Cost-plus and target costing concepts The following conversation took place between Dean Lancaster, vice president of marketing, and Dina Conaway, controller of Redwood Computer Company: Dealt: I am really excited about our new computer coming out. 1 think ii will lx* a real market success. Dina: I'm really glad you think so. I know that our success will In- determined by our price. If our price is too high, our competitors will be the ones with the market success. Dean: Don't worry about it. We'll just mark our product cost up by 25% and it will all work out. I know we'll make money at those markups. By the way. what does the estimated product com look like? Dina: Well, there's the rub. The product cost looks as if it's going 10 come in at around $1,000. With a 25% markup, that will give us a selling price of $1,250. Dean: I see your concern. That's a little high. Our research indicates that computer prices are dropping and that (his type of computer should be selling for around $900 when we release it to the market. Dina: I'm not sure what to do. Dean: Let me see if I can help. How much of the $1,000 is fixed cost? Dina: About $300. Dean: There you go. The fixed cost is sunk. We don't need to consider it in our pricing decision. If we reduce the product cost by $300, the new price with a 25% markup would be right at $875. Boy, I was really worried for a minute there. 1 knew something wasn't right. How might target costing be used to help solve this pricing dilemma?

The following series of statements or phrases are associated with product life-cycle viewpoints. Identify whether each one is associated with the marketing, production, or customer viewpoint. Where possible, identify the particular characteristic being described. If the statement or phrase fits more than one viewpoint, label it as interactive. Explain the interaction. a. Sales are increasing at an increasing rate. b. The cost of maintaining the product after it is purchased. c. The product is losing market acceptance and sales are beginning to decrease. d. A design is chosen to minimize post-purchase costs. e. Ninety percent or more of the costs are committed during the development stage. f. The length of time that the product serves the needs of a customer. g. All the costs associated with a product for its entire life cycle. h. The time in which a product generates revenue for a company. i. Profits tend to reach peak levels during this stage. j. Customers have the lowest price sensitivity during this stage. k. Describes the general sales pattern of a product as it passes through distinct life-cycle stages. l. The concern is with product performance and price. m. Actions taken so that life-cycle profits are maximized. n. Emphasizes internal activities that are needed to develop, produce, market, and service products.

Jolene Askew, manager of Feagan Company, has committed her company to a strategically sound cost reduction program. Emphasizing life-cycle cost management is a major part of this effort. Jolene is convinced that production costs can be reduced by paying more attention to the relationships between design and manufacturing. Design engineers need to know what causes manufacturing costs. She instructed her controller to develop a manufacturing cost formula for a newly proposed product. Marketing had already projected sales of 25,000 units for the new product. (The life cycle was estimated to be 18 months. The company expected to have 50 percent of the market and priced its product to achieve this goal.) The projected selling price was 20 per unit. The following cost formula was developed: Y=200,000+10X1 where X1=Machinehours(Theproductisexpectedtouseonemachinehourforeveryunitproduced.) Upon seeing the cost formula, Jolene quickly calculated the projected gross profit to be 50,000. This produced a gross profit of 2 per unit, well below the targeted gross profit of 4 per unit. Jolene then sent a memo to the Engineering Department, instructing them to search for a new design that would lower the costs of production by at least 50,000 so that the target profit could be met. Within two days, the Engineering Department proposed a new design that would reduce unit-variable cost from 10 per machine hour to 8 per machine hour (Design Z). The chief engineer, upon reviewing the design, questioned the validity of the controllers cost formula. He suggested a more careful assessment of the proposed designs effect on activities other than machining. Based on this suggestion, the following revised cost formula was developed. This cost formula reflected the cost relationships of the most recent design (Design Z). Y=140,000+8X1+5,000X2+2,000X3 where X1=MachinehoursX2=NumberofbatchesX3=Numberofengineeringchangeorders Based on scheduling and inventory considerations, the product would be produced in batches of 1,000; thus, 25 batches would be needed over the products life cycle. Furthermore, based on past experience, the product would likely generate about 20 engineering change orders. This new insight into the linkage of the product with its underlying activities led to a different design (Design W). This second design also lowered the unit-level cost by 2 per unit but decreased the number of design support requirements from 20 orders to 10 orders. Attention was also given to the setup activity, and the design engineer assigned to the product created a design that reduced setup time and lowered variable setup costs from 5,000 to 3,000 per setup. Furthermore, Design W also creates excess activity capacity for the setup activity, and resource spending for setup activity capacity can be decreased by 40,000, reducing the fixed cost component in the equation by this amount. Design W was recommended and accepted. As prototypes of the design were tested, an additional benefit emerged. Based on test results, the post-purchase costs dropped from an estimated 0.70 per unit sold to 0.40 per unit sold. Using this information, the Marketing Department revised the projected market share upward from 50 percent to 60 percent (with no price decrease). Required: 1. Calculate the expected gross profit per unit for Design Z using the controllers original cost formula. According to this outcome, does Design Z reach the targeted unit profit? Repeat, using the engineers revised cost formula. Explain why Design Z failed to meet the targeted profit. What does this say about the use of unit-based costing for life-cycle cost management? 2. Calculate the expected profit per unit using Design W. Comment on the value of activity information for life-cycle cost management. 3. The benefit of the post-purchase cost reduction of Design W was discovered in testing. What direct benefit did it create for Feagan Company (in dollars)? Reducing post-purchase costs was not a specific design objective. Should it have been? Are there any other design objectives that should have been considered?

