Determine how many contracts (for 5000 seats each

Chapter 8 1 Cost Estindm and F o r e ~ m ~ n g 349
Determine how many contracts (for 5,000 seats each) your company should accept. Explain
your answer fully and state explicitly any assumptions or qualifications you feel are necessary.
8-6. The Argus Boat Company manufactures aluminum paddles for use in canoes and small
boats. Its demand for this product fluctuates from month to month depending on orders
received. ABC manufactures to order only and ships the product immediately, since it has
very little space for inventory accumulation. Its regular price is $10.00 per unit. Based on
past demand. ABC has compiled a probability distribution of demand for next month, as
shown below.
Today ABC's top salesman has asked the sales manager to authorize a special deal to
a new customer: 2,000 paddles at $9.00 each. The sales manager in turn has asked the
production manager for an estimate of costs per unit and has received the production data
shown below. This data was derived by a careful analysis of the input requirements for
various output levels and is kept in this form because costs of the inputs frequently change.
The production manager advises that input costs are currently $12 per hour for labor; $3.25
per kilogram for materials; and $0.035 per kilowatt-hour for electric energy. He further
advises that they are expected to remain at these levels over the next month, during which
tlme the special batch would be scheduled if the order is accepted.
Demand Data
Quantity
Dehnded
Der Month
.
Probabilitv
Production Data
Units of
Labor
Output
(hours)
Materials
(kg)
Energy
(kwh)
1,m
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000
11,000
12,000
477
807
1,010
1,140
1.224
1,280
1,337
1,478
1,800
2,407
3,304
4,434
500
LOW
1,500
2,OoO
2,520
3,050
3,600
4,180
4,690
5,320
5,970
6,660
4,885.71
7,600.00
9,857.14
12,000.00
13,485.71
15,071.43
17,314.29
19,400.00
22,214.29
23,600.00
25,700.00
28,200.00
P a n 3 1 Production and Cost Analysis
In addition to the regular production costs, the special batch of 2,000 paddles will
require a $3,000 setup cost for the customer's insignia to be imprinted in the metal and
another $3,000 for extraordinary packing and shipping costs. Also, the salesman has just
submitted his expense account, which contains $1,000 in expenses associated with a special
trip to see this potential new client and to bring negotiations to their present stage. ABC's
overhead costs are expected to be $24,000 next month.
(a) Derive the marginal and average cost curves from the data given and show these on a
graph.
(b) Advise the sales manager about the appropriate decision, giving full supporting reasoning and calculations.
(c) State any qualifications and reservations you have regarding your recommendation.
The Done Brown Cookie Company produces high-nutrition Brownie biscuits which it sells
to retailers for $22.55 per carton of twenty-four packets. Although demand for Brownies is
not seasonal, it nonetheless fluctuates during the year. Over the past nine months of operations demand has varied between 6,000 and 10.000 cartons per month, but there is a general
growth trend in sales.
The vice-president of corporate planning, Mr. Black, has put forward the proposal
that the firm expand its present plant. Having investigated the financial situation of Done
Brown, he suggests that the cash that the directors are considering paying out as an extra
dividend would be put to better use if invested in plant expansion and renovation. He contends that running a larger plant at half capacity would be more economical than running the
present plant.
The vice-president of production, Mr. Green, on the other hand, asserts that the plant
is running smoothly and that sales forecasts in no way indicate that a larger plant is necessary at this time. Mr. Black, though, seems to have a convincing argument, having procured
the cost figures for a competing brownie manufachuer who has a larger plant than does
Done Brown. He suggests that Done Brown should model its plant after that of the
competitor.
A task force has been assigned to study the question of expansion. It is to analyze
costs for both firms, analyze the sales forecast, as shown below, and submit its findings to
the board of directors, along with a recommended plan of action. You are the head of the
task force. Is Mr. Black correct? Should Done Brown expand its plant? Support your recommendation with discussion of the issues involved. Defend any assumptions that you feel are
necessary.
Sales Forecast: Avemge
Sales per Month
over the Next Year '
Volume
Probability
8 ,000
9,000
10,000
11,000
12,000
0.05
0.20
0.50
0.20
0.05
A
'
.
I
I
I
I
I
I
i
,
I
Chaprer 9 / Models of the Firm's Pricing Decision
395
(b) Explain the publisher's side of the argument. What is its perception of the market situation? Why does it expect both sales revenue and contribution to fall at lower prices?
The cement industry in a particular region is characterized by five f m s producing what are
highly similar products. Over the years these f m s have found that active price competition
is to be avoided, since this strategy has led to prolonged periods of low profitability. At the
same time, each fm jealously guards its market share and will quickly match any price
reduction by a competitor. Whenever costs increase for all firms, the f m s act, as if by
consensus, to raise prices concurrently to preserve their profit positions.
