Solution manual cost management measuring monitoring and motivating performance 1st by wolcott ch13

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Chapter 13
Joint Management of Revenues and Costs
LEARNING OBJECTIVES
Chapter 13 addresses the following questions:
Q1
Q2
Q3
Q4
Q5
Q6
Q7
Q8

How is value chain analysis used to improve operations?
What is target costing, and how is it performed?
What is kaizen costing, and how does it compare to target costing?
What is life cycle costing?
How are cost-based prices established?
How are market-based prices established?
What are the uses and limitations of cost-based and market-based pricing?
What additional factors affect prices?

These learning questions (Q1 through Q8) are cross-referenced in the textbook to individual
exercises and problems.

COMPLEXITY SYMBOLS
The textbook uses a coding system to identify the complexity of individual requirements in the
exercises and problems.
Questions Having a Single Correct Answer:

No Symbol
This question requires students to recall or apply knowledge as shown in the
textbook.
This question requires students to extend knowledge beyond the applications
e
shown in the textbook.

Open-ended questions are coded according to the skills described in Steps for Better Thinking
(Exhibit 1.10):

Step 1 skills (Identifying)

Step 2 skills (Exploring)

Step 3 skills (Prioritizing)

Step 4 skills (Envisioning)


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13-2 Cost Management

QUESTIONS
13.1

Just-In-Time (JIT) is an inventory management and manufacturing system where
products are manufactured as demanded and raw materials are delivered just when they
are needed in the manufacturing cycle. Very little inventory is kept on hand; suppliers
deliver small amounts on a regular basis. Organizations adopt Just-In-Time systems to

keep inventory costs down and also to better manage quality because defects are often
monitored more closely with JIT systems. Systems such as JIT are known as demandpull systems, because demand pulls inventory through the system to the point of sales.

13.2

Similarities between target and Kaizen costing:
Rely on goal setting to achieve cost reduction
Focus on product design and the manufacturing process to find ways to reduce
cost
Encourage organizations to work with suppliers to reduce costs
Use functional teams to determine where costs can be cut
Encourage employees to take an active part in the cost cutting decision making
process
Take advantage of the trade-offs among price, functionality, and quality
Focus on continuous improvements in products and processes
Differences between target and Kaizen costing:
Target costing occurs in the design and decision-making phase of product
development
Kaizen costing occurs after the product has been manufactured for the first time,
and continues throughout the life of the product.
Similarities and Difference among life cycle, target, and Kaizen costing
Life cycle costing (LCC) is similar to Kaizen costing in that cost reductions over
time are expected. LCC is different because there is no goal setting for specific
targeted costs and the product is unprofitable in the beginning of the life cycle.
In target costing, an unprofitable product is never manufactured, but under life
cycle costing the product is expected to make a profit at some time, although not
at the beginning of its life cycle.

13.3

Target and Kaizen costing are most appropriate in the following situations:
Product development and design phases are long and complex.
The production process is complex.
The market is willing to pay for differences in quality or function.
The manufacturer can push some cost reductions onto suppliers and
subcontractors.
The manufacturer can influence the design of subparts.
Students should draw from these characteristics in identifying products for which target
and kaizen costing would and would not be appropriate. For example, these methods
would be appropriate for automobile design and production, heavy equipment
manufacture, camera manufacture, computers, and electronics. Some service industries


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Chapter 13: Joint Management of Revenues and Costs 13-3
use various forms of target costing practices. For example, hospitals are reimbursed by
Medicare with a flat-fee per patient by the diagnosis the patient is given. Doctors agree
on clinical pathways, that is, the steps taken to treat the average patient with that
diagnosis. The clinical pathway is designed to cost less than the reimbursement amount.
Similarly, a CPA firm may use these methods to evaluate whether services can be
provided to achieve desired profits or whether the firm should continue offering services
to a client. Target and kaizen costing are not generally useful for simple product
manufacturing such as small toys or for food and beverages such as colas, cereals, or
pasta products.
13.4

The value chain cycle follows these processes in an organization, in a continuous manner:
research and development, product or service design, manufacturing process or service
delivery design, manufacture or service delivery, marketing, distribution, customer

service. Following are some of the benefits from value chain analysis: enhanced
efficiency, cost reduction, improvements in supplier and customer relationships, the
ability to identify and eliminate non-value-added activities, reductions in rework, scrap,
and waste, production cycle time reductions, and an increased ability to negotiate lower
prices with suppliers.

13.5

First determine the product’s target price, quality, and functionality. Then determine the
target cost. Design the product and manufacturing or delivery process to achieve the
target cost. A pilot project is set up to evaluate the feasibility of the product and process
design and operation. If the product meets the target criteria, it goes into full production.
At each stage decisions are made about whether the product will be able to meet the
price, quality, and functionality requirements. If these are not met, the product will not
be produced or the requirements will change in response to customer input.

13.6

Cost-based pricing is performed by adding a mark-up to some measure of product cost,
such as variable costs or a partially or fully allocated cost. For example, if a computer’s
variables costs were $300 and the required mark-up 100%, the price would be $600
($300 + 100%*$300).

13.7

Market based prices are determined using some measure of customer demand. Managers
identify the amount that customers are willing to pay for a good or service and set the
price at that amount. With historical information about prices and quantities sold, the
price elasticity of demand formula can be used to determine a profit-maximizing price.
Market research could be conducted and competitors’ prices could be analyzed. The

Internet is also a source for pricing information.

13.8

Supply chain analysis explores the flow of resources from the initial suppliers (inside or
outside the organization) to the delivery of products or services to customers or clients.
Often, prices of inputs are reduced through negotiations with suppliers and may entail
long-term contracts. To further reduce costs, the purchasing organization may provide
engineering or other kinds of assistance to the supplier.


