manufacturer
1 Profit on sales of 60 000 units:
Sales revenue (60 000 $18.00) $1 080 000
Less: Variable costs:
Manufacturing and administrative (60 000 $9.00) 540 000
Sales commissions (60 000 $18.00 10%) 108 000 648 000
Contribution margin 432 000
Less: Fixed costs ($180 000 + $15 000) 195 000
Profit $237 000
2 Required price on special order:
Unit contribution margin required on target additional profit

special order =
unit sales volume in special order
$30 000
= $3.00 per unit
10 000

Sales price required = unit variable cost + required unit
contribution margin
= 9.00 + 3.00 = $12.00 per unit
As an alternative approach, let X denote the price required in order to earn additional profit of $30 000 on
the special order:
10 000X 10 000($9.00) = 30 000
10 000X = 120 000
X = $12.00 per unit

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EXERCISE 20.29 (15 minutes) Product mix; limited resources: manufacturer
The most profitable product is the one that yields the highest contribution margin per unit of the scarce resource,
which is direct labour. The direct labour hours required per unit of West1 is 0.0476 ($1 $21) and per unit of
West2 is 0.2857 ($6 $21). The two products contribution margins per labour hour are calculated as follows:
West1 West2
Unit contribution margin $3.00 $12.00
Labour hours required per unit of product 0.0476 0.2857
Contribution margin per direct labour hour
West1: ($3.00 0. 0476) $62.03
West2: ($12.00 0. 2857) $ 42.00
Therefore, West1 is a more profitable product, since product West1 has the highest contribution margin per unit of
the scarce resource (direct labour hours).
EXERCISE 20.30 (20 minutes) (appendix) Linear programming; formulate and solve
graphically: manufacturer
1 (a) Notation: X denotes the quantity of Zanide produced per day

Y denotes the quantity of Kreolite produced per day
(b) Contribution margin:
Zanide Kreolite
Price $ 36 $ 42
Unit variable cost 28 28
Unit contribution margin $ 8 $ 14
(c) Linear program:
Maximise 8X + 14Y
Subject to: 2X + 2Y 24
1X + 3Y 24
X, Y 0

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2 Graphical solution:
25
20
15
Machine I constraint
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Optimal solution (X = 6, Y = 6)
Objective function
Machine II constraint
5
Feasible region
X
5 10 15 20 25
Corner points in feasible region Objective function value
X=0 Y=0 $ 0
X=0 Y=8 112
X=6 Y=6 132
X = 12 Y=0 96
The maximum objective function value is achieved when X = 6 and Y = 6. Thus, the company should
produce six drums of Zanide per day and six drums of Kreolite per day.
3 The objective function value at the optimal solution is a $132 total contribution margin as shown in
requirement 2.

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SOLUTIONS TO PROBLEMS
PROBLEM 20.31 (45 minutes) Economic-value pricing; strategic pricing of new
products
1 Economic-value pricing comparisonsDryWell versus Dry Master
DryWell Dry Master EV to customer
Purchase price $12 000 $12 000
Additional functionality $400 400
Installation 200 300 (100)
Maintenance costs 6 400 5 400 1 000
$13 300
2 The price which Razzle could charge is $13 300, given that the Dry Master represents increased economic
value to the customer. Whether the firm will charge this price depends on the attitude of the customers
when comparing the new machine to the present market leader. It may be more appropriate to price the
Dry Master closer to the DryWell initially in order to prove itself under operating conditions and thereby
gain market acceptance.
The laundry owners are unlikely to buy the new machine unless the annual cost to own and operate it at
least equals that of the existing machine, even if it has one more year of useful life. The annual cost to own
and operate both machines can be shown below, with the figures for the Dry Master built up from the
bottom line of the DryWell.
DryWell Dry Master
Initial cost $12 000 $15 225
Installation 200 300
12 200 15 525
Divide by useful life (8 and 9 years, respectively) 1 525 1 725
Add yearly maintenance 800 600
Annual cost to own and operate $2 325 $2 325
This suggests that the laundry owner could pay a maximum price of $13 300 and still be as well off, given
the added functionality and the longer life of the proposed new machine.
3 The demand for these machines is derived; that is, the user is the real customer, not the owner of the coin-
operated laundry. The laundry owner may not care about softer, fluffier clothes, but may have to respond to
this requirement if enough of their customers raise it as an issue. The laundry owners may be more likely
to value the speed of the wash. Razzle should undertake further research to see how the laundry owner
values each of these two featuresalthough the laundry owner may not care about soft, fluffy clothes, the
faster speed may benefit the business through added capacity. More information about the operating costs
such as relative electricity usage may be useful.

