PRICING DECISIONS

13.31 M/s HMV

1. Effect on monthly operating income of accepting the order

Calculation of Incremental Profit / Loss by acceptance of the order.

Particulars Qty Rate -Rs. Amount-Rs.

Additional Revenue 1,000 38.00 38,000

Additional Cost
Direct Materials 15.00 15,000
Direct manufacturing labour 8.00 8,000
Variable manufacturing overheads 7.00 7,000
Variable marketing overheads 5% on Rs.38 1.90 1,900
Total 31,900

Additional Contribution 6,100

Additional Fixed Cost -

Additional Profit 6,100

Assumptions :
01. The Fixed overheads (manu. + marketing) shall remain unchanged
acceptance of the order.
02. There is sufficient capacity to serve this additional customer in addition to existing sales.

Conclusion :
2. The President's decision of rejecting the order is 'NOT JUSTIFIED' as this
order would have increased profit of the Organisation by Rs. 6,100 without
adversely affecting existing income.

While deciding so, the President was unjustified on following two grounds :
01. He decided based on total budgeted manufacturing cost which include fixed overheads
which is an irrelevant cost for this decision;
02. He did not include variable marketing overheads in taking decision.This
was a relevant cost.

3. Key Issues :
(i) There is a possibility that existing customers might demand price reduction. If this order
is independent of other regular orders, then only additional income can be anticipated
otherwise it may have a big negative effect on total sales and income of the organisation.

(ii) It has to be seen whether the order for 1,000 tapes is a one-time-only order, or there
is the possibility of sales in subsequent months The fact that the customer is not in
HMV's "normal marketing channels" does not necessarily mean that it is a one time order.
PRICING DECISIONS ANSWERS

12.27 M/s HMV

Effect on monthly operating income of accepting the order

1. Additional Profit 6,100

Conclusion :
2. The President's decision of rejecting the order is 'NOT JUSTIFIED'.
 13.33

M/s Babloo Toys

Working backwards for Cost-Volume-Profit

01. Selling Price in 2006

Amount/Unit-
Amount-$ Rs.

Sale in 2006 Units 15,000

960
Investment Rs. 1,800,000 80
Return on Investment @ 20% 360,000 24
Full Cost 200
Selling Price 224

Mark-up = (24/200) x 100 12%

02. Variable Cost + Mark-up = Selling Price

Mark-up is 40% of Variable Cost

Thus, Variable Cost ( 100% ) + Mark-up ( 40%) = Selling Price
Or, Selling Price / 140% = Variable Cost= 224 / 140% =
Variable Cost = Rs./unit 160

03. Fixed Cost = Total Cost - Variable Cost = 40

Units Sold 15,000
Total Fixed Cost 600,000

Reduced Sale 13,500

Selling price 230
Variable Cost 160
Contribution/Unit 70
Total Contribution 945,000
Less : Fixed Cost 600,000
Operating Income 345,000
Previous operating Income= 15,000 x 24/- = 360,000
Should not raise the selling price as this operating
income is less than earlier one of Rs. 3,60,000/-

03. Revised Investment 1,650,000

Return on Investment (ROI) 20% 330,000
Sale Quantity Units 15,000
Selling Price Rs. / Unit 210
Total Sale Value $ 3,150,000
Less : ROI 330,000
Total Cost 2,820,000
Target cost/unit in 2007 188
 ANSWERS

12.29 M/s Babloo Toys

01. Selling Price 224

02 Mark-up % 12%

03. Variable Cost = Rs./unit 160

04. Operating Income 345,000

05. Target cost/unit in 2007 188

 13.39

Dr.Reddy

1. Minimum price per dose without changing Dr.Reddy's income.

Rs./direct
manu.lab
Cost-Rs. our hour Cost/dose
Variable direct-manufacturing labour cost 160
Variable overhead cost 90
Incremental administrative costs 50,000 50
Minimum cost (price for bidding) for 1000
doses 300 0.30