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13-4 Cost Management
13.9
Common Advantages:
Use of goal setting encourages better performance
Team approach motivates employee cooperation
Allows a competitive price advantage for a short period of time
Common Disadvantages:
Stress of cost reduction environment can impair employee wellbeing
Encourages organizations to forego some products having long term profit
potential that are not profitable in the beginning
13.10 This problem is called the death spiral because as demand falls, average costs increase
because fewer units are produced. This means that price will increase because it is based
on average cost. When price increases, demand usually falls, so production will also fall,
and average cost will increase, causing prices to increase, causing demand to fall, and
finally the company goes out of business.
13.11 Not-for-profit organizations often receive donations and grants to help off-set operating
costs. Therefore they do not have to set prices so that their operating costs are recovered.

They have other organizational objectives, such as providing services to low-income
people. Hence they may set prices using a sliding scale according to ability to pay. They
may not charge for some products or services.


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Chapter 13: Joint Management of Revenues and Costs 13-5

EXERCISES
13.12 Value-Added and Non-Value-Added Activities
A. Inspection activities are non-value-added. Some organizations have very low defect
rates, making it unnecessary to inspect; that is, the product design and manufacturing
process insures high quality production. The concept of high quality is to ―do it right the
first time.‖ Some firms may inspect incoming materials to guarantee high quality during
their manufacturing processes, but these costs could be eliminated through contractual
arrangements with suppliers that include high penalties for low quality material
deliveries.
B. Moving materials to work stations could also be either value-added or non-value-added,
depending on the circumstance. In organizations that use JIT systems, the amount of
materials handling is reduced to the minimum level necessary, which reduces costs.
C. Manufacturing extra inventory to keep employees busy is non-value added if there are no
sales for the inventory.

13.13 Lickety Split
Percent change in price = ($1.93 - $1.75)/$1.75 = +10%
Percent change in demand = (1,000 – 850)/1,000 = –15%
The elasticity is ln (1 + percent change in quantity sold)/ln(1+percent change in price)
= ln(1–0.15)/ln(1+0.1)
= –0.16252/0.09531 = –1.705

Variable cost = $640/1,000
Profit-maximizing price = [–1.705/(–1.705+1)]*$0.64 = $1.55
To maximize profits, the manager needs to lower the price rather than increase it.
13.14 Harold’s Flowers
A. The elasticity is ln(1+0.35)/ln(1–0.20)
= 0.30010/–0.22314 = –1.345
Mark-up = [–1.345/(–1.345+1)] – 1 = 2.899, or 2.9
Variable cost = $0.40
Price = (2.9 x $0.40) + 0.40 = $1.56


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13-6 Cost Management
B. The elasticity is ln(1–0.12)/ln(1+0.10
= –0.12783/0.09531 = –1.341
Mark-up = [–1.341/(–1.341+1)] – 1 = 2.93
The formulas indicate that he should increase his current markup, to nearly 300%.
However, these formulas are very sensitive to errors in the estimates of price and quantity
changes, so they should be used only as guidelines. He can slowly begin increasing the
mark-up until he reaches the point where contribution margin times quantity sold
maximizes his profits.

13.15 Big Bertram
A. It is a cellular or kanban system. An employee work team manufactures each item in a
small workstation using Just-In-Time inventory control methods.
B. Each employee inspects his own work, and so defects are caught very quickly. Inventory
is delivered to each cell just as it is needed and products are made only when they are
ordered so inventory costs are minimized. Usually there are space savings.
C. A cellular system succeeds when manufacturing is continuous and the defect rates are

low. If the supplier has any problems with the software and deliveries are slow, the line
cannot manufacture anything. If there are any problems with quality, it may take longer
to get these adjusted because the software has already been released materials for
delivery. In addition, Big Bertram would want to emphasize the security aspects of the
supplier’s access to its inventory levels. Firewalls and strong security code systems
would be needed to protect the integrity of Bertram’s database and specialized software
programs. Organizations in competitive industries guard their production information to
protect their private information regarding areas of their competitive strengths.

13.16 Chrysler
A. If Chrysler had used target costing for the P.T. Cruiser, the first step would have been to
determine a market price for the new model. Focus groups and customer surveys would
have been conducted. Once the market price had been established, the required profit
margin would be subtracted, leaving the target cost. At this point a team would be
assembled of engineers, accountants, and marketing people to design the product and the
manufacturing process. If the team is able to do this at the target cost, a pilot production
line is implemented. If costs come in at the target cost, the P.T. Cruiser would go into
full production. If the target cost cannot be met, at either the design or pilot stage, the
whole process is reiterated several times. If the Cruiser never came in at the target cost,
the marketing department could do more research to see if customers would respond to an
increased price or decreased quality or function. If the target cost is never met, the
product is dropped.


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Chapter 13: Joint Management of Revenues and Costs 13-7
B. New products such as the P.T. Cruiser may be well received, or they may not be.
Consumers’ preferences vary across age groups, across geographical locations, across
income brackets, across gender lines, and many other characteristics. Because of this, the

survey and focus group information may not represent the population of consumers
needed. In addition, economic factors affect the success of a new product. None of these
can be known for certain ahead of time.

13.17 Sea Breeze Taffy
A. Elasticity = ln(1+0.20)/ln(1-0.10)
= 0.18232/–0.10536 = –1.730
B. Variable cost = $2,400/1,500 = $1.60
Profit maximizing price = [–1.730/(–1.730+1)] x $1.60 = $3.79
C. She should drop the price, but in slow increments to determine the point at which the
contribution margin times quantity sold maximizes profits.
D. The following factors could affect her price decision:
Any constraints in the resources and capacity she has available
Competitor’s actions
General economic factors, if the economy is down, she may need to lower her
price
Weather affects the number of customers and she may need to run sales during
slow times to move inventory and ingredients that have a short shelf life.