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PROBLEM 20.32 (50 minutes) Product cost distortion and product pricing;
departmental overhead rates: manufacturer
1 Budgeted overhead costs:
Department I Department II
Variable overhead
Department I: 37 500 $12 $450 000
Department II: 37 500 $6 $ 225 000
Fixed overhead 225 000 225 000
Total overhead $675 000 $ 450 000
Total budgeted overhead for both

departments ($675 000 + $450 000) $1 125 000
Total expected direct labour hours for

both departments (37 500 + 37 500) 75 000
budgeted overhead
budgeted direct labour hours
Predetermined overhead rate =
$1 125 000
= 75 000
= $15.00 per direct labour hour

2 Velvet Leather
Total cost $600.00 $750.00
Mark-up (15% of cost)
Velvet: $600 0.15 90.00
Leather: $750 0.15 ______ 112.50
Price $690.00 $862.50
3 Department I Department II
Budgeted overhead (from requirement 1) $675 000 $450 000
Budgeted direct labour hours 37 500 37 500
$675 000 $450 000

Calculation of predetermined overhead rate
37 500 37 500
Predetermined overhead rate $18.00 $12.00

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4 Velvet Leather
Direct material $240 $390
Direct labour 210 210
Manufacturing overhead:
Department I:
Velvet: 2 $18 36
Leather: 8 $18 144
Department II:
Velvet: 8 $12 96
Leather: 2 $12 24
Total cost $582 $768
5 Velvet Leather
Total cost (from requirement 4) $582.00 $768.00
Mark-up (15% of cost)
Velvet: $582 0.15 87.30
Leather: $768 0.15 ______ 115.20
Price $669.30 $883.20
6 The management of Stevenson Furniture 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 Velvet model
were overcosted and the Leather model were undercosted. This in turn resulted in the Velvet model being
overpriced and the Leather model being underpriced. The cost and price distortion resulted from the
following facts: (1) the Velvet model spends most of its production time in Department II, which is the
least costly of the two departments; and (2) the Leather model spends most of its production time in
Department I, which is more costly than Department II.

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PROBLEM 20.33 (30 minutes) Time and material pricing: service firm
1 (a) Time charges:
annual overhead (excluding
material handling and storage) hourly charge to
Hourly labour cost + annual labour hours + cover profit magin
$270 000
= $40.00 + 12 000 Labour hours + $10.00
= $72.50 per labour hour

(b) Material charges:
Material cost material cost annual materia l handling and storage costs

incurred on job incurred on job annual cost of materials used
$62 500
1
= Material cost incurred on the job x $625 000
= Material cost incurred on the job x 1.10
2 Price quotation
Time charges: Labour time 400 hours
Rate $72.50 per hour
Total $29 000
Material changes: Cost of materials for job $150 000
+ Charge for material handling and storage *

($150 000 x 0.10) 15 000
Total $165 000
Total price of job: Time $29 000
Material 165 000
Total $194 000
3 Price of job without markup on material costs (from requirement 2) $ 194 000
Markup on total material costs ($165 000 10%) 16 500
Total price of job $210 500

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PROBLEM 20.34 (25 minutes) Cost-plus pricing; bidding: wholesaler
1 000 000 doses to be packaged
1 Direct labour hours (DLH) required for job = 2000 doses/DLH
= 500 DLH
Traceable out-of-pocket costs:

Direct labour ($24.00 500) $ 12 000
Variable overhead ($12.00 500) 6 000
Administrative cost 2 000
Total traceable out-of-pocket costs $20 000
total traceable out - of - pocket costs

Minimum price per dose = 1 000 000 doses
$20 000
= 1 000 000 doses = $0.02 per dose