It has become obvious recently that a cement producer in another region is considering entering the market by building a sixth plant in the vicinity of the plants of the existing
five f m s . This firm would have higher costs per unit, however, because the existing five
f m s control all nearby sources of the basic raw material, limestone.
The existing f m s have similar cost structures and find that their marginal costs per
ton are virtually constant at $20 per ton. At current output levels of about 200,000 tons each
per annum, the f m s must cover $5 per ton in overhead costs. and they now price their
cement at $32 per ton. The potential entrant's average variable costs are expected to be 20%
higher and its total fixed costs per annum are expected to be 15% lower than those of the five
existing f m s . If entry takes place next year, the new f m is expected to gain about 10% of
the market in the first year (pricing at $32 per ton), gradually improving its position to an
equal share as a result of the very slight product differentiation invo!ved with this product.
The overall market demand for the product is expected to be constant over the next few
years, and the market price elasticity of demand is quite low, at -0.2. .
(a) Should the existing f m s practice limit pricing to forestall the entry of the sixth f m ?
What price would be necessary to'-prevent entry?
@) If the sixth fm does enter the industry, what price level would maximize contribution
for each f m after the entrant fm achieves an equal share of the market?
9-9. Fiori Pasta Company produces highquality pasta products. It has estimated its demand
curve for its spaghetti to be P = 39.898 - 0.03757Q. where Q represents thousands of
cartons (each containing five dozen packets of spaghetti) demanded per year by its wholesale
customers. Its cost of producing this spaghetti has been estimated as TC = 2,500,000 +
12Q + 0.01538Q2. Fiori is having a management meeting to reconsider its pricing strategy.
Its current price for the spaghetti is $27.50 per carton. The president, Don Fiori, wants to
maximize sales volume subject to earning a target profit of $500,000 per year. The vice
president of sales, Tony Fiori, wants to maximize sales revenue, since his bonus relates only
to sales revenue. The vice-president of production, Gina Fiori, wants to maximize profits so
they can afford to install the latest high-technology manufacturing equipment. You have
been hired to give an impartial analysis of the problem facing Fiori Pasta.
(a) Calculate the profit-maximizing price and output level, and the profits at that price
level.
(b) Calculate the price, output, and profit levels that would be preferred by Tony Fiori.
(c) Plot the TC, TR,and profit curves on a graph, and estimate from the graph the output
level that would satisfy Don Fiori. What is the associated price level?
(d) Prepare your report for presentation at the Fiori management meeting.
9-10. Two bakeries serve a small, isolated rural community. Golden Bread Company is the lowcost price leader, and Farmer's Family Bakery is the price follower. Golden's cost function
has been estimated as TC = 8,000 + 6.5Q + 0.00047Q2, where TC is the f m ' s total cost
per month and Q represents dozens of loaves of bread. The market demand curve has been
estimated as P = 24 - 0.00125Q. The market views the products of the two bakeries as
essentially similar, and so they share the market equally when their prices are equal.
Popular Bakery is a major city bakery that is considering entering the rural market. Its
production facilities are large, and its average variable cost per unit is constant at a level
about 20% less than Golden's minimum average cost. However, the additional transportation cost that Popular would have to incur would mean that its delivered cost would be about
i/
Chaprer 10 / Pricing Decisions in Practice
453
(c) Was the study worth it? Will it pay for itself in the future weeks?
The Archibald Truck Service (ATS) Company has been successfully servicing and repairing large trucks and tractor trailers for several years, specializing in Kenworth, Peterbilt,
and Mack tractor service. Their pricing policy on each job is to charge $25 per hour labor
and the "book price" for materials and replacement parts. The labor charge represents the
actual cost to ATS plus 25%, and the "book prices" represent the invoice cost of the
materials and parts plus 25%. Thus, ATS effectively sets price by marking up its direct
costs by 25%. The founder and general manager, Mr. Joseph Archibald, reasons that this
relatively low price structure is the best approach, since there is a lot of repeat business in
service and repair work. He would rather have more work in the present period and maximize profits over the longer term.
For a typical service and repair job his cost is $600, and he charges $750. He does,
on the average, 60 jobs per month. His overhead costs are $8,000 per month. Mr. Archibald is concerned that his monthly profits are too low; he wants at least $2,000 per month
and is not earning that amount at present. He has asked all his customers over the past two
months to complete a questionnaire, and from this he has been able to estimate that price
elasticity for his service and repair job is approximately E = - 1.1.
(a) Construct the demand, total revenue, and total cost curves for ATS from the data
given.