13.18 Oysters Away
[Note: This problem requires knowledge of special order decisions (Chapter 4).]
A. Elasticity = ln(1–0.15)/ln(1+0.10)
= –0.16252/0.09531 = –1.705
Variable cost (vc) = $120,000/2,000 = $60
Profit maximizing price = [–1.705/(–1.705+1)]*vc
= 2.42 x $60 = $145 per case
B. The minimum price for a special order decision is variable cost, so it is $60 for Oysters
Away.
C. Linda must be sure that there are no constraints on the amount of oysters available at this
time. She also needs to know whether there would be any increase in wages or fixed

costs if she adds more capacity. She needs to know whether other customers might find


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13-8 Cost Management
out about this price and demand lower prices. Students may think of other relevant
factors.

13.19 Blade Runner
A. Current price is equal to the cost plus 10% of the cost = 110% x $150 = $165.
B. New price = $165 – (10% x $165) = $148.50
Because the company wants to achieve a 10% return on sales, the new contribution
margin = $14.85 ($148.50 x 10%). The contribution margin takes into account both fixed
and variable product costs, because none of the costs will be incurred unless the motor
scooter is produced.
Therefore the new target cost is cost = $148.50 – $14.85 = $133.65
C. Need to reduce each cost by ($150 – $133.65)/$150 = 10.9%:
Original Amount
$ 45
15
10
10
20
25
25
$150

Target Cost
$ 40.095

13.365
8.91
8.91
17.82
22.275
22.275
$133.650

13.20 Blade Runner (continued)
A. Following are the new costs:
Direct materials
$ 40.50
Direct labor
13.50
Machining
9.20
Inspection
10.00
Engineering
16.00
Marketing
22.50
Administration
25.00
$136.70
Costs need to be reduced further by $136.70 - $133.65 = $3.05
B. The next step will be to look for more cost savings so that the target cost can be met. No
savings were mentioned for inspection, so that is one area that could be explored. Other
departments may have to cut back further to meet the target cost of $133.65. After the

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Chapter 13: Joint Management of Revenues and Costs 13-9
target cost has been met, a pilot project would be set up. If the scooter can be produced
for $133.65 in the pilot project, the product would be manufactured. If costs still were
too high, the target costing process would be reiterated.
C. Any changes in suppliers would need to be carefully considered. The reliability of the
supplier, the timeliness of delivery and quality of products supplied, all need to be
explored. If suppliers do not meet required standards, new vendors must be found, and/or
the target cost may not be met. Productivity gains by labor could reduce quality. Any
trade-offs in quality or functionality to meet the target cost need to be explored and
discouraged. The new target cost assumes no reductions in quality or functionality. For
each category: is the cost reduction actually attainable without affecting quality or
functionality? For marketing, will the cost reduction affect sales volumes? Will cutting
inspection costs mean that more defective units are sold? Will direct labor workers feel
too much pressure to continually reduce costs and turnover increase? Will the machining
department continue to be precise in their work while cutting costs?
D. Questions (i.e., uncertainties) about whether the company will be able to achieve its
planned cost reductions are listed below. Students may think of others.
Direct materials – How certain can managers be that the price set by vendors now will
continue over the next accounting period? How certain can they be that no changes in the
price of raw materials will occur?
Direct labor – How certain can managers be that labor productivity will continue to
improve? Could labor demand a pay rate increase in the next year?
Machining – How certain can managers be that no new technology will be developed,
making their current machines obsolete?
Inspection – How certain can managers be that inspectors will not demand an increase in
salaries, or that they will continue to provide high quality inspections?
Engineering – How certain can engineers be that any changes will either improve quality

or reduce costs as they anticipate?
Marketing – How certain can managers be that the popular media will not increase prices
for advertising? How certain can they be that appropriate customers are targeted in the
advertising campaigns?
Administration – How certain can managers be that administrative costs do not increase,
especially costs for computerized systems and software?


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13-10 Cost Management

PROBLEMS
13.21 Budget Cupboards
[Note: An example is provided in the textbook for students to follow in answering Part A.]
A. Here are possible answers to this question; students may think of others.
Potential Area for
Cost Reduction
Manufacturing
process

Potential Cost Reduction
(1)
Reduce inventory by using a JIT
system

Administration

Outsource functions such as
payroll if it is cheaper to do so

Changes in quality
or functionality

Identify specialty functions with
low volume sales and consider
discontinuing them

(2)
Reduce inspection by using cellular
manufacturing (also increases
flexibility so that specialty items
can be manufactured to order more
easily)
Explore software that would
increase efficiency and reduce
number of employees needed
Identify lower cost materials that
would not reduce current quality

B. To price more competitively, overall costs need to be reduced without affecting product
quality or functionality. Value chain analysis and JIT are methods that are used to reduce
costs. JIT manufacturing reduces inventory storage and insurance costs, and frees up
extra space in the manufacturing plant. If there are alternative uses for the space, the
overall contribution margin should increase. Value chain analysis enables managers to
categorize activities into value-added and non-value added. Then the non-value added
activities are eliminated or minimized to save costs. The supply chain can be analyzed to
determine whether vendors can reduce their costs or provide higher quality goods and
services at the same price.

13.22 Sandy
A. Target and kaizen costing are both market-based pricing techniques. Once the market
price is established, both methods set cost goals for production. However, target costing
occurs at the decision-making phase of product development and kaizen costing occurs
once the product has be manufactured and price reductions are anticipated. Target
costing specifies a particular cost for the product and the product will not be
manufactured unless the target cost is met. In contrast, kaizen specifies specific cost
reduction goals for the product across its life cycle.