2 As in requirement 1 500 direct labour hours are required for the job.
Direct labour ($24.00 500) $ 12 000
Variable overhead ($12.00 500) 6 000
Fixed overhead ($20.00 500) 10 000
Administrative cost 2 000
Total cost $30 000
Maximum markup (15%) 4 500
Total bid price $34 500

total bid price
Bid price per dose = 1 000 000 doses
$34 500
1 000 000 doses
=
= $0.0345 per dose
3 If the price calculated by Halifax Pharmaceuticals is greater than $0.03, some factors that Halifaxs
management should consider before deciding whether or not to submit a bid at the maximum allowable
price of $0.03 include:
whether Halifax Pharmaceuticals has spare capacity
whether there are other more profitable jobs that might use the spare capacity
whether the maximum bid of $0.03 contributes toward covering fixed costs (in this particular case
the contribution margin per dose would be $(0.03 0.02), which gives a total contribution margin
of $10 000)
the possible impact on existing customers who may be charged a higher selling price

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whether or not the order is a one-off order.

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PROBLEM 20.35 (40 minutes) Bidding on a special order: manufacturer
1 Bid based on standard pricing policy:

Direct material $512 000
Direct labour (11 000 DLH @ $30) 330 000
Manufacturing overhead (11 000 DLH @ $18) 198 000
Full manufacturing costs $1 040 000
Markup (50% of total cost) 520 000
Standard pricing policy bid $1 560 000
2 Minimum bid acceptable to Ward:

Direct labour (11 000 @ $30) 330 000
Variable manufacturing overhead (11 000 @ $10.80*) 118 800
Opportunity cost of lost sales 70 400
Minimum bid $1 031 200
budgeted overhead
* Variable overhead rate =
budgeted direct labour hours
$1 944 000
=
(12x15 000) DLHrs
= $10.80 per direct labour hour
Selling price per unit of standard product $24 000
Variable costs per unit
Direct labour (250 DLH @ $30) 7 500
Variable overhead (250 DLH @ $10.80) 2 700 15 200
Net contribution per unit $ 8 800
Standard product requirements (12 000 DLH 3) 36 000 DLH
Special order requirements 11 000 DLH
Total hours required 47 000 DLH
Plant capacity per quarter (15 000 DLH 3) 45 000 DLH
Shortage in hours 2 000 DLH
Lost unit sales (2000 DLH 250 DLH) 8
Lost contribution $70 400

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PROBLEM 20.36 (45 minutes) Pricing of special order: manufacturer
1 The order will boost Harmons net profit by $27 900, as the following calculations show.
Sales revenue $82 500
Less sales commissions (10%) 8 250 $74 250
Less manufacturing costs:
Variable manufacturing overhead* 8 400
Total manufacturing costs 51 000
Net profit before tax $ 23 250
Income tax (40%) 9 300
Net profit after tax $ 13 950
* Based on an analysis of the year just ended, variable overhead is 30 per cent of direct labour ($1125 $3750).
For Holistics Pizzas order: Direct labour cost 0.30 = $28 000 0.30 = $8 400.
2 Yes. Although this amount is below the $82 500 full-cost price, the order is still profitable. Harmon can
afford to pick up some additional business, because the company is operating at 75 per cent of practical
capacity.
Less sales commissions (10%) 6 350 $57 150
Less manufacturing costs:
Variable manufacturing overhead 8 400
Total manufacturing costs 51 000
Income tax (40%) 2 460
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 whether the order proceeds.
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.
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4 Profits will probably decline. Harmon originally used a full-cost pricing formula to derive an $82 500 bid
price. A drop in the selling price to $63 500 signifies that the firm is now pricing all its orders at less than
full cost, which would decrease profitability.
Reduced prices could lead to an increase in profit if the company were able to generate additional volume.
This situation will not occur here, because the problem states that Harmon has operated, and will continue
to operate, at 75 per cent of practical capacity.
5 An Excel spreadsheet is used to answer requirements 1 and 2 using changed data.

