By Dennis Caplan, University at Albany (State University of New York)



CHAPTER 13:  The Role of Cost in Setting Prices


Exercises and Problems:


13-1: In a controversial decision, Congress withdraws funding from the next generation of aircraft carriers and reassigns the money to public schools, particularly for improving education in art history and comparative literature.


In a move that stuns the nation, the Secretary of the Navy takes advice from a bumper sticker and announces that the Navy will hold a bake sale to fund the new aircraft carrier. Navy personnel have minimal training in baking, so the Navy decides to outsource some production, including the purchase of 570,000 lemon bars from Nabisco.


The Navy is accustomed to buying equipment like jet fighters and missiles under cost-plus contracts. Under a cost-plus contract, the Navy pays the defense contractor for the cost of production plus a predetermined profit. Cost-plus contracts have the advantage of encouraging defense contractors to accept projects for which there is a great deal of uncertainty about the cost. In other words, cost-plus contracts minimize risk to the contractor.


Not knowing any better, the Navy’s procurement officer signs a cost-plus contract with Nabisco on March 1st for the lemon bars. The Navy agrees to pay Nabisco the full cost (variable plus fixed) of manufacturing each lemon bar, plus 20 cents. These costs are based on actual costs (not budgeted costs). Nabisco must manufacture all of the lemon bars by March 31st. Because each lemon bar has powdered sugar on top forming the outline of an anchor, none of Nabisco’s current inventory of lemon bars can be used for the contract.


Nabisco will manufacture the lemon bars in its factory in Eureka, California. This factory is already dedicated to lemon bar production. It is currently producing 400,000 lemon bars per month for supermarkets. (This satisfies demand; lemon bars are not as popular as they once were.) At this production level, variable manufacturing costs (mostly ingredients, utilities and factory labor) total $300,000 per month. The factory’s fixed costs are $500,000 per month (mostly depreciation expense on building and equipment, administrative costs and managerial salaries). Factory capacity is one million lemon bars per month, so the factory has sufficient unused capacity to meet current demand and also fulfill the Navy contract. The variable manufacturing cost per bar should be the same for the Navy contract as for current production. Variable marketing and selling costs are 10 cents per lemon bar for sales to supermarkets, but these costs are not incurred in connection with lemon bars produced for the navy contract. Nabisco sells lemon bars to supermarkets at an average sales price of $1.50 per bar.



A)        Calculate the total price per lemon bar that the Navy will pay Nabisco.


B)        Calculate the total profits that the contract will generate for Nabisco.


C)        Now assume that the factory stops manufacturing lemon bars for its usual customers, and only makes lemon bars for the Navy (so production is reduced to 570,000 bars). Now calculate the total price per lemon bar that the Navy will pay Nabisco.



13-2: The Children's Carousel in the municipal park in Lake Wobegon is evaluating its ticket prices and operating hours. It is open Friday through Tuesday during the summer months for 15 weeks. The following information pertains to last year's summer season.  Costs are expected to remain the same for this year.


Average riders per day

Variable operating costs per day when open

  (e.g., operator’s salary, ticket taker’s salary, electricity,

  fee assessed by the city for park security and maintenance)

Fixed overhead costs per year

Marketing costs per year

Customer service costs per year

Ticket sales price











A)        What is the unit cost basis (i.e., cost per rider) for establishing a long-run price for ride tickets?


B)        It is April, and the carousel has not yet opened for the year. The manager, Hillary Grover Cleveland Clinton, wants to open the carousel all week, including Wednesdays and Thursdays. She is willing to do this as long as it doesn't decrease her overall profits for this year. A study suggests that attendance on these two days would average 200 riders daily, but that attendance on the other days of the week would drop by 50 per week. A special one-time promotion to advertise the Wednesday and Thursday hours will cost $1050. How much should the manager charge per ticket for Wednesdays and Thursdays this summer if she wants to break even from the decision to expand the hours of the carousel? In other words, her incremental profits this year from the expansion should be zero. How much should she charge on Wednesdays and Thursdays, if she keeps the current $6.50 ticket price for the other days of the week?