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Chapter 13: Joint Management of Revenues and Costs 13-11
B.
Target Costing
Information Needed
Estimated selling price for a given
design and functionality
Estimates for sales volume

Estimated product costs:
Direct materials
Direct labor
Overhead costs

Uncertainties
How certain can managers be that customers will be
willing to pay the estimated price? Will competition
drive the price down?
Will competitors’ advertising campaigns affect demand?

How certain are managers that demand will not change if
economic conditions change?
How certain are managers that prices and quality will
hold over time?
How certain are they that labor productivity will meet
their estimates? Will employees demand higher pay
rates?
Will electricity rates or taxes or insurance rates
change? Will salaries for supervisory employees
increase? Will other overhead costs increase or
decrease?
If the design phase takes very long, how certain can
managers be that estimated costs will hold until
production begins?
Kaizen Costing

Information Needed
Same information as above
Estimates for cost reductions over
time:
Direct materials
Direct labor
Overhead costs

Uncertainties
Same uncertainties as above
How certain are managers that vendors will reduce
prices and maintain quality over time?
How certain are they that labor productivity will
increase over the product’s life cycle so that estimated

cost reduction goals can be met? Will employees be
willing to continually strive for productivity gains
without reducing quality or functionality?
Some costs will likely increase over time, such as
property taxes and utilities. How certain are managers
that other costs can be cut to override any cost
increases and reduce costs further? Can they find
activities to eliminate to reduce overhead costs, such
as number of set-ups?

C. Managers are able to create biased estimates under any system, by underestimating or
overestimating costs and revenues. If managers are biased toward producing particular
goods or services, they may unintentionally be very optimistic in their estimates of prices
and volumes, and overestimate them. They may also underestimate costs, not checking
with vendors to be certain that quality remains high when direct material costs are


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13-12 Cost Management
reduced. In addition, they may ask direct labor employees to estimate time under the best
circumstances, not average circumstances. Because these analyses rely on the target
costing team’s estimates, any bias in the estimates affects the decision, and potentially the
success of the product. Similarly if managers are biased against products or services,
they will underestimate volumes and prices, and overestimate costs. In this case, a
decision could be made to forego an otherwise profitable product or service.
D. Kevin needs to understand that biased estimates affect all types of analyses. An
advantage of target costing is that a pilot project is implemented before full production
begins. At this stage any optimistic biases in estimates are highly likely to be revealed.
While this method uncovers positive biases, negative biases may not be as easily

discovered. However, because target and kaizen costing use teams, individual biases are
likely to be minimized with input from a number of different people. Both target and
kaizen costing focus on market prices, and this information is relatively easy to obtain in
many industries, so team members can monitor their own biases with concrete
information from the market place or from customer surveys. All methods of decisionmaking are subject to bias, so managers must continually monitor their own and
colleagues’ tendencies toward bias as plans are developed and decisions made.

13.23 Heritage Jewelry Store
A. John is probably influenced by traditional pricing methods in this industry. The mark-ups
may be published in industry trade journals and John knows that his competitors are
using similar methods and so feels comfortable using this method.
B. Elasticity is the sensitivity of demand to changes in price. The demand for some products
is greatly affected by any change in price. For example, commodities prices are
published daily. Demand for these products is considered very elastic (very responsive to
price changes). For other products, changes in price lead to little change in demand. For
example, demand for expensive cars such as a Rolls Royce or Lotus is inelastic; it is not
very responsive to small changes in price.
C. When prices increase, consumers will not buy products for which demand is very elastic.
For example, if frost has damaged this year’s asparagus crop and the price increases,
consumers will substitute other vegetables for asparagus and demand will decrease.
However, if the weather is perfect for asparagus and the crop is large, prices decrease and
demand increases because consumers buy asparagus instead of other vegetables that are
similarly priced.
D. If John has not tracked sales and prices over the years, he does not have accurate data
with which to use in the elasticity formulas. Therefore he cannot be certain about the
accuracy of his estimates. These formulas are very sensitive to error, and if they are
based on inaccurate estimates, he may set a price that is profit-minimizing instead of
maximizing. In addition, response to changes in his prices may depend on whether his
competitors match his new prices, and John cannot know for certain whether their prices
will change.

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Chapter 13: Joint Management of Revenues and Costs 13-13
E. Elasticity of demand depends on the availability of substitutes. As more substitutes are
developed, demand becomes more elastic. In addition, as competitors enter a market,
prices may drop to levels at which demand is satisfied, and small decreases in prices will
not affect demand. As new markets open through globalization, prices may increase
because demand is greater than supply for a period of time. Students may think of other
possibilities.
F. Changes in the economy cause a shift in the demand function. If economic times are
good, people may be more willing to buy higher priced goods and services. Alternatively
if there is a downturn, people may forego some types of purchases. For example, during
a recent recession (2001 to 2003) people continued to indulge in low-priced luxury
products such as specialty coffee drinks, but cut back on large expenditures such as
luxury cars or boats. These changes in consumer preferences affect the elasticity of
demand for these products.