First we need to recalculate Harmons bid price:
DATA INPUT
['000s]
Less sales commission $ 1 000 Sales commission 8%
Net sales $11 500
Costs:
Direct material $ 2 900
Direct labour $ 3 800
Manufacturing overhead: variable $ 1 125
Manufacturing overhead: fixed $ 750
Corporate administration: fixed $ 375
Total costs $ 8 950
Income tax $ 1 020 Tax rate 40%
Capacity used 75%
Holistic Pizza Bid
Estimated direct material $14 600
Estimated direct labour $28 000
Estimated manufacturing overhead $14 000 Cost driver : Labour 50%
Estimated corporate overhead $ 2 800 Cost driver : Labour 10%
Estimated total costs excluding sales

commission $59 400
Add 25% for profit and taxes $14 850
Suggested total price before sales

commission $74 250

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Suggested total price with adjustment
for sales commission $80 707
(a) If the bid price is accepted, this order would boost Harmons net income by $14 016:
Less sales commission $ 6 457 $74 250
Less manufacturing costs
Direct labour $28 000
Variable manufacturing overhead* $ 8 289
Total manufacturing costs $50 889
Net profit before tax $23 361
Income tax $ 9 344
Net profit after tax $14 016

*Based on an analysis of the year just ended (variable overhead/direct labour) = 29.6%
b) A sales price of $63 500 would be marginally profitable:
Less sales commission $ 5 080 $58 420
Less manufacturing costs
Estimated manufacturing overhead $14 600
Direct labour $28 000
Variable manufacturing overhead $ 8 289
Total manufacturing costs $50 889
Income tax (40%) $ 3 012

23
PROBLEM 20.37 (40 minutes) Make or buy; use of limited resources: manufacturer
1 The incremental cost of producing one unit of component B18 is calculated as follows:
Direct material $ 7.50
Direct labour 9.00
Variable overhead 4.50
Total variable cost per unit $21.00
Purchase price quoted for component B18 $27 00
Incremental cost of production per unit 21.00
Net loss per unit if purchased from the supplier $ 6.00
Net loss per machine hour if component B18 is purchased = $6.00/3 machine hours = $2.00 per machine
hour
B12 B18
2
$ $
Purchase price quoted 22.50 27.00
Direct material 4.50 7.50
Direct labour 8.00 9.00
Variable overhead 4.00 4.50
Total variable cost 16.50 21.00
Net benefit per unit of making component 6.00 6.00
Machine hours required per unit 2.5 3
Net benefit per machine hour of making component 2.40 2.00
Machine hours available 41 000

Best use of machine time: produce 8000 units of component B12
[8000 (2.5 hrs. per unit)] 20 000
Machine hours remaining for production of component B18 21 000
Machine hours required per unit of component B18 3 t
Feasible production of component B18 (21 000/3) 7 000 units
Required quantity of component B18 11 000 units
Feasible production of component B18 7 000 units
Quantity of component B18 to be purchased from the supplier 4 000 units
Conclusion: purchase 4000 units of component B18 and manufacture the remaining bearings. The answer
to requirement 2 is d.
3 Variable cost per unit of component B18 $21.00

Traceable, avoidable, fixed cost per unit of component B18 ($88 000/11 000 units) 8.00
Maximum price Brighton Industries should pay for component B18 $29.00

24
PROBLEM 20.38 (15 minutes) Limited capacity; production planning: manufacturer
1 Machine hour requirements:
Department
Product 1 2 3 4
M07 500 500 1000 1000
T28 400 400 800
B19 2000 2000 1000 1000
Total required 2900 2900 2000 2800
Total available 3000 3100 2700 3300
Excess (deficiency) 100 200 700 500
Direct labour hour requirements:
Department
Product 1 2 3 4
M07 1000 1500 1500 500
T28 400 800 800
B19 2000 2000 2000 1000
Total required 3400 4300 3500 2300
Total available 3700 4500 2750 2600
Excess (deficiency) 300 200 (750) 300
The monthly sales demand cannot be met for all three products as a result of the labour shortage in
Department 3.

