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Strategic Accounting for Management

Chapters 9 and 7 solutions to the Essential


Activities
Solutions to:
Questions: 9.1, 9.5, 9.6, 9.8, 9.10, 7.1, 7.3, 7.8
Exercises: 9.16, 9.18, 9.21, 7.20, 7.22
Self-assessment problem: 7.26
Question 9.1
1.

customers

2.

competitors

3.

costs.

The three major influences on pricing decisions are:

Question 9.5 Two alternative starting points for long-run pricing decisions
are
1.
Market-based pricing, an important form of which is target pricing.
The market-based approach asks, Given what our customers want and how
our competitors will react to what we do, what price should we charge?
2.
Cost-based pricing which asks, What does it cost us to make this
product and, hence, what price should we charge that will recoup our costs
and achieve a target return on investment?
Question 9.6 Cost-plus pricing is a pricing approach in which managers add
a mark-up to cost in order to determine price.
Question 9.8 Two examples where the difference in the costs of two
products or services is much smaller than the differences in their prices
follow:
1. The difference in prices charged for a telephone call, hotel room or car
rental during busy versus slack periods is often much greater than the
difference in costs to provide these services.
The difference in costs for an airplane seat sold to a passenger travelling on
business or a passenger travelling for pleasure is roughly the same.
However, airline companies price discriminate. They routinely charge
business travellersthose who are likely to start and complete their travel
during the same week excluding the weekenda much higher price than
pleasure travellers who generally stay at their destinations over at least one
weekend.

Question 9.10
Customer profitability analysis highlights to managers
how individual customers differentially contribute to total profitability. It
helps managers to see whether customers who contribute sizably to total
profitability are receiving a comparable level of attention from the
organisation.
Question 7.1
In market-based pricing we observe the market for the prices of similar
products or services and make adjustments where our product exhibits
attributes that are different from those of existing products. If we adopt a
cost-based approach to pricing we first establish the costs of the product or
service then add the desired mark-up to arrive at the selling price. In
reality, we will refer to the market to assess the validity of this price.
Question 7.3
Value engineering is a systematic evaluation of all aspects of the valuechain business functions, with the objective of reducing costs while
satisfying customer needs. Value engineering via improvement in product
and process designs is a principal technique that companies use to achieve
target costs per unit.
Question 7.8
Three benefits of using a product life-cycle reporting format are:
1.
The full set of revenues and costs associated with each product
becomes more visible.
2.
Differences among products in the percentage of total costs
committed at early stages in the life cycle are highlighted.
3.
Interrelationships among business function cost categories are
highlighted.

Exercise 9.16
All amounts in thousands of A dollars
Wholesale

Retail
Down
under
Stereo

World
market

$580,000

$130,000

$100,000

30,000

40,000

7,000

500

Revenues (at
actual prices)

390,000

540,000

123,000

99,500

Cost of goods
sold

325,000

455,000

118,000

90,000

Gross margin

65,000

85,000

5,000

9,500

Delivery

450

650

200

125

Order
processing

800

1,000

200

130

Sales visit

5,600

5,500

2,300

1,350

Total cust.level optg.costs

6,850

7,150

2,700

1,605

$ 58,150

$ 77,850

Revenues at list
prices
Price discounts

Australia
Wholesaler

New
Zealand
Wholesaler

$420,000

Customer-level
operating costs

Customer-level
operating
income

2,300

7,895

2. Customer Distribution Channels

Wholesale Customers

Revenues (at actual prices)

Total

Total

Australian

New Zealand

Total

Down under

World

(all customers)

Wholesale

Wholesaler

Wholesaler

Retail

Stereo

Market

(1) = (2) + (5)

(2) = (3) + (4)

(3)

(4)

(5) = (6) + (7)

(6)

(7)

$390,000

$540,000

$123,000

$99,500

$1,152,500

$930,000

1,006,305

794,000

146,195

136,000

45,000

38,000

101,195

$ 98,000

Customer-level costs
Customer-level operating income
Distribution-channel costs
Distribution-channel-level oper. income
Corporate-sustaining costs
Operating income

Retail Customers

331,850 a
$ 58,150

65,000
$

36,195

(all amounts in $000s)


a

Cost of goods sold + Total customer-level operating costs from Requirement 1

$222,500

462,150 a

120,700 a

212,305

$ 77,850

10,195
7,000
$

3,195

2,300

91,605 a
$ 7,895

3.
If corporate costs are allocated to the channels, the retail channel
will show an operating loss of $10,805,000 ($3,195,000 $14,000,000), and
the wholesale channel will show an operating profit of $47,000,000
($98,000,000 $51,000,000). The overall operating profit, of course, is still
$36,195,000, as in requirement 2. There is, however, no cause-and-effect
or benefits-received relationship between corporate costs and any
allocation base, i.e., the allocation of $51,000,000 to the wholesale
channel and of $14,000,000 to the retail channel is arbitrary and not useful
for decision-making. Therefore, the management of Ramish Electronics
should not base any performance evaluations or investment/disinvestment
decisions based on these channel-level operating income numbers. They
may want to take corporate costs into account, however, when making
pricing decisions.