13.24 Haywood Ceramics
A. Under cost-based pricing, decreases in volumes result in increases in prices. Because
demand is sensitive to price, as prices increase, volumes are likely to decrease. Over time
the product is discontinued because sales do not cover costs. This is called the death
spiral.
B. There are a number of different reasons that customers would continue to shop at
Haywood or choose to shop elsewhere. If there are other ceramics studios nearby, pricesensitive customers will find another studio with better prices. Some customers may
decide to change hobbies if they believe the price increases are unwarranted. Some
customers may value their relationship with the studio and not be willing to change, even
if prices increase.
C. Pros: Customers may enjoy their relationship with the owner and be willing to accept

price increases to continue the relationship because they understand the reason for the
price increase.
Cons: Customers may not care about why prices increase, but be more concerned about
their ability to pay higher prices. These customers could be annoyed by letters explaining
the price increase and feel resentful that they cannot afford to buy at Haywood, or cannot
participate in their hobby as often.
D. Following is the recommendation of Roberta Maynard in ―Taking the Guesswork Out of
Pricing‖ (Nation’s Business, December, 1997). She recommends that small businesses
fail to consider the many interrelated factors that should affect pricing decisions. She
suggests that pricing decisions should consider the company’s costs, the expected costs of
product updates and new equipment, objectives for each product, and competitors’
products. She quotes a business consultant from Arthur Andersen who says that business
owners typically price products arbitrarily, or they base prices only on cost or on
competitors’ prices. In addition, customer perceptions, involvement of distributors and
suppliers, government regulations, ethical considerations, and economic conditions play


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13-14 Cost Management
roles. Maynard gives a coffee wholesales example of the role of communicating with
customers. When the cost of green coffee rose dramatically, the small business owner
sent a six-page letter to customers explaining how coffee prices were changing, what his
firm was doing to control costs, suggested things customers could do to reduce their
costs, and informed them of the new price and when the change would be made. He
allowed customers to place orders at current prices. He believed that his approach gave
him credibility. He didn’t lose a single customer. Students may have made a similar
recommendation.

13.25 Java Alive

[Note about problem complexity: Item A is not coded as Step 2-3 because the solution is
explicitly described in the textbook.]
A. Java Alive can develop information about prices and demand and use the profitmaximizing formula to guide their pricing decisions.
B. Other information needed includes the size of the local coffee shop market, Java Alive’s
market share, competitors’ drinks and prices, economic predictions for the local and
regional area, any seasonal variation in sales and differences in elasticity due to seasonal
variation.

13.26 Transrapid
A. Here are examples of information that could be gathered before recommending a pricing
policy; students may think of others.
Information about prices, number of train departures, and volumes from train
systems in other similar sized cities because this would give me an indication
about price and volume relationships.
Information about competing transportation systems, for example information
about prices, frequency, and volume of riders for busses in the area, or in similar
locations
Information on expected economic conditions, particular gas and parking prices
because automobiles would be a competing form of transportation so as costs to
drive a car increase, ridership on trains may increase.
B. Before making a recommendation to Transrapid, it would be wise to conduct market
research. Transrapid did this before building the system. As reported by the consultants
who worked with Transrapid:
―The engineers were thinking of a system to accommodate trains departing every
10 minutes. Research indicated, however, that the value-to-customer increased
significantly when planned departure frequency went from every hour to every


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Chapter 13: Joint Management of Revenues and Costs 13-15
half-hour to every 20 minutes. The value was only slightly increased if the
departure interval was further decreased to the planned 10 minutes. At the same
time, costs increased dramatically due to more complex electronics in the track,
more train units, more personnel, and so forth. The result: Transrapid has now
been re-engineered for scheduled departures every 20 minutes. The resulting
design simplifications and scheduling of fewer trains per hour result in savings of
hundreds of millions of dollars.‖1
Considering its pricing policies, Transrapid could set the initial price to be competitive
with other land-based transportation, such as busses and other trains. As information is
logged into its information system, a price based on product elasticity could be
developed.
C. Customer preferences may be different for this type of product than others because the
product potentially reduces the amount of time that customers travel. It is difficult to
know the value that people set on extra time. In addition, it is difficult to know whether
increasing the scheduled departure times would affect the price people are willing to pay.
Because these factors are uncertain, gathering information about their preferences could
be an important part of the pricing process. If prices are set too high, people will not try
the train service, even though they may benefit from having more time for other
activities. If prices are set too low, and need to be increased later, people may complain
and look for other modes of transportation at that point.

13.27 Hanson & Daughters
A. Elasticity = ln (1 + percent change in quantity sold)/ln(1+percent change in price)
= ln(1 – 0.10)/ln(1 + 0.10)
= –0.10536/0.09531 = –1.105
B. Variable cost (VC) = $50,000/100,000 = $0.50
Profit maximizing price = [elasticity/(elasticity + 1)] x VC
= (–1.105/(–1.105+1)] x $0.50
= 10.52 x $0.50

= $5.26
This solution assumes that Hanson has enough capacity to fill increasing volumes of
demand. The profit-maximizing price is that point where contribution margin is largest
overall, so as contribution margin decreases, volume of sales has to increase to more than
make up for the decrease in margin. If an organization cannot increase volumes to this
point, it may be better off with a higher contribution margin and sales within its relevant
range of operations.

1

Hermann Simon and Ulf Munack, ―Setting the Right Price, at Internet Speed,‖ Brandweek, August 21, 2000,
pages 22-27.


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13-16 Cost Management
C. Customers may find substitutes for the product such as a cheaper brand or another type of
juice.
D. Quality is good, the price was perceived as being reasonable, in light of quality, customer
loyalty.
E. The assumptions are that the variable cost remains constant, that elasticity is greater than
1 and constant, and that changes in the price of juice do not affect product costs or sales
of other products. In addition, the calculations are very sensitive to error, so any
measurement error could affect the price. These are strong assumptions. If they are not
met, the calculated price may not maximize profits.
F. Here is a sample recommendation. Student responses will vary, but should include the
following points.
My best estimate is that a price of $5.26 will maximize your profits. However, you
should reduce your price slowly and monitor demand and profits. Keep reducing the

price slowly until profit plateaus, and then keep the price steady at that point. You want
to identify the point at which lower prices and higher volumes maximize profits.