25
2 The goal is to maximise contribution margin. Fixed costs are not relevant. The scarce resource is direct
labour hours (DLH) in Department 3.
EFM should first produce the product that maximizes contribution margin per unit of the scarce resource
(DLH). In this case two products, M07 and B19, require direct-labour hours in Department 3.
Product
M07 T28 B19
Sales price $196 $123 $167
Variable costs
Direct material $ 7 $13 $17
Direct labour 66 38 51
Variable overhead 27 20 25
Variable selling 3 2 4
Total variable costs $103 $73 $97
Contribution margin $93 $50 $70
Contribution
Contribution Department 3 margin
Product margin DLH per DLH
M07 $93 3 $31
B19 70 2 35
Department 3
DLH
Units required Balance (DLH)
Maximum DLH available

in Department 3 2750
Product B19 first 1000 2000 750
Product M07 second 250 750 -0-
Resulting production schedule
Product Units Comments
M07 250 Produce as much as the constraint allows (750 3 DLH per
unit). Reduced production is based on its lower contribution
margin per direct-labour hour.
T28 400 Produce up to monthly sales demand; unaffected by

Department 3.
B19 1000 Produce as much as possible to maximize contribution margin

per DHL.

26
Schedule of contribution margin by product
Contribution Units Contribution

Product margin per unit produced to profit
M07 $93 250 $23 250
T28 50 400 20 000
B19 70 1000 70 000
Total contribution margin $113 250
3 To supply the additional quantities of M07 that are required, EFM should consider:
subcontracting the additional units
operating on an overtime basis
acquiring labour from outside the community.

27
PROBLEM 20.39 (30 minutes) CVP analysis; advertising decisions; spare capacity:
manufacturer
1 The sales volume of Classic model must increase by at least 160 000 units in order to offset the cost of
increased advertising, as shown in the following calculations:
Breakeven sales = $320 000 ($8 $4 $2) = $320 000 $2 = 160 000 units.
2 The sales volume of the Economy model must increase by at least 1 920 000 units in order to offset the
cost of increased advertising, as shown in the following calculations:
Breakeven sales = $320 000 [($6 $3 $2) $6] = $320 000 .166666667 = 1 920 000 units.
3 Mammoth should advertise the more profitable model or the Economy model to maximise its profitability.
The most profitable product is the one that yields the highest contribution margin per unit of the scarce
resource, machine hours. The Economy model gives higher contribution margin per machine hour, as
shown below:
Classic Economy
Unit contribution margin $2.00 $1.00
Machine hours required per unit of product 0.75 0.2
(Fixed manufacturing cost/$2 per machine hour)
Contribution margin per machine hour
Classic: ($2.00 0.75) $2.66667
Economy: ($1.00 0.2) $5.00
The estimated increase in total contribution margin if all production were dedicated to producing the
Economy model instead of Classic model would be $266 667 (rounded), as shown below.
Increase in contribution margin = $5 100 000 machine hours $2.66667 100 000 machine hours
= $500 000 $266 667
= $233 333 (rounded)
Mammoth should advertise the more profitable model or the Economy model to maximise its profitability. The
most profitable product is the one that yields the highest contribution margin per unit of the scarce resource,
which is the machine hour. The economy model gives a higher contribution margin per machine hour.
4 The calculations in above requirements do not provide sufficient information to make an informed
decision. Additional information could include the following:
customer demand for both products
impact on customer demand if no classic pens are produced
customer preferences in the new private sector school market
the effectiveness of different forms of marketing
the market share of each product.

28
PROBLEM 20.40 (40 minutes) (appendix) Linear programming; formulate and solve
graphically
1 In order to maximise contribution margin, the objective function and constraint functions would be
formulated as follows:
Notation:
S = number of batches of Star bars
M = number of batches of Moon bars
TCM = total contribution margin
The contribution margin is the selling price less variable cost for each product. Thus, for the Moon bar, the
contribution margin is $250 ($700 less $450), and for the Star bar, it is $400 ($600 less $200). Therefore,
the objective function is as follows:
Maximise TCM = 250M + 400S
Subject to the following constraints:
Mixing Department: 1.5S + 1.5M 525
Coating Department: 2.0S + 1.0M 500
Materials: M 300
Non-negativity: S 0 and M 0
2 The number of batches of each bar that should be produced to maximise contribution can be determined by
graphing the linear program, as shown below. The optimal solution is to produce 200 batches of Moon bars
and 150 batches of Star bars.
3 The total contribution margin, then, is $110 000 [(200 $250) + (150 $400)].
Graph of linear program:

29
PROBLEM 20.41 (45 minutes) (appendix) Linear programming): service firm
1 The objective function and constraints that Great Cooking Company should use to maximise profits are as
follows:
Maximise 60P + 45H
Subject to: 2P + H 60 (preparation)
2P + 3H 120 (cooking)
P 45 (freezing)
P0
H 0
2 Graph of linear program:
Haute Cuisine
70
60 Preparation constraint
Objective function
50
40
Optimal solution (P = 15, H = 30) Freezing constraint
30
20
Feasible
region
10
Cooking
constraint
Premier
Cuisine
0 10 20 30 40 50 60

30
3&4 Corner points Objective function
in feasible region value Contribution
margin at the
P=0 H=0 ($60)(0) + ($45)(0) = 0 optimal solution
P=0 H = 40 ($60)(0) + ($45)(40) = $1800 = $2250.
P = 15 H = 30 ($60)(15) + ($45)(30) = $2250
P = 30 H=0 ($60)(30) + ($45)(0) = $1800
5 Graph of linear
program:
Haute Cuisine
70
Objective function
60
50
Cooking
constraint
40
Freezing
constraint
30
20
Optimal solution
Feasible (P = 45, H = 10)
region

10
Premier
Cuisine
0 10 20 30 40 50 60

31
Corner points Objective function
in feasible region value
P=0 H =0 ($60)(0) + ($45)(0) = 0
P=0 H = 40 ($60)(0) + ($45)(40) = $1800
P = 45 H = 10 ($60)(45) + ($45)(10) = $3150
P = 45 H=0 ($60)(45) + ($45)(0) = $2700
Contribution margin at the optimal solution = $3150.

32
SOLUTIONS TO CASES
CASE 20.42 (60 minutes) Pricing a professional conference: pricing strategies, relevant
costs and revenues
CGI can maximise its contribution from its annual conference by continuing to price each function separately.
This would yield a contribution of $1 095 216, which is significantly above the contribution that may be earned if
any of the flat fees were charged.
Pricing option Contribution
Separate pricing $1 095 216
Flat fee options:
$650 546 896
600 512 064
$550 $460 648
(a) Contribution analysis for separate pricing (estimated hotel registrations = 60% 2 000 = 1 200)
Estimated
Function Attendance Revenue Expense Contribution
Registration 100% 2 000 = 2 000 $1 000 000 $0 $1 000 000
Reception 100% 2 000 = 2 000 0 300 000 (300 000)
Plenary address* 100% 2 000 = 2 000 0 0* 0
Keynote luncheon 90% 2 000 = 1 800 144 000 108 000 36 000
Six concurrent sessions* 70% 2 000 = 1 400 112 000 0* 112 000
Plenary session* 70% 2 000 = 1 400 84 000 0* 84 000
Six workshops 50% 2 000 = 1 000 100 000 0* 100 000
Banquet 90% 2 000 = 1 800 $270 000 $216 000 $54 000
Hotel credit for free rooms:

1200
(9 216) 9 216
(
50 x $160 x .8 x 3 )
Total $1 710 000 $614 784 $1 095 216

* Meeting rooms and halls are free when 1000 members are expected to register at the hotel.
Reflects 20% discount.

33
(b) Contribution analysis for flat fee pricing:
$650 fee $600 fee $550 fee
Number of attendees (given) 1 600 1 750 1 900
Estimated hotel registrations (60%) 960 1 050 1 140
Number of free rooms (registration divided by 50,
with no fractional credit) 19 21 22
Revenue (fee attendees) 1 040 000 1 050 000 1 045 000
Expenses
Reception ($150 100% attendees) 240 000 262 500 285 000
Plenary address * 0 0 0
Keynote luncheon ($60 90% attendees) 86 400 94 500 102 600
Six concurrent sessions* 0 0 0
Plenary session* 0 0 0
Six workshops 1 200 0 0
Banquet ($120 90% attendees) 172 800 189 000 205 200
Total expenses 500 400 546 000 592 800
Revenues less expenses 539 600 504 000 452 200
Room credit ($384 free rooms) 7 296 8064 8 448
Contribution $546 896 $512 064 $460 648
* Meeting rooms and halls are free when 1000 members register at the hotel.
Reflects 20% discount: ($160 3 days) .80 = $384