Cost Behavior, High-Low Method, Pricing Decision Fonseca, Ruiz, and Dunn is a large, local accounting firm located in a southwestern city. Carlos Ruiz, one of the firms founders, appreciates the success his firm has enjoyed and wants to give something back to his community. He believes that an inexpensive accounting services clinic could provide basic accounting services for small businesses located in the barrio. He wants to price the services at cost. Since the clinic is brand new, it has no experience to go on. Carlos decided to operate the clinic for 2 months before determining how much to charge per hour on an ongoing basis. As a temporary measure, the clinic adopted an hourly charge of 25, half the amount charged by Fonseca, Ruiz, and Dunn for professional services. The accounting services clinic opened on January 1. During January, the clinic had 120 hours of professional service. During February, the activity was 150 hours. Costs for these two levels of activity usage are as follows: Required: 1. Classify each cost as fixed, variable, or mixed, using hours of professional service as the activity driver. 2. Use the high-low method to separate the mixed costs into their fixed and variable components. (Note: Round variable rates to two decimal places and fixed amounts to the nearest dollar.) 3. Luz Mondragon, the chief paraprofessional of the clinic, has estimated that the clinic will average 140 professional hours per month. If the clinic is to be operated as a nonprofit organization, how much will it need to charge per professional hour ? How much of this charge is variable? How much is fixed? (Note: Round answers to two decimal places.) 4. CONCEPTUAL CONNECTION Suppose the accounting center averages 170 professional hours per month. How much would need to be charged per hour for the center to cover its costs ? Explain why the per-hour charge decreased as the activity output increased. (Note: Round answers to two decimal places.)

Continuous improvement is the governing principle of a lean accounting system. Following are several performance measures. Some of these measures would be associated with a traditional standard-costing accounting system, and some would be associated with a lean accounting system. a. Materials price variances b. Cycle time c. Comparison of actual product costs with target costs d. Materials quantity or efficiency variances e. Comparison of actual product costs over time (trend reports) f. Comparison of actual overhead costs, item by item, with the corresponding budgeted costs g. Comparison of product costs with competitors product costs h. Percentage of on-time deliveries i. First-time through j. Reports of value- and non-value-added costs k. Labor efficiency variances l. Days of inventory m. Downtime n. Manufacturing cycle efficiency (MCE) o. Unused (available) capacity variance p. Labor rate variance q. Using a sister plants best practices as a performance standard Required: 1. Classify each measure as lean or traditional (standard costing). If traditional, discuss the measures limitations for a lean environment. If it is a lean measure, describe how the measure supports the objectives of lean manufacturing. 2. Classify the measures into operational (nonfinancial) and financial categories. Explain why operational measures are better for control at the shop level (production floor) than financial measures. Should any financial measures be used at the operational level? 3. Suggest some additional measures that you would like to see added to the list that would be supportive of lean objectives.