13.28 Bainbridge University
A. This problem is open ended because there are a variety of solutions to the university’s
problem. These solutions could involve not increasing tuition but cutting costs,
increasing tuition and not cutting costs, or a combination of tuition increases and cost
cutting. In addition, the amount that tuition could be increased is an open-ended problem
that does not have a single correct answer. The same is true of potential cost cuts, and the
combination of tuition increases and cost cuts. There are likely a number of different
optimal solutions to this problem.
B. Some class members may want to analyze competitors’ programs and tuition and
financial aid policies. Some class members could gather information to determine the
elasticity of demand for the MBA degree. Some class members may gather information
about costs, and may choose to use activity-based-costing and activity-based
management or target and kaizen costing to reduced costs. Alternatively, value-chain
analysis could be performed to provide information about costs and value-added and nonvalue added activities.
C. For this problem, an assumption is made that students will perform target costing. They
may have made a different assumption, so the steps they list will be different from these.
For target costing, the students would need to follow the target costing cycle presented in
exhibit 13.4. They would need to gather information about past volumes and tuition
levels, and current information using surveys of current and prospective students’ price
preferences. In addition, they would need information about the direct costs of the
program, number of courses offered, and number of students enrolled in different
courses. Further, information about revenues from all possible sources would need to be


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Chapter 13: Joint Management of Revenues and Costs 13-17

gathered, including all educational offerings such as executive education, CPE courses,
donations, grants, and government support.
D. Student responses will vary. At a minimum, students should consider multiple sources of
information, and they should describe some trade-offs in making the decision. Here is a
sample response.
When deciding upon an appropriate level of tuition, I would evaluate the results of
marketing research, the ability of students or other providers to pay tuition, alternative
sources of funds, and the ability of the university to reduce costs. For example, if market
research suggests that students are price sensitive, then the rate of tuition charged by
competitor universities and the extent of available financial support from employers or
governmental agencies might weigh heavily in the decision. I would also consider the
university’s values and priorities. For example, some universities establish a relatively
high tuition rate, but then give scholarships to students meeting certain criteria, such as
low income, race, gender, scholastic aptitude, and so on.

13.29 Fancy Fleece
A. Because this product involved large costs for research and development before the
product could be manufactured, life cycle costing would be the best analysis method.
B. Market-based costing is the only real alternative for pricing. If cost-based pricing is used,
the price is likely to be so high that demand would be very small.
C. This is a new product with a new manufacturing process, creating many uncertainties.
For example, accountants cannot be certain that estimated costs for direct materials will
hold. Changes in prices and quantities required could affect these costs. Similarly, they
cannot be certain that direct labor will meet the productivity estimates. The direct labor
rate could also increase. Accountants cannot be certain that fixed and variable overhead
costs will remain constant. Price changes or productivity changes could affect these
estimates. They cannot know whether new technology will reduce the cost of production.
D. Because this is a new product, variable costs cannot be estimated easily. If variable costs
increase or are underestimated initially, the price based on these estimates will not cover
variable costs.

13.30 State of Arizona
A. Not-for-profit organizations usually have other sources of funds than revenues from their
products and services. This allows them to set prices based on different objectives than
just contribution margin. Some not-for-profits charge based on customer ability to pay,
and they may provide services for free to low-income customers. For-profit
organizations usually set one price for all customers, and the price includes a profit
margin.


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13-18 Cost Management

B. Fees for caves in national parks, such as Oregon Caves National Monument, are $7.50 for
adults and $5.00 for children. Kentucky Caverns are priced at $10.95 for adults and
$6.95 for children. Carlsbad Caverns in New Mexico charges $6.00 for adults and $3.00
for children to enter the park, and an additional $8.00 for adults and $5.00 for children to
take a guided tour.
C. Information about other attractions in the local area could be gathered, for example prices
for mine tours, entrance fees for any other types of similar tourist activities that could
substitute for the cave tours. Surveys of tourists at nearby natural attractions, such as the
Grand Canyon would provide information about pricing. Focus groups could be held
with local residents touring the facility and then providing information about acceptable
prices.
D. Because tourists can substitute among activities, the price for tours is likely to affect
volume. Because national park entrance fees are $5 to $6, prices set similarly would
probably attract the highest volume of tourists, but this may not be the profit-maximizing
price. It is possible that prices up to $10 to $15 would result in lower volumes, but a
larger contribution. If capacity limits are a problem, prices could be increased during

times when demand exceeds capacity and lowered when demand is low.
E. There is no one answer to this part. Sample solutions and a discussion of typical student
responses will be included in assessment guidance on the Instructor’s web site for the
textbook (available at www.wiley.com/college/eldenburg

13.31 Burton Turner and Short Whittum
A. The following pricing policies are available: cost-based pricing and market-based
pricing.
B. This is an open-ended problem and has no single, ―correct‖ solution. There are many
different cost-based prices that could be developed, depending on the cost definition
used. Because the cost of wholesale gasoline varies widely, retail prices also vary
widely. Information for setting market-based pricing could be competitors’ prices, or
could be developed from the relationship between price and demand.
C.
1. Turner and Whittum may see nothing wrong with their desire to collude in setting
prices. They may feel that they each have loyal customers who will continue to use
their services even if small price differences arise.
2. Regular customers may not care whether the prices are collusively set because they
value their relationships with the owner more than responding to changes in prices.
However, over time prices could become higher than in nearby communities and
local and out of town customers might feel resentful at having to pay more in this
town.


