Practice Problem 10.

39

a) Let us begin by computing the overhead rate. Her total overhead is $390,000 and her total
labor cost is [(1,000 × $75per unit) + (5,000 ×$50 per unit)] = $325,000. Thus, her overhead
rate is $390,000/$325,000 = $1.20/labor $.
With this rate in hand, we can compute her