Variable and Fixed Costs, Cost Formula, High-Low Method Li Ming Yuan and Tiffany Shaden are the department heads for the accounting department and human resources department, respectively, at a large textile firm in the southern United States. They have just returned from an executive meeting at which the necessity of cutting costs and gaining efficiency has been stressed. After talking with Tiffany and some of her staff members, as well as his own staff members, Li Ming discovered that there were a number of costs associated with the claims processing activity. These costs included the salaries of the two paralegals who worked full time on claims processing, the salary of the accountant who cut the checks, the cost of claims forms, checks, envelopes, and postage, and depreciation on the office equipment dedicated to the processing. Some of the paralegals time appears to vary with the routine processing of uncontested claims, but considerable time also appears to be spent on the claims that have incomplete documentation or are contested. The accountants time appears to vary with the number of claims processed. Li Ming was able to separate the costs of processing claims from the costs of running the departments of accounting and human resources. He gathered the data on claims processing cost and the number of claims processed per month for the past 6 months. These data are as follows: Required: 1. Classify the claims processing costs that Li Ming identified as variable and fixed. 2. What is the independent variable? The dependent variable? 3. Use the high-low method to find the fixed cost per month and the variable rate. What is the cost formula? 4. CONCEPTUAL CONNECTION Suppose that an outside company bids on the claims processing business. The bid price is 4.60 per claim. If Tiffany expects 75,600 claims next year, should she outsource the claims processing or continue to do it in-house?

Cost-plus and target costing concepts The following conversation took place between Dean Lancaster, vice president of marketing, and Dina Conaway, controller of Redwood Computer Company: Dealt: I am really excited about our new computer coming out. 1 think ii will lx* a real market success. Dina: I'm really glad you think so. I know that our success will In- determined by our price. If our price is too high, our competitors will be the ones with the market success. Dean: Don't worry about it. We'll just mark our product cost up by 25% and it will all work out. I know we'll make money at those markups. By the way. what does the estimated product com look like? Dina: Well, there's the rub. The product cost looks as if it's going 10 come in at around $1,000. With a 25% markup, that will give us a selling price of $1,250. Dean: I see your concern. That's a little high. Our research indicates that computer prices are dropping and that (his type of computer should be selling for around $900 when we release it to the market. Dina: I'm not sure what to do. Dean: Let me see if I can help. How much of the $1,000 is fixed cost? Dina: About $300. Dean: There you go. The fixed cost is sunk. We don't need to consider it in our pricing decision. If we reduce the product cost by $300, the new price with a 25% markup would be right at $875. Boy, I was really worried for a minute there. 1 knew something wasn't right. 1.If you were Dina, how would you respond to Dean's solution to the pricing problem?

Flexible budgeting, performance measurement, and ethics Montevideo Manufacturing, Inc. produces a single type of small motor. The bookkeeper who does not have an in-depth understanding of accounting principles prepared the following performance report with the help of the production manager. In a conversation with the sales manager, the production manager was overheard saying, You sales guys really messed up our May performance, and it is only because production did such a great job controlling costs that we arent in even worse shape. Required: 1. Do you agree with the production manager that the manufacturing area did a good job of controlling costs? 2. Prepare a flexible budget for Montevideo Manufacturings expenses at the following activity levels: 45,000 units, 50,000 units, and 55,000 units. 3. Prepare a revised performance report, using the most appropriate flexible budget from (2) above. 4. Now what is your response to the production managers claim? 5. Assume that you have just been hired as the new accountant. You observe that the production manager is about to receive a large bonus based on the favorable materials, labor, and factory overhead variances indicated in the flexible budget prepared by the bookkeeper. Using the IMA Statement of Ethical Professional Practice as your guide, what standards, if any, apply to your responsibilities in this matter?