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Chapter 13: Joint Management of Revenues and Costs 13-19
3. Government officials would see Turner and Whittum’s behavior as collusion in
setting prices. Even if gas and service prices are similar to prices in nearby small
towns, government officials believe that prices should be set independently by

competitors to guarantee free market economies.
D. Legally, Turner and Whittum are prohibited from colluding on prices. From an ethical
point of view, price collusion is detrimental to the local business environment and should
not occur. Therefore, both viewpoints would condemn collusion because it restricts free
trade. Legal consequences are more stringent than ethical consequences.
E. Because the town is so small, local residents cannot know whether both owners are
monitoring each other’s prices and pricing competitively or colluding on prices.
However, if prices are set competitively, they would increase relatively slowly, and are
likely to be affected only by increases in underlying costs. The Wall Street Journal
occasionally carries reports of large companies in the fast food or airlines industries that
raise prices expecting others to follow suite, and finally reduce their prices because no
one else increased prices. If prices are set collusively, they would increase because both
parties agree to the increase, so it is likely that they would be higher under collusion than
under competition. If prices are higher for services in this small town, local residents are
paying more than they should. This could mean unnecessary hardship for some people
on limited incomes. Because of these possibilities, price collusion is unethical.
F. Price changes can be monitored but it would be very difficult to determine that collusion
was taking place without actually recording a conversation in which prices were set
collusively, or the practice of collusive pricing was mentioned.

13.32 Mountain County Legal Services
A. Avoidable costs would be any variable costs. Supplies appear to be the only variable
costs, so the average cost of supplies of $1.20 ($6,000/5,000) would be the minimum fee.
B. Avoidable costs for the whole department would be the cost of lawyers, secretary,
supplies, and paralegal and the avoidable administrative cost, plus the $8,000 savings in
rent, or $38.00 [($178,000 + $4,000+$8,000)/5,000]. These costs would be dropped if
the program were dropped.
C. The minimum fee for all avoidable and allocated costs is $44.40 ($222,000/5,000).
D. This fee may be higher than many of the clients can afford and so volumes would drop.
Then the fee would have to be increased, and volumes would likely drop again.

E. This price would be considered arbitrary because the cost allocations are considered
arbitrary. The current allocation bases are salary for administrative costs and space
occupied for rent. The use of other allocation bases would result in different amounts of
allocations, and a different pricing structure.


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13-20 Cost Management
F. The county executive may rely on those closer to the clients to determine how to best
carry out instructions. Alternatively, the executive may not have analyzed the
information and realize that there are a number of different ways to interpret the edict.

13.33 French Perfumery
A. Breezy
Sales volume
Price
Revenue
Variable costs
Contribution margin

Original Data
New Price and Demand
200,000
160,000
$6.00
$6.60
$1,200,000
800,000
$ 400,000

$1,056,000
640,000
$ 416,000

B. The uncertainty depends on several factors. The problem does not indicate how
accountants estimated these amounts. If optical character readers tracked changes in
prices and volumes, the estimates might be relatively accurate. However, the profitmaximizing formula is sensitive to small changes in estimates. Measurement error could
reduce the ability to anticipate how changes in price will affect demand. Other factors
that could affect demand are competitors’ prices, the availability of close substitutes, and
economic downturns.


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Chapter 13: Joint Management of Revenues and Costs 13-21

BUILD YOUR PROFESSIONAL COMPETENCIES
13.34 Focus on Professional Competency: International/Global Perspective
A.
1. Global competition results in increased pressure on prices at a given level of quality
and functionality. Compared to domestic competitors, global competitors may have
lower prices from lower resource costs (such as labor), more efficient production
facilities, or greater product innovation. Thus, global competition places more
pressure on companies to compete effectively and operate efficiently. To maintain
low prices but still pay attention to quality and functionality, costs must be managed.
The most competitive companies succeed in a global economy and, therefore, cost
management is crucial.
2. As more firms enter markets, prices become more competitive. As markets go global,
many more firms enter these markets and, therefore, the degree of price

competitiveness increases, placing downward pressure on prices.
B.
1. Any information gathered from public sources is not generally considered to be
espionage. Because products are readily available for sale, a competitor may
purchase a competitor’s product, tear it apart, and rebuild it. Many companies
routinely reverse-engineer competitors’ products. In addition, a quick search on the
Internet will confirm that many engineering companies can be hired for reverseengineering projects.
Although reverse-engineering is common, legal issues sometimes arise. For example,
during the 1990s Intel and AMD battled each other in the courts over AMD’s reverseengineering of Intel’s computer chips. The two companies ultimately reached an outof-court settlement, and during 2004 technology experts claimed that Intel has since
reverse-engineered one of AMD’s computer chips.2 In the 2004 Intel case, it appears
that the reverse-engineering involved Intel’s use of documentation made publicly
available by AMD.
In the 2004 Intel case, one commentator argued that ―there’s a distinction between
reverse engineering and using public documents to engineer a competitive product.‖3
This comment makes it clear that at least some people believe it is acceptable to use
publicly available information but that it is unethical to take a competitor’s product
apart to learn how it was made. The ethical issues surrounding reverse-engineering
are murky. It is clear that conflicts of interest exist between companies, and these
conflicts can lead to ethical as well as legal questions. Social issues also exist, as
discussed in Part B.2.

2

See, for example, Tom Halfhill, ―Be Thankful for Reverse-Engineering,‖ Maximum PC, June 2004, available at
www.maximumpc.com/reprints/reprint_2004-06-01b.html.
3
Mark Devlin, ―64-Bit Battle Rages: Who Will Win the Duel?‖ Desktop Engineering, June, 2004, available at
www.deskeng.com/index.php?option=content&task=view&id=41&Itemid=54.