2. Return on full cost after Income tax 9% which is 60% of gross return
which is @ 40% (Net of tax).

Return on full cost before Income tax 15%

(Gross of tax) = 9%/60%

Rs./direct
manu.lab
Cost-Rs. our hour Cost/dose
Variable direct-manufacturing labour cost 160
Variable overhead cost 90
Fixed overhead cost 300
Incremental administrative costs 50,000 50
Full cost 600
Return @ 15% on full cost 90
Minimum price for bidding for 1,000 doses 690 0.69

3. Dr.Reddy should consider following factors.

(i) Whether it has an excess capacity to manufacture;
(ii) Whether there are jobs other than Batra's, offering a better profitability;
(iii) Whether the maximum bid price of Re.0.70/dose contributes to recover fixed cost.
0% of gross return
 ANSWERS
12.35 Dr.Reddy
Rs./direct
manu.labour
hour Cost/dose

1. Minimum cost (price for bidding) for 1000 doses 300 0.30

2. Minimum price for bidding for 1,000 doses 690 0.69

13.40 Advertisement in TOI

Considerations other than cost in pricing.

1. The business executives travel and stay on a Sunday-through-Thursday basis.

They return home after their business is conducted during the week days.
They are price insensitive because they have to travel during weekdays for their
business.
Their stay cost is reimbursed by their employers.
Thus, hotels can earn higher operating income by charging business travelers
higher prices because higher prices have little effect on their demand for hotel stay.

2. In contrast, pleasure travelers who pay for their hotel rooms are more sensitive
to the hotel room rates.
They may make their travel plans in a way that enables them to take advantage
of lower weekend room rates.
This may be done by mini vacations taken during the weekends only.
Thus it is profitable for hotels to charge lower rates to stimulate demand among
pleasure travelers.

3. Most of the hotel costs are fixed.

The variable costs are a relatively minor part of the total costs and relate mainly
to linen services.
Therefore, often the hotels reduce their room rates to attract customers during
slack season.
Even at reduced rates, hotels can cover their variable costs and generate
contribution margin which may add directy to their profit as they recover their
entire fixed costs in the Peak season by charging the customers with the higher
rates.
hursday basis.

eekdays for their

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mand for hotel stay.

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take advantage

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with the higher
22.32 M/s Tata

1. The minimum price at which Airbag division will sell the product to
Igo division would be Rs.1,100 per unit which is the incremental
cost for the selling division.
The Airbag division has idle capacity (currently working at 80%
capacity). Hence, there is nothing to lose on opportunity cost for
the selling division as it does not forgo any external sales and
contribution from the internal transfers. This also achieves the
goal congruence.

2. Transfer price policy to transfer at incremental cost in case of

idle capacity evaluated on following criteria:
(i) Achieve goal congruence:
Yes, it will achieve as described in requirement 1.

(ii) Evaluating division performance:

No. This is so because the transfer price does not
excee full costs. By transferring at incremental cost
and not covering fixed cost, the Airbag division will
show a loss. This loss needs to be born by remaining
80% utilisation which can not be said to be a good
measure of evaluating a division's performance.

(iii) Motivating management effort:

Yes, if based on budgeted cost (as it is fixed for a
specified period); if it is based on actual incremental
cost, the Airbag division has little incentive to control
the costs.

(iv) Preserving division autonomy

No, because it is rule-based. The Airbag division has
no say in fixing the price for such transfers.
22.27
3. If the two divisions were to negotiate a transfer price, the range
of possible transfer prices will be between Rs. 1,100 and Rs.1,400
per unit.
The Airbag division has an excess capacity which can be used for
such a supply to Igo division. Airbag division will be willing to supply
the airbags only if the transfer price equals or exceeds Rs.1,100
which is its incremental cost of manufacturing the airbags.

The Igo division will be willing to buy airbags from the Airbag division
only if the price does not exceed Rs. 1,400 per airbag, the price
at which the Igo division can buy aribags in the market from outside
 suppliers.

Thus, each division will try to transact with the other for a price
between Rs.1,100 and Rs.1,400 per airbag and will maximize overall
income of M/s Tata .