(b) Advise Mr. Archibald of the price level and the implied markup rate on the average
service and repair job which would maximize sales volume subject to the attainment of
his profit target.
(c) Explain to Mr. Archibald the conditions under which that markup rate will remain
optimal despite shifts in the cost and demand curves.
(d) Give him some guidance on how he should adjust the markup rate if the conditions
referred to in part (c) do not hold.
The Napper Bag and Canvas Company, Ltd., is a specialist manufacturer of down-filled
sleeping bags for sale in the camping equipment market. In this market there are several
large companies with annual sales between $25 million and $30 million and many smaller
companies with sales between $1 million and $5 million. Most of these companies have
diversified product lines of camping equipment, including tents, cooking equipment, c a m p
ing furniture, and sleeping bags with various types of filling. Napper's sales of $1.6 million
last year came entirely from down-filled sleeping bags, however. Although more expensive
than other materials, down has substantially more insulating value by weight and volume
and commands the attention of a loyal segment of serious outdoorspeople. Only a few f m s
produce quality down-filled bags, but these firms face peripheral competition from other
firms producing bags filled with other natural and artificial materials.
Last year Napper sold 21,000 bags directly to large department stores, catalog sales
companies, and specialty sporting equipment stores. These clients typically require contracts guaranteeing prices for one year. The cost of manufacturing sleeping bags depends
on the size of the bag, the materials used, and the amount of fill. A breakdown of Napper's
latest manufacturing costs for a typical style is as follows:
Cost
Item
Down filling
Other raw materials
Direct labor
Manufacturing overhead
Total unit cost
per Unit
$30.00
14.40
8.12
6.09
$58.61
Chapter 12 / Competinve Bids and Price Quotes
517
SSZON
12-1. Outline three situations in which you have recently been the buyer in a competitive bidding
or price quote situation (even if you received only one quote in each instance).
12-2. Make a list of those items that you would expect to enter the incremental cost calculation
for a contract to remove the sea gulls from the vicinity of a major coastal airport.
123. In calculating the incremental costs of a particular project, how would you treat the possible future cost of a lawsuit that may occur as a result of this project, where the cost of such
a lawsuit may range from $10,000 to $500,000 with an associated probability distribution?
How would you value the goodwill that is expected to be generated as a result of undertaking a particular contract? If there is expected goodwill, would you be prepared to bid lower
than otherwise? Why?
Explain why the strategy of choosing the bid price with the highest expected value is likely
to generate the greatest contribution to overheads and profits over a large number of successful and unsuccessful bids.
Outline the different types of bids that may be tendered. What is the relationship between
the fured-price bid and the other two types of bids?
Explain how the strategy of marking up incremental costs by a standard percentage (and
subsequently winning some contracts and losing some contracts) may over a period of time
give equivalent results as compared with the maximum-expected-value strategy.
Outline the factors that would cause you to use a lower markup on incremental costs (as
compared with your usual markup) in a phrticular bidding situation.
Explain the logic behind value analysis. What is the relationship between value analysis
and attribute analysis of consumer choice behavior?
Why is collusive bidding illegal? Does it hurt the customer? The competing firms? Other
fms?
4ND SHORT CASES
The Billings hinting Company is preparing to bid for a contract to supply half a million
brochures to a national mail-order company. The fum has calculated its incremental costs
to be $50,000. Past experience with this type of contract has resulted in the following
schedule, which shows the percentage of wins at each markup rate over incremental cost,
for the past three years.
Markup Rate
Conrracts Won
fW
f%)
10
94
72
20
30
40
50
45
18
6
(a) Calculate the expected value of the contribution at each of the bid prices implied by the
above markup rates.
.,
%cine Analvsis
and Decisions
,
(b) Interpolate between these rates to arrive at the markup rate, and bid price, that I
mizes expected contribution from the contract.
(c) What assumptions and qualifications underlie your analysis?
Your company, Bright Paints, is one of several companies manufacturing a special
signs. Your two major customers are the state and the i
ing paint used for MIC
Departments of Transportation. The federal Department of Transportation has m
tali,ed for bids for 10,600 gallons of this special paint in a light blue,-to be delive
two months after signing the contract. You can foresee being able to fit in a rod
of 10,000 gallons of the blue paint and have decided to bid on the job. h i s pard
contract is absolutelv standard. similar in all resDects to hundreds of contracts vou hiR
m the past two years.
Your pricing policy has always been to apply a markup to incremental cost
ne bid price. Your markup has varied with the competitive situation perceived
each bid. You have assembled data on all past bids, relating the markup rate used I
percentage of times your bid was the winning one, as shown below. Incremental c$
this contract has been estimated to be $76,200.