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13-22 Cost Management
2. Reverse engineering has several social costs and benefits. Consumers are likely to
benefit, because reverse engineering often increases price competition and may also
improve product features. At the same time, the business environment often becomes
more competitive and some competitors could exit the market, leaving only a few
firms who might serve customers less well. The effects of reverse-engineering on
innovation are unclear. Some people argue that product innovation is harmed from
reverse engineering; they believe that companies are more likely to invest in
innovation when they are protected from this type of competition through patent or
copyright laws. However, others argue that innovation increases when companies are
threatened by reverse-engineering because companies are forced to innovate even
more to stay ahead of their competitors.4
3. As manufacturing jobs are lost, they are generally not replaced by other high-paying
jobs for people with relatively low levels of education. Some new job creation that
does not pay well occurs in service industries such as fast foods. Some new job
creation occurs in the technology sector, where people need higher levels of
knowledge and education. This creates a social problem, especially when the
education systems are not well-funded. On the other hand, consumers generally
benefit from lower prices as manufacturers reduce their costs. Reduced prices allow
consumers to purchase more goods and help keep inflation levels low.
C.
1. Global supplier demographics are the characteristics, such as the number, location,
age, and size of companies that supply a product.
2. If there are a number of suppliers located nearby and these companies have been in
business for a long time and are very reliable, resource costs tend to be lower than
otherwise. If there are few suppliers, their locations are distant, and there is little
information about their reliability because they are relatively new to the business,
costs could be higher.

3. Global customer demographics are the characteristics of customers—their locations,
size, number, age, buying patterns, and so on.
4. If there are a large number of customers, prices can probably be set lower because
large volumes of products are sold at competitive prices. Alternatively, if there are
few customers, sellers may need to concentrate on both price and quality, but prices
will tend to be higher because fixed costs need to be covered by the contribution
margins from these few customers. On the other hand, changes in global customer
demographics can lead to greater demand that increases selling prices, particularly if
product supply does not keep pace with the increased demand.

4

See, for example, Mark A. Haynes, ―Commentary: Black Holes of Innovation in the Software Arts,‖ available at
www.law.berkeley.edu/journals/btlj/articles/vol14/Haynes/html/text.html.


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Chapter 13: Joint Management of Revenues and Costs 13-23
D.
1. Many sources of information are available about how to communicate effectively in a
given global setting. Sources include books about languages and customs, articles,
college courses, and seminars.
2. Communication involves all verbal and nonverbal interactions with others.
Differences in communication between domestic and foreign settings vary by setting.
Below are some of the common differences; students may think of others.
Business etiquette
Expected gender roles
Expression of or deferral to authority
Negotiating tactics

Gift-giving protocols
Dress codes
Meal and entertainment expectations
Dietary choices

13.35 Integrating Across the Curriculum: Information Technology
A. No, the new system is not likely to completely eliminate out-of stock occurrences.
Although it will track inventory levels across the supply chain, out-of-stock occurrences
could still occur when demand for a given part exceeds forecasts or when delays occur in
manufacturing or delivery. However, the company should experience fewer out-of-stock
occurrences under the new system than under the old one because the new system tracks
activity for all parts, not just the 100 highest-cost and best-selling ones.
B. Students do not know exactly how Mopar does business with its customers, so they need
to speculate, which is a more difficult task. Most likely, Mopar’s customers are parts
distributors and, perhaps, individual auto repair shops. Those companies’ customers are
individual consumers who need a part to repair a vehicle. When an average consumer
brings a vehicle to a repair shop, they expect most parts to be available that same day.
This means that some company—the repair shop or a nearby distributor—must carry a
large number of parts that can be delivered immediately. Accordingly, Mopar’s ability to
institute a JIT inventory management system could depend on whether its customers
demand fast delivery. If Mopar would lose significant amounts of sales if it is no longer
to meet fluctuating demand for parts, then a JIT system might not be possible for its
deliveries to customers. However, Mopar could still institute a JIT system for delivery of
raw materials to its production systems. It could use forecasted deliveries to its
customers, plus some amount of safety stock for its own warehouses, to plan its
manufacturing operations.
C. Data can be inaccurate because of errors, such as entry of incorrect part numbers, when
inventory is transferred. It can also be accurate because of errors in counting and
compiling physical inventory counts. Mopar’s new system relies on the accuracy of
inventories at each of its own warehouses as well as the accuracy of suppliers’ and

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13-24 Cost Management
customers’ inventories. Thus, errors in any of these systems will cause inaccuracies in
the data used by Mopar to forecast production and shipment requirements.
D. The use of electronic systems for recording inventory movement, such as bar codes or
RFID tags, can reduce errors caused by human transaction entry. Errors can also be
reduced by frequently counting physical inventories and adjusting accounting records to
the physical counts. These controls also reduce database inaccuracies caused by
inventory theft, by providing managers with more timely information about inventory
shrinkage problems. Additional controls to prevent inventory theft include security, such
as warehouse access restrictions and computerized controls over the inventory database.
E. The estimate of annual savings from reduced backorders and rush orders was probably
based on probability distributions of these events under the new and old systems. For
example, think about a part that was not individually tracked under the old system.
Mopar had information about prior period inventory levels, but it did not have records
about the quantity and timing of individual sales or of inventory levels at its suppliers or
customers. The new system allows the company to monitor these items. Over time, this
monitoring will allow Mopar to better forecast its inventory needs. The estimated
savings consist of two items: (1) a reduced probability of backorders for the part times an
estimated cost of fulfilling a backorder, and (2) a reduced probability of rush orders for
the part times an estimated cost of fulfilling a rush order. The probabilities would most
likely be developed from the system software itself; the company would establish an
acceptable probability of these events, and the system would build these probabilities into
the production and distribution forecasts. The estimated costs of filling a backorder or a
rush order could be based on an analysis of the incremental costs associated with these
activities. The annual savings estimates depend on assumptions about the new system’s
ability to achieve given probabilities of backorder and rush order events, and it also

assumes that the company can accurately estimate the costs of these events. An
assumption also exists that the new system does not alter manufacturing costs.