34
CASE 20.43 (90 minutes) Pricing a special order; ethics: manufacturer
1 The lowest price Swift would bid for a one-time special order of 25 000 kg (25 batches) would be $51 325,
which is equal to the incremental costs of producing the order, calculated as follows.
Direct materials:
On a one-time-only special order, chemicals used in manufacturing the firms main product have a
relevant cost of their expected future cost, represented by the current market price per kilogram.
Chemicals not used in current production, which have no other use, have a relevant cost that is their
salvage value to the firm.
CW-3: (400 kg per batch) (25 batches) = 10 000 kg.
Substitute CN-5 on a one-for-one basis to its total of 5500 kg.
The relevant cost is the salvage value. $1 000
The remaining 4500 kg would be CW-3 at a relevant cost of
$.90 per kgits expected future cost. 4 050
JX-6:(300 kg per batch) (25 batches) = 7500 kg at $0.60 per kg 4 500
MZ-8(200 kg per batch) (25 batches) = 5000 kg at $1.60 per kg 8 000
BE-7: (100 kg per batch) (25 batches) = 2500 kg.
The relevant cost per kg is $0.65 $0.20 (handling charge) = $0.45
the amount Swift could realise by selling BE-7. 1 125
Total direct materials cost $18 675
Direct labour:
(60 DLH per batch) (25 batches) = 1500 direct labour hours.
Because only 800 hours can be scheduled during regular time this month, overtime would have to
be used for the remaining 700 hours; therefore, overtime is a relevant cost of this order.
(1500 DLH) ($14.00 per DLH) $21 000
(700 DLH) ($7.00 per DLH) 4 900
Total direct labour cost $25 900
Overhead:
This special order will not increase fixed overhead costs. Therefore, fixed overhead is not relevant,
and the relevant overhead charge is the variable overhead rate, as follows:
(1500 DLH) ($4.50 per DLH)= 6 750
Total cost of special order $51 325

35
2 The price that Swift should quote Taylor for recurring orders of 25 000 kgs (25 batches) is $82 906, which
is calculated as follows.
Direct materials:
Because of the possibility of future orders, all raw materials must all be costed at the current
market price per kg.
CW-3:(10 000 kgs) ($0.90 per kg) $ 9 000
JX-6:(7500 kgs) ($0.60 per kg) 4 500
MZ-8:(5000 kgs) ($1.60 per kg) 8 000
BE-7:(2500 kgs) ($0.65 per kg) 1 625
Total direct materials cost $23 125
Direct labour:
60% of the production of a batch (900 DLH) can be done on regular time; the remaining 600 DLH
cause overtime to be incurred and are a relevant cost of this new product.
Regular time (1500 DLH) ($14.00 per DLH) $21 000
Overtime premium (600 DLH) ($7.00 per DLH) 4 200
Total direct labour cost $25 200
Overhead:
All new products should contribute to fixed overhead as well as cover all variable costs and
provide the 25 per cent markup. Therefore, the overhead charge would be:
(1500 DLH) ($12.00 per DLH) $ 18 000
Full absorption cost $ 66 325
Markup (25%) 16 581
Full manufacturing cost plus 25 markup $82 906
3 The owner of Taylor Nursery is not acting ethically in this situation. It is inappropriate to allow Swift to
revise its bid on the basis of sharing confidential information from the Dalton Industries bid. All firms
competing for the Taylor Nursery contract should be given the same product specifications, information,
and time frame with which to prepare a bid.

