A meeting of senior managers at the Newcastle
Division has been called to discuss the pricing strategy for a new product.. In
the last year a significant number of new products have failed to achieve their
forecast sales volumes. The accountant has already stated that the profit for
the year-end will be lower than budget and the main reason for this is the
disappointing sales of new products. As a result, two different strategies are
proposed.
Details of
pricing strategies
The first strategy is to set a selling price of $170
with annual fixed costs at $22,000,000.
A number of managers are in favor of this strategy
as they believe it is important to
reduce costs.
The second strategy is to have a much higher
expenditure on advertising and promotions
and set a selling price of $190. With the higher
selling price the annual fixed costs would
increase to $27,000,000. The marketing department is
very clear that greater expenditure
on advertising and promotions is essential for this
product.
The problem has been estimating demand, particularly
elasticity of demand.
Managers are uncertain if demand is elastic (i.e.
goes UP with a price decrease and DOWN with a price increase) or inelastic
(demand is relatively stable whether prices go up or down).
Estimated demand (units)
150,000
160,000
180,000
200,000
210,000
Variable costs
per unit
The managers estimate that the variable cost per
unit is $35.
Overhead
Overhead is applied based on ABC. There are four
activity pools:
Activity Estimated Costs Estimated Activity Level
Set-ups $500,000100,000
Finishing $600,000 50,000
Product changes $100,000 25,000
Assembly $300,000 60,000
Actual activity
was as follows:
Set-ups 10
Finishing 5
Product changes 10
Assembly 5
Service Costs
There are two production departments: Assembly and Finishing. Each of
these two departments uses the services provided by the IT and Maintenance
Departments, which both support the production functions and each others’
functions as well. Newcastle uses the
step method of allocating these service department costs to the production
departments. IT is allocated on the
basis of hours of department operations and Maintenance is allocated on the
basis of departmental Direct Labor hours.
Maintenance is allocated first.
|
The following costs IT: $400,000 Maintenance: $200,000 Use the calculated OH |
|
Production Department data:
|
Assembly |
Finishing |
IT |
Maintenance |
|
|
Hours |
10,000 |
15,000 |
30,000 |
5,000 |
|
Direct |
8,000 |
16,000 |
8,000 |
16,000 |
Required:
a. Determine the amount of Maintenance costs allocated to the Assembly
and Finishing Departments using the step method of allocating service
department costs.
b. Determine the amount of IT costs allocated to
the Assembly and Finishing Departments using the step method of allocating
service department costs.
c. Determine the total overhead costs of the Assembly
and Finishing Departments when this (step) method of allocating service
department costs is used.
Questions
Question 1
What is the break-even for each alternative? Show
calculations.
Question 2
What is the total product cost, excluding service
department allocations, for each alternative?
Question 3
What is the
total cost that should be attributed to each alternative, including allocated
service costs?
Question 4
Explain how your answer would change if demand
elasticity was:
a) elastic b)
inelastic
