1.

Heartland Corporation manufactures flour milling machinery according to customer

specifications. The company operated at 75% practical capacity during the year just
ended, with the following results (in ‘000s)

Sales Revenue 12,500

Less: Sales Commission 1,250
Net Sales 11,250
Expenses:
Direct material 3,000
Direct Labour 3,750
Manufacturing overhead-variable 1,125
Manufacturing overhead-fixed 750
Corporate Administration-fixed 375
Total Costs 9,000
Income before taxes 2,250
Income Taxes(40%) 900
Income after taxes 1,350

Heartland, which expects continued operations at 75% of capacity, recently submitted a bid of
$82,500 on custom designed machinery for Premier Foods, Inc., Heartland used a pricing
formula in deriving the bid amount, the formula being based on the last year’s operating results.
The formula follows:

Estimated direct material $14,600

Estimated direct labour 28,000
Estimated manufacturing overhead at 50% of direct labour 14,000
Estimated corporate overhead of 10% of direct labour 2,800
Estimated total cost excluding sales commission 59,400
Add 25% for profit and taxes 14,850
Suggested price(with profit) before sales commission 74,250

Proposed sales commission @10%

Required:

1. Calculate the impact the order would have on Heartland’s net income if the $82,500 bid
were accepted by Premier Foods, Inc.
2. Assume that Premier has rejected Heartland’s bid but has stated it is willing to pay
$63,500 for the machinery. Should Heartland accept the offer.
3. At what bid price would Heartland break even on the order?
4. Explain how the profit performance would be affected if Heartland accepted all of its
work at prices similar to Premier’s counter offer described in requirement 2.
Solution

The significance of

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 “continued operations at 75% of capacity, recently submitted a bid of $82,500 on custom
designed machinery for Premier Foods, Inc., Heartland used a pricing formula in deriving the bid
amount”

75% capacity is significant because any additional production can happen without any additional
fixed cost.
Hence in this case, we need to find out the incremental cost of production

Estimated direct material $14,600

Estimated direct labour 28,000
Variable manufacturing overheads (1125/3750*28000) 8,400
Estimated corporate overhead of 10% of direct labour (not an incremental -
cost)
Estimated total incremental cost excluding sales commission 51,000

If the bid of 82,500 is accepted, then the profit earned is (82500-8250-51000)=23250/-

Going by the above calculation, yes, they must

$56,666

If all offers are accepted at incremental cost, company cannot earn profits. Special offers with
information asymmetry which does not affect the market price can be accepted at incremental
cost to increase profit margin post break even

2. MPE, Inc. will very soon enter a very competitive market place in which it will have
limited influence over the prices that are charged. Management and consultants are
currently working to fine tune the company’s sole service, which hopefully will generate
a 12% first year return(profit) on the firm’s $18,000,000 asset investment. Although the
normal return in MPE’s industry is 14% executives are willing to accept the lower figure
because of various set up inefficiencies. The following information is available for first
year operations:
Hours of service to be provided: 25,000
Anticipated variable cost per service hour:$22
Anticipated fixed cost:$1,900,000 per year

Required:
a) Assume the management is contemplating what price to charge in the first year of
operation. The company can take its cost and add a markup to achieve a 12% return;
alternatively , it can use target costing. Given MPE’s marketplace, which of the
approaches would be appropriate? Why?
Since it is a competitive market, target cost would be appropriate
b) How much profit must MPE generate in the first year to achieve a 12% return? Also
calculate the revenue per hour.

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 184.40 (22+76+ 18000000*12%/25000)
c) Assume that prior to the start of business in Year 1, management conducted a
planning exercise to determine if MPE could achieve a 14% return in year 2. Can the
company achieve this return if (a) competitive pressures dictate a maximum selling
price of $175 per hour and (b) service hours and the variable cost per service hour are
the same as the amounts anticipated in Year1. Show calculations.

Cannot achieve 14% return

3. Morrow Company is a large manufacturer of auto parts for auto makers and parts
distributors. Although Morrow has plans throughout the world, most are in North
America. Morrow is known for the quality of its parts and reliability of its operations.
Customers receive their orders in a timely manner and there are no errors in the shipment
and billing of these orders. For these reasons, Morrow has prospered in a business that is
very competitive, with competitors such as Delphi, Visteon and others.

Morrow just received an order for 100 auto parts from National Motors Corp., a major
auto manufacturer. National proposed a $1,500 selling price per part. Morrow usually
earned 20% operating margin as a percent of sales. Morrow recently decided to use target
costing in pricing its products. An examination of the production costs by the engineers
and accountants showed that this part was assigned a standard full cost of $1425 per part.
(this includes $1000 production, $200 marketing, and $225 general and administration
costs per part). Morrow’s value assessment group undertook a cost reduction programme
for this part. Two production areas that were investigated were the defective unit rate and
the tooling costs. The $1000 production costs included a normal defective cost of $85 per
part. Group leaders suggested that production charges could reduce defective cost to $25
per part.

Forty five tools were used to make the auto part. The group discovered that the number of
tools could be reduced to 30 and less expensive tools could be used on this part to meet
National’s product specifications. These changes saved an additional $105 of the product
cost per part. By studying other problem areas, the group found that general and
administration costs could be reduced by $50 per unit through use of electronic data
interchange with suppliers and just-in-time inventory management.

In addition, Morrow’s sales manager told the group that National might be willing to pay
a higher selling price because of Morrow’s quality reputation and reliability. He believed
that National’s proposed selling price was a starting point for negotiations. Of course,
National had made the same offer to some of Morrow’s competitors.

Required:

What should be Morrow’s target cost per auto part? Explain.

Target cost= 1500- (1500*20%)= 1200

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 As a result of value engineering, determine Morrow’s cost for the auto part. Will Morrow
meet the target cost per part? Do you recommend that Morrow take on National’s offer?
Why/ Why not?

Current cost= 1425

Savings from current cost
$60
$105
$50

$215
Revised cost= $1210

Since it is very close to target cost, they must accept the offer

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