The exact transfer price betwee above two prices will depend on the
bargaining strengths of the two divisions.

The negotiated transfer price has the following properties.

(i) Achieve goal congruence:

Yes, it will achieve as described in requirement 1.

(ii) Evaluating division performance:

Yes. This is so because the transfer price is the result
of direct negotiations between the two divisions.
Ofcourse, the transfer price will be affected by the
bargaining strength of both divisions.

(iii) Motivating management effort:

Yes, because the transfer price will remain unaffected
by changes in the actual cost of production after it is
negotiated.

(iv) Preserving division autonomy

Yes, because the transfer price is based direct
negotiations between the two divisions and is not
specified by the head office on the basis of some rule
like incremental cost of Airbag division.

3. Neither method is perfect but negotiated transfer price as in

requirment-3 has more favourable properties than the cost-based
transfer price as described in requirement-2 above.
22.34 The Bangalore Instrument Company

1(a) Contribution margin of Super-Chip and Okay-Chip

Rs./unit
Super-chip Okay-chip
Selling price 600 120
Less: variable cost
Direct materials 20 10
Direct manufacturing labour 280 70
Total variable cost 300 80
Contribution margin/unit 300 40
Hours required per unit of the products 2 0.5
Contribution margin/hour 150 80

Number of units to be sold by Semiconductor

1(b) Divison Super-chip Okay-chip Total

Total hours available for both products 50,000

Maximum units required by a customer 15,000

Total hours required for each product 30,000 20,000 50,000
Maximum units which can be produced
and sold 15,000 40,000

Contribution 4,500,000 1,600,000 6,100,000

Less: Fixed Cost 400,000
Operating margin of BIC when there is no 5,700,000
Process Control Division's operations.

22.29
2. Operating margin of the Bangalore Instrument Co.
(When there are Process Control Dvn's operations).

Contribution margin of Super-Chip and Okay-Chip

Rs./unit
Super-chip Okay-chip
Selling price 500 120
Less: variable cost
Direct materials 20 10
Direct manufacturing labour 280 70
Total variable cost 300 80
Contribution margin/unit 200 40 33%
Hours required per unit of the products 2 0.5
Contribution margin/hour 100 80

In case of transfer of 5,000 Super-chips to

Process control division,

Number of units to be sold by Semiconductor

Divison Super-chip Okay-chip Total

Total hours available for both products 50,000

Maximum units required by a customer 15,000

Units required by Process control division 5,000
Total units required 20,000
Total hours required for each product 40,000 10,000 50,000
Maximum units which can be produced
and sold 20,000 20,000

Operating margin of Semiconductor division

Total contribution (15,000x300+5,000x200/-);
20,000x40/- 5,500,000 800,000 6,300,000
Less: Fixed cost 400,000
Operating margin 5,900,000
22.29

Control Unit
(Based on
Operating margin of Process Control division Super-chip)
Units sold 5,000
Selling price 1,320
Less: variable cost
Direct materials 500
Direct manufacturing labour (6 hrsxRs.100/hr) 600
Total variable cost 1,100
Contribution margin/unit 220
Total Contribution - Rs. 1,100,000
Less: Fixed Cost 800,000
Operating margin 300,000
Operating margin of BIC 6,200,000

As the operating margin of the company is higher by Rs.3,00,000 in

supplying 5,000 Super-chips to Process Control Division, this
strategy should be adopted by the company to replace the circuit
board.

3. If Super-chip is not supplied to Process control division, the operating margin

of Semiconductor division will be - Rs. 5,700,000

Process Control Division will procure Circuit Board from market and then also
will earn same margin as it earns by replacing it with Super-chip i.e. Rs. 300,000
Total Operating margin 6,000,000

BIC earns more by replacing the circuit board by 5,000 units- Rs. 200,000
(Rs.62,00,000 - Rs.60,00,000)
BIC earns more this way per unit Rs./unit 40

Current transfer price 500

Less: extra earning in Semiconductor division 40
Net price below which performance of Semiconductor division 460
will deteriorate
Therefore, any price between Rs.460 and Rs.500 per unit of Super-chip as a
Transfer price to Process Control Division will maximize the profit of BIC.