ABC Data; Resource-Capacity Planning; Nonfinancial Performance Indicators ZenonComputer competes at the retail level on the basis of customer service. It has invested significantresources in its customer service department. Recently, the company has installed a traditionalactivity-based costing (ABC) system to provide better cost information for pricing, decision making,and customer profitability analysis. Most of the costs of running the customer service departmentare considered committed (i.e., short-term fixed) costs (principally, personnel and equipment costs).The budgeted cost for the upcoming period is $800,000. Activity analysis, recently conducted whenthe ABC system was implemented, revealed the following information:ActivitiesPercentage ofEmployee TimeEstimated (Budgeted)Cost Driver QuantityHandling customer orders 75% 8,000 customer ordersProcessing customer complaints 10 400 customer complaintsConducting customer credit checks 15 500 credit checksRequired1. Based on the…

Life-Cycle Costing Kate Stephens, the COO of BioDerm, has asked her cost management team for a product-line profitability analysis for her firm’s two products, Xderm and Yderm. The two skin care products require a large amount of research and development and advertising. After receiving the following statement from BioDerm’s accountants, Kate concludes that Xderm is the more profitable product and that perhaps cost-cutting measures should be applied to Yderm: Required Explain why Kate may be wrong in her assessment of the relative performance of the two products. Suppose that 75% of the R&D and selling expenses are traceable to Xderm. Using this assumption, compute the life-cycle income for each product and the return on sales for each product. Consider your answers to requirements 1 and 2 with the following additional information: R&D and selling expenses are substantially higher for Xderm because it is a new product. Kate has strongly supported development of the new…

Ethics and a Cost-Volume-Profit Application Danna Lumus, the marketing manager for a division that produces a variety of paper products, is considering the divisional manager's request for a sales forecast for a new line of paper napkins. The divisional manager has been gathering data so that he can choose between two different production processes. The first processwould have a variable cost of $10 per case produced and total fixed cost of $100,000. The second process would have a variable cost of $6 per case and total fixed cost of $200,000. The selling pricewould be $30 per case. Danna had just completed a marketing analysis that projects annual sales of 30,000 cases. Danna is reluctant to report the 30,000 forecast to the divisional manager. She knows that the first process would be labor intensive, whereas the second would be largely automated with little labor and no requirement for an additional production supervisor. If the first process is chosen, Jerry Johnson, a good friend,…

Cost drivers and value chain. Torrance Technology Company (TTC) is developing a new touchscreen smartphone to compete in the cellular phone industry. The company will sell the phones at wholesale prices to cell phone companies, which will in turn sell them in retail stores to the final customer. TTC has undertaken the following activities in its value chain to bring its product to market:A. Perform market research on competing brands Design a prototype of the TTC smartphone Market the new design to cell phone companies Manufacture the TTC smartphone Process orders from cell phone companies Deliver the TTC smartphones to the cell phone companies Provide online assistance to cell phone users for use of the TTC smartphone Make design changes to the smartphone based on customer feedback During the process of product development, production, marketing, distribution, and customer service, TTC has kept track of the following cost drivers: Number of smartphones shipped by TTC Number of…

Company X produces radio equipment. Thecompany is considering the use of high-quality materials to enhance the quality of itsproducts and create a positive reputation inthe market. If the company applies the plan,the variable cost per unit would increase. Thecompany will also need to pay additionalmoney into an advertising campaign. Overall,the company expects that contributionmargin would increase. Moreover, thecompany expects that the additionaladvertising costs would be lower than theincrease in contribution margin. What wouldbe the effect of the new plan on operatingincome?

Solution Summary: The author explains target costing, which is the most popular cost estimate method, and how it solves the dilemma of pricing in the question.

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