C)        Assume Hillary decides to open on Wednesdays and Thursdays and charges the price you calculated in Part B plus $0.25 more. She has excess capacity on Wednesdays of on average 100 rides. A tour operator, Clarence Bunsen, offers Hillary $2.00 per ride for 30 rides each Wednesday for next season. Should Hillary accept the offer? What are her relevant costs for making this decision?


D)        Despite taking Cost Accounting as an undergraduate, Hillary is confused by your answer to Part C, and puts off her decision about the tour operator's offer until the end of the month. In the meantime, the new Federal Assistance Program "Pork for Toddlers" offers to contract with the carousel for 50 rides per week. The Program will pay Hillary the carousel's full cost per ride plus 20% (i.e., 120% of full cost). Being socially progressive, and believing she won't lose money on the program, she immediately accepts the government contract. Now it is the end of the month, and she has to decide about the tour operator's offer (see Part C). Now what are the relevant costs and revenues for deciding whether to accept the tour operator's offer?



13-3: Jeff Wong is an entrepreneur on a small island in the South Pacific. Following is the demand function for cell phone service on the island, which is a new service that Jeff is going to introduce on the island. The table shows the elasticity of demand: the number of residents who would subscribe if the monthly fee were as indicated. For example, if Jeff charges $140 per month (actually, any amount between $126 and $140), he will have 14 subscribers. If he lowers the price to $125, he will have 18 subscribers, and he will continue to have 18 subscribers until he gets down to $115, at which point he will have 20 subscribers. He will never have more than 20 subscribers.





# of customers willing to pay up to the amount indicated in the left-hand column for the service


















Jeff has the following cost function for providing the service. First, he must pay a flat fee of $1,000 per month to rent the transmission equipment and to act as an authorized dealer for the cell phone carrier. After that, he pays $50 per month per subscriber to the carrier for the service. For example, if he has 10 subscribers, he will pay $1,500: the $1,000 fixed cost, plus $500 ($50 x 10) in variable costs.


Jeff does not know the information about the demand function presented in the above table. Jeff mistakenly believes that at a sales price of $115 per subscriber, demand will be 22 subscribers. He then estimates his profits as follows:


            22 x ($115 - $50) - $1,000 = $430.


“Great!” Jeff says to himself. “I can make over $400 per month.” Jeff then sets the price at $115. However, at the end of the month, he only makes $300 for the month, calculated as follows:


            20 x ($115 - $50) - $1,000 = $300.


“That’s no good,” Jeff says to himself. “I want to earn $400 per month.” Jeff then decides to raise his sales price just enough to make exactly $400 per month, under the assumption that he is not going to lose any existing customers. (Remember, Jeff does not know the demand function shown above.) Furthermore, Jeff decides that if he loses customers, he will keep raising the sales price to make up for the loss in customer base, to plan to make $400 in profit at the new sales price. In other words, Jeff always fails to anticipate that he will lose additional customers as he raises his price. But Jeff is mistaken, because he is ignoring the elasticity of demand, and because whenever he raises his monthly fee, customers are allowed to cancel their contracts.


Required: Given Jeff’s pricing strategy, and the demand function that Jeff does not know but that you do know, derive each successive price that Jeff will charge for phone service. Is there an equilibrium sales price that Jeff will attain (i.e., a sales price that gives Jeff $400 profit that he will arrive at given his pricing strategy). If so, what is that final sales price?