Alternatively,
Incremental cost per unit to the point of transfer (variable cost) 300

For transferring 1 Super-chip to Process Control division, 2 labour hours

are required with the help of which 4 Okay-chips could be manufactured
and sold.
Therefore, contribution lost on Okay-chips- 4 unitsx Rs.40/unit = 160
Transfer Price of Super-chip in case of uncertain price of control unit= 460

22.29
4. Transfer price of Super-chip when 12,000 control units are to be sold.

Total hours available 50,000 Hours

Hours required for outside sale of Super-chip
(15,000 units x 2 hrs/unit) 30,000 Hours
Remaining hours for internal transfer 20,000 Hours
Maximum units which can be transferred to
Process control division 10,000 Units

Transfer price for 10,000 units 460 Rs./units

For additional 2,000 units 600 Rs./units
Incremental cost (Variable cost) 300
Loss of contribution by not selling outside 300

Transfer
price-Rs/unit
We can summarize as under: of Super-chip
Transfer 0 units to 10,000 units internally 460
Transfer 10,000 units to 25,000 units internally 600
 Pricing of products

M/s Bell Ltd. is attempting to decide the selling price of two

Q.1 products X and Y. The products are made by the same grade of
labour and 40,000 labour hours are budgeted for the year 2013.
The budgeted fixed overheads are Rs. 80,000 and it is expected
that it will work at full capacity.

The variable cost Rs. per unit- Product X Product Y

Materials 4 5
Labour (@ Rs. 3 per hour) 6 15
Expenses (1 machine hour) 2 2
Total 12 22

Sales demand is estimated roughly to be 7,500 units for X and 5,000 units for Y.

What would be the unit selling prices to give a profit of 25% on full cost if
overheads are absorbed –
(i) On a direct labour hour basis.
(ii) On a machine hour basis.
00 units for Y.
 Pricing of products

Q.1 M/s Bell Ltd. is attempting to decide the selling price of two products X and Y. the
products are made by the same grade of labour and 40,000 labour hours are budgeted
for the year 2013. The budgeted fixed overheads are Rs. 80,000 and it is expected
that it will work at full capacity.

The variable cost Rs. per unit- Product X Product Y

Materials 4 5
Labour (@ Rs. 3 per hour) 6 15
Expenses (1 machine hour) 2 2
Total 12 22

Sales demand is estimated roughly to be 7,500 units for X and 5,000 units for Y.

What would be the unit selling prices to give a profit of 25% on full cost if
overheads are absorbed –
(i) On a direct labour hour basis.
(ii) On a machine hour basis.

Solution

1 Budgeted Labour hour rate=

Rs. 80,000/40,000 labour hours = 2.00 Rs/labour hour

M/c Hr Machine
Budgeted Machine hour rate Units per unit hours
Product X @ 1 m/c hour per unit = 7,500 1 7,500
Product Y @ 1 m/c hour per unit = 5,000 1 5,000
12,500

2 Cost rate per machine hour=

Rs. 80,000/12,500 hours = 6.40 Rs/machine hour

(a) Selling price based on labour hours Product X Product Y

Variable cost 12.00 22.00

Fixed overheads
for 2 labour hours per unit @ Rs.2 per labour hour 4.00
for 5 labour hours per unit @ Rs.2 per labour hour 10.00
Total cost of the product 16.00 32.00
Profit @ 25% of total cost 4.00 8.00
Selling price 20.00 40.00

(b) Selling price based on machine hours Product X Product Y

Variable cost 12.00 22.00

Fixed overheads
for 1 machine hour per unit @ Rs.6.40 per machine
hour 6.40 6.40
Total cost of the product 18.40 28.40
Profit @ 25% of total cost 4.60 7.10
Selling price 23.00 35.50