Exercise 9.18 Customer profitability, distribution


1.

1.

The activity-based costing for each customer is:


Charleston

Chapel Hill

Pharmacy

Pharmacy

Order processing,
A$40 13; A$40 10

A$ 520

A$ 400

351

540

350

500

154

200

80

2. Line-item ordering,
A$3 (13 9; 10 18)
3. Store deliveries,
A$50 7; $50 10
4. Carton deliveries,
A$1 (7 22; 10 20)
5. Shelf-stocking,
A$16 (7 0; 10 0.5)
Operating costs

A$1375

A$1720

The operating profit for each customer is:


Charleston

Chapel Hill

Pharmacy

Pharmacy

Revenues,
A$2 400 7; A$1 800 10

A$16 800

A$18 000

14 700

16 500

Gross margin

2 100

1 500

Operating costs

1 375

1 720

Operating profit

A$

Cost of goods sold,


A$2 100 7; A$1 650 10

725

A$ (220)

Chapel Hill Pharmacy has a lower gross margin percentage than Charleston
(8.33% vs. 12.50%) and consumes more resources to obtain this lower margin.
Strong should use Charleston as a benchmark to find out in what areas and
how to improve the profitability of business with Chapel. Most of the resource
consumption measures reported is relatively high for Chapel given the revenue
earned. Strong should meet with Chapel to talk about the feasibility of fewer
and larger orders leading to fewer store deliveries which would reduce costs
and increase average revenue per delivery.
2.

Ways in which Ross Ltd could use this information include:


a) Pay increased attention to the top 20% of the customers. This could
entail asking them for ways to improve service.

b) Alternatively, you may want to highlight to your own personnel the


importance of these customers; e.g., it could entail stressing to
delivery people the importance of never missing delivery dates for
these customers.
c) Work out ways internally at Ross Ltd to reduce the rate per cost driver;
e.g., reduce the cost per order by having better order placement
linkages with customers. This cost reduction by Ross Ltd will improve
the profitability of all customers.
d) Work with customers so that their behaviour reduces the total systemwide costs. At a minimum, this approach could entail having
customers make fewer orders and fewer line items. This latter point is
controversial with students; the rationale is that a reduction in the
number of line items (diversity of products) carried by single-stores
may reduce the diversity of products Ross Ltd carries.

Exercise 9.21 Cost-plus, target return on investment pricing


1. Target operating income = Return on capital in dollars = $13,000,000 10%
= $1,300,000
2.
Revenues*

$6,000,000

Variable costs [($3.50 + $1.50) 500,000


cases

2,500,000

Contribution margin

3,500,000

Fixed costs ($1,000,000 + $700,000 +


$500,000)

2,200,000

Operating income (from requirement 1)

$1,300,000

* solve backwards for revenues

Selling price =

$6,000,000
= $12 per case.
500,000 cases

Mark-up % on full cost


Full cost = $2,500,000 + $2,200,000 = $4,700,000
Unit cost = $4,700,000 500,000 cases = $9.40 per case
Mark-up % on full cost =

$12 - $9.40
= 27.66%
$9.40

3.
Budgeted Operating Income
For the year ending December 31, 20xx
Revenues ($14 475,000
cases*)

$6,650,000

Variable costs ($5 475,000


cases)

2,375,000

Contribution margin

4,275,000

Fixed costs

2,200,000

Operating income

$2,075,000

* New units = 500,000 cases 95% = 475,000 cases

Return on investment =

$2,075,000
= 15.96%
$13,000,000

Yes, increasing the selling price is a good idea because operating income
increases without increasing invested capital, which results in a higher return
on investment. The new return on investment exceeds the 10% target return
on investment.