13-4: The Epomeo Company is a defense contractor with both cost-plus and fixed price contracts with the U.S. military. The company currently has two active contracts. The first contract is a fixed price contract with the Navy that involves the sale of 20,000 HD units in 2008 at $150 per unit. The variable cost per unit is $55, which consists of $45 of variable manufacturing costs and $10 of variable non-manufacturing costs. The second contract is a cost-plus contract with the Marines that involves the sale of 12,000 RD units in 2008, at a sales price of 130% of the full (fixed plus variable) manufacturing cost. The variable cost per RD unit is $135, consisting of $115 of direct manufacturing costs and $20 of non-manufacturing costs. Fixed manufacturing overhead costs for 2008 are budgeted for $500,000, and fixed non-manufacturing costs are budgeted for $230,000. There is no variable manufacturing overhead. Epomeo allocates fixed manufacturing overhead based on variable manufacturing costs (i.e., variable manu­facturing cost is the allocation base).


Required: What is the sales price per unit for 2008 for each unit sold to the Marines?



13-5: Cessna makes a particular type of airplane for both the Army and the domestic market in a factory dedicated to that one product. Fixed costs at the factory are $28,000,000 per month. Variable costs at the factory (direct materials, direct labor and variable overhead) are $3,200,000 per airplane. In the domestic market, the airplane sells for $4,100,000. The Army reimburses Cessna the full cost of each airplane plus 22%. Production is currently 36 airplanes per month, and sales are currently 27 airplanes to the domestic market and 9 airplanes to the Army, per month.


Required: What will be the change in total monthly profit earned from sales of this type of plane, if the Army continues to buy 9 airplanes per month, but domestic sales and production increase by 5 airplanes per month?



13-6: Many people support the concept of school voucher programs. The general idea of school vouchers is that a family that enrolls a child in a private school instead of the public school system receives a voucher. The family gives the voucher to the private school to help pay the child’s tuition. The private school is then reimbursed by the government for the amount of the voucher. The philosophy of the program is that families that use private schools are not utilizing public school resources, so they should receive a partial refund of taxes that support the public schools. The vouchers constitute this refund.


Another goal of voucher programs is to provide public schools incentives at the local level to improve the quality of education. Under most voucher programs, each school’s funding is based on enrollment. If the public school attracts more students, its funding is increased. If public school enrollment drops, its funding is cut. This aspect of the program is similar to cost-plus contracting, except that “cost” is determined using a “base-line” year, and the “plus” component does not constitute corporate profits, but rather constitutes additional resources for the school to improve the quality of its programs.



Briefly discuss how effective each of the following reimbursement schemes would be in


(1)        providing incentives and resources for the local public schools to improve quality, and


(2)        minimizing the risk that public school funding, and hence, quality, will decline in the short-run.


In each case, “base-line” refers to information for the year immediately prior to the first year of the voucher program.


A)        Each public school receives funding equal to its base-line fixed costs, plus an amount calculated as follows: the school’s base-line variable cost per student plus a small increment, multiplied by the number of students enrolled after the voucher program is initiated.


B)        Each public school receives funding equal to its base-line fixed costs, plus its base-line variable cost per student multiplied by the number of students enrolled after the voucher program is initiated.


C)        Each public school receives funding equal to the number of students enrolled after the voucher program is initiated, multiplied by its base-line full cost per student. Base-line full cost refers to base-line variable cost per student plus an allocation of fixed costs calculated by dividing base-line fixed costs by the base-line number of students.


D)        Each public school receives funding equal to the sum of its base-line fixed and variable costs, plus a small variable amount for each student in excess of its base-line enrollment.



13-7: Sedgewik makes a turbine for both the military and the domestic market. Fixed costs at the factory are $2,000,000 per month. Variable costs at the factory (direct materials, direct labor and variable overhead) are $20,000 per turbine. In the domestic market, the turbine sells for $45,000. The military reimburses Sedgewik the full cost of each turbine plus 18%. 


Required: Assume the company sells 30 turbines to the military at full cost plus 18%. Let Y equal the total number of unit sales in both markets (so that Y – 30 is the number of units sold in the domestic market). Write down an equation that expresses the company’s breakeven point in terms of Y. (You only need to write down the equation; you do not need to attempt to solve it, or even to isolate Y on one side of the equation.)



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Management Accounting Concepts and Techniques; copyright 2006; most recent update: November 2010


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