36
CASE 20.44 (45 minutes) Adding a product line; limited capacity: manufacturer
1 In order to maximise the companys profitability, Sportway Corporation should purchase 9000 tackle
boxes from Maple Products, manufacture 17 500 skateboards, and manufacture 1000 tackle boxes. This
combination of purchased and manufactured goods maximises the contribution per direct labour hour
available. The analysis supporting this conclusion follows:
Calculate unit contribution margins
Purchased Manufactured
Tackle Tackle Skate-

Boxes Boxes boards
Selling price $91.00 $91.00 $50.00
Less:
Material (73.00) (22.00) (17.50)
Direct labour (18.75) (7.50)
Manufacturing overhead* (6.25) (2.50)
Selling and administrative cost (4.00) (11.00) (3.00)
Contribution margin $14.00 $33.00 $19.50
Direct labour hours per unit 1.25 0.5
Contribution per hour $26.40 $39.00
*Calculation of variable overhead per unit:
Tackle boxes:
Direct labour hours $18.75 $15.00 = 1.25 hours
Overhead per direct labour hour $12.50 1.25 = $10.00
Capacity 8000 boxes 1.25 = 10 000 hours
Total overhead 10 000 hours $10 per hour = $100 000
Total variable overhead $100 000 $50,000 = $50 000
Variable overhead per hour $50 000 10,000 = $5.00
Variable overhead per box $5.00 1.25 = $6.25
Skateboards:
Direct labour hours $7.50 $15.00 = .5 hours
Variable overhead $5.00 .5 = $2.50

In calculating the contribution margin, $6.00 of fixed overhead cost per unit for distribution
must be deducted from the selling and administrative cost.
The optimal use of Sportway Corporations scarce resource (direct labour) is to manufacture skateboards,
up to the number of skateboards that the company can sell (17 500). With its remaining labour time,
Sportway can produce 1000 tackle boxes.

37
2 The following table shows the improvement in the companys total contribution margin if it manufactures
17 500 skateboards and 1000 tackle boxes, rather than manufacturing 8000 tackle boxes.
The optimal use of Sportways available direct labour hours (DLH):
DLH Balance Unit Total

per Total of contri- contri-
Item Quantity unit DLH DLH bution bution
Total hours ........................ 10 000
Skateboards ......................17 500 0.50 8750 1250 $19.50 $341 250
Make boxes .......................1 000 1.25 1250 33.00 33 000
Buy boxes .........................9 000 14.00 126 000
Total contribution ............. $500 250
Less:
Contribution from manufacturing 8000 boxes

(8000 $33.00) .........................................................................................................................
264 000
Improvement in contribution margin ...............................................................................................

$236 250

38

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CHAPTER 20

PRICING AND PRODUCT MIX DECISIONS

20.5 The economic models of pricing decisions are of limited use.

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

20.8 Three disadvantages of pricing based on absorption cost are as follows:

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Quantity sold Unit sales Total revenue Changes in

20 $500 $10 000

40 475 19 000 } $9 000

100 400 40 000

2 Total revenue curve:

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

100 445 44 500

Total cost increasesTotal revenue rate

Total cost increases at a declining rate

Quantity sold per month

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

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)

2 Total revenue and cost curves: see below.

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

1 Variable manufacturing cost

$100 000 $24 000 $168 000

$100 000 $72 000

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

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

$495 =total unit cost 1.125

= $440 ($275 + $55) $66

Cost-plus pricing formula

2 (a) Variable manufacturing cost $275 $495 = $275 + (80% $275)*

Applied fixed manufacturing cost 55

(b) Absorption manufacturing cost $330 $495 = $330 + (50% $330)

(c) Variable manufacturing cost $275

Variable selling and administrative

Total variable cost $341 $495 = $341 + (45.16% $341)**

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

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

1 Variable manufacturing cost $200 $400 = $200 + (100% $200)a

Applied fixed manufacturing cost 70

2 Absorption manufacturing cost $270 $400= $270 + (48.15% $270)b

Variable selling and administrative cost 30

Allocated fixed selling and administrative cost 50

3 Total cost $350 $400= $350 + (14.29% $350)c

Variable manufacturing cost $200

Variable selling and administrative cost 30

4 Total variable cost $230 $400= $230 + (73.91% $230)d

EXERCISE 20.27 (15 minutes) Time and material pricing: manufacturer

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Sales revenue (60 000 $18.00) $1 080 000

Less: Variable costs:

Manufacturing and administrative (60 000 $9.00) 540 000

Contribution margin 432 000

Less: Fixed costs ($180 000 + $15 000) 195 000

Profit $237 000

2 Required price on special order:

Unit contribution margin required on target additional profit

= 9.00 + 3.00 = $12.00 per unit

10 000X 10 000($9.00) = 30 000

10 000X = 120 000