Markup Rate
(96)
Contracts Won
25
15.7
(%)
Why would your company have previously bid at zero markup over incremental
Why didn't it win all of those bids?
Cb). What is the bid price that maximizes the expected contribution of the conma?
Underlying you&alysis is the assumption of ceterisparibus. Which things in
lar must remain unchanged for your bid to be the optimal one?
(d) Why, or why not, is the fixed-price mode of bidding likely to be the best one tod
this contract?
i
The Esna Fabricating Company manufactures valves, faucets, and similar items
tract for various industrial and commercial clients. Whenever the company has no q
jobs to do, it uses its labor force and plant to produce a line of faucets which it 4
distributor for eventual sale in hardware stores. Esna can produce 5,000 of these fi
weekly, on average, and can sell them for $1.65 per unit, this representing a 50% 1
over variable costs. This production is suspended whenever Esna wins a more %
contract, however. Esna is currently considering bidding for a contract to manufactq
era1 very large pressure valves for use in the pulpmaking industry. Esna has incund
in expenses to acquire the detailed specifications for examination prior to s u b 4
bid. It has estimated the costs associated with this job as follows:
f
Dit labor (300 labor hours @ $20) $6,000
Direct materials
Variable overhead expenses
Allocated overheads (150% of direct labor)
8,650
4,270
9,000
1
Chapter I2 1 Competitive Bids and Price Quotes
519
If the contract is won, Esna expects to incur another $2,500for design costs before beginning manufacture of the valves, and the manufacturing process is expected to take 300
labor hours, or three weeks of the plant's time. No new direct labor will need to be hired
for the job, since the regular labor force (diverted from faucet production) is expected to be
sufficient to handle the job.
Esna's bidding policy is to mark up incremental costs of each job such that the
expected value of contribution is maximized. An examination of the outcomes of over 300
jobs bid for in the past two years indicates that the probability of winning the contract is
related to the ratio of the bid price to incremental cost, for each particular contract, in the
following way:
P = 2.825
- 0.115R -
1.427R2
where P is the success probability and R is the ratio of the bid price to the incremental costs
of each job tendered for.
(a) What are the probabilities of winning the contract at markups of lo%, 15%, 20%,
25%, and 30%, respectively?
(b) What price should Esna submit?
(c) Outline any reservations or qualifications you may have concerning your recommended
bid price.
12-4. Bids have been called for the fabrication of a steel Watergate, and Stenson Steel is in
the process of preparing to bid on this contract. The practice in your company has been
to charge each contract with bid preparation costs of $2,000,which is actually about
three times the actual value of time and office supplies spent on each bid but is costed
this way because the company is the successful bidder only once in every three times it
bids, on average. The bidding policy in the past has been to add a 15% margin to the
incremental and allocated costs, and hence your colleague, a recent M.B.A. graduate
from a rival university, insists that the appropriate bid price is $138,230,calculated as
follows:
Bid preparation costs
Direct materials
Direct labor
Variable overhead
Fixed overhead
Profit margin
Suggested bid price
.
I
$2,000
18,600
33,200
14,400
52,000
18,030
$138,230
You are a little womed that conditions in the industry have deteriorated recently.
You are aware that some of your competitors have been operating below capacity, and you
suspect that demand for steel-fabricated products is likely to be depressed for the coming
twelve months.
(a) What is the absolute minimum price you would bid on this contract? Explain and
defend your answer.
(b) On the basis of the information given, what bid price would you recommend?
(c) What factors would you wish to investigate and evaluate before choosing the actual bid
price?
Complete with newly-minted MBA in hand, you have joined Smithfield Re-Construction
as Senior Pricing Analyst. Your first job is a bid-pricing problem. The Fitzwilliarn Machinery Company has called for tenders on a contract to renovate one of their buildings. This
job will involve gutting a building and reconfiguring the floor plan for new office space.
,
Pal
Pricing Analysis and Decisions
Direct Labour
Materials
Indirect Labour
Overhead allocation
$320,000
480,000
160,000
320,000
12 months, if you should win the contract. Your cost of capital is 14%.
You learn that your f m always bids on the basis of full costs plus a m
from 10 to 30 per cent of full costs. Previous bidding on this basis has
following record:
Markup rate (%)
Contracts tendered for
Contracts won
(d) Suppose that the above cost data are expected values representing a range
each case. Briefly argue the wisdom of bidding on a cost-plus or risk sh
(e) Outline all assumptions and qualifications that underlie your answer.
Capacity utilization
Goodwill consideration
Near full
Very concerned
Type of plant
Small and
hevious bidding
pattern
Incremental cost
plus 35-50%
Moderately
concerned
Full cost plus
&12%