Exercise 7.20 - Cost-plus target return on investment pricing


1.
capital

Target operating income = target return on investment invested

Target operating income (25% of A$900 000)


Total fixed costs

A$225 000
375 000

Target contribution margin

A$600 000

Target contribution per room-night, (A$600 000 15 000) A$40


Add variable costs per room-night

Price to be charged per room-night

A$45

Proof
Total room revenues (A$45 15 000 room-nights)

A$675 000

Total costs:
Variable costs (A$5 15 000)

A$ 75 000

Fixed costs

375 000

Total costs

450 000

Operating income

A$225 000

The full cost of a room-night = Variable cost per room-night + fixed cost per
room-night
The full cost of a room-night =
A$30

A$5 + (A$375 000 15 000) = A$5 + A$25 =

Mark-up per room-night = Rental price per room-night Full cost of a roomnight
= A$45 A$30 = A$15
Mark-up percentage as a fraction of full cost = A$15 A$30 = 50%
2.
If price is reduced by 10%, the number of room-nights Dubois
could rent would increase by 10%.
The new price per room would be 90% of A$45

A$40.50

The number of rooms Dubois expects to rent is 110% of 15 000


The contribution margin per room would be A$40.50 A$5
Contribution margin (A$35.50 16 500)

16 500
A$35.50

A$585 750

Because the contribution margin of A$585 750 at the reduced price of A$40.50
is less than the contribution margin of A$600 000 at a price of A$42, Dubois
should not reduce the price of the rooms. Note that the fixed costs of A$375
000 will be the same under the A$42 and the A$37.80 price alternatives and
hence, are irrelevant to the analysis.

Exercise 7.22 Life-cycle product costing


1.

Variable cost per unit = Production cost per unit + Mktg and distribn. cost per unit
= $50 + $10 = $60

Total fixed costs over life of Boast = A$6 590 000+ A$1 450 000+ A$19 560 000+
A$5 242 000+ A$2 900 000

= $35,742,000
BEP in units =

Fixed costs
$35,742,000
= 714,840 units
=
Selling price Variable cost per unit
$110 $60

2a.
Revenues ($110 1,500,000 units)

$165,000,000

Variable costs ($60 1,500,000 units)

90,000,000

Fixed costs

35,742,000

Operating income

$ 39,258,000

2b.
Revenues
Year 2 ($240 100,000 units)

$ 24,000,000

Years 3 & 4 ($110 1,200,000 units)


Total revenues

132,000,000
156,000,000

Variable costs ($60 1,300,000 units)

78,000,000

Fixed costs

35,742,000

Operating income

$ 42,258,000

Over the products life-cycle, Option B results in an overall higher operating


income of $3,000,000.
3. Before selecting its pricing strategy, Insync Ltd managers should evaluate
whether the same pricing policy will be adopted globally. Different markets
may need different pricing. For example, special taxes on imports may mean
higher prices in foreign markets Insync Ltds pricing strategy must be sensitive
to changing customer preferences and reactions of competitors.

Self-assessment Problem 7.26 Target prices, target costs, value


engineering, cost incurrence, locked-in cost, activity-based costing
1.
New CP99

Old CP99
Cost Change
Direct materials
costs
Direct
manufacturing
labour costs

A$2.20 7 000 = A$15 400


A$182 000 less

A$166 600

28 000 A$0.50 7 000 = A$3 500 less

24 500

Machining costs

Unchanged because capacity


31 500 same

31 500

Testing costs

(20% 2.5 7 000) A$2 =


35 000 A$7 000

28 000

Rework costs

14 000 (See Note 1)

5 600

Ordering costs

3 360 (See Note 2)

2 100

Engineering costs
Total
manufacturing costs

Unchanged because capacity


21 140 same
A$315 000

21 140
A$279 440

Note 1:
10% of old CP99s are reworked. That is, 700 (10% of 7000) CP99s made are
reworked. Rework costs = A$20 per unit reworked 700 = A$14 000. If rework
falls to 4% of New CP99s manufactured, 280 (4% of 7000) New CP99s
manufactured will require rework. Rework costs = A$20 per unit 280 =
A$5600.
Note 2:
Ordering costs for New CP99 = 2 orders/month 50 components A$21/order
= A$2100
Unit manufacturing costs of New CP99 = A$279 440 7000 = A$39.92
2.
Total manufacturing cost reductions based on new design=A$315 000
A$279 440
= A$35 560
Reduction in unit manufacturing costs based on new design=A$35 560 7000
= A$5.08
per unit.
The reduction in unit manufacturing costs based on the new design can also
be calculated as:
Unit cost of old design, A$45 (A$315 000 7000 units) Unit cost of new

design, A$39.92 = A$5.08


Therefore, the target cost reduction of A$6 per unit is not achieved by the
redesign.
1.
Changes in design have a considerably larger impact on costs per unit
relative to improvements in manufacturing efficiency (A$5.08 versus A$1.50).
One explanation is that many costs are locked in once the design of the radiocassette is completed. Improvements in manufacturing efficiency cannot
reduce many of these costs.
Design choices can influence many direct and overhead cost categories, for
example, by reducing direct materials requirements, by reducing defects
requiring rework, and by designing in fewer components that translate into
fewer orders placed and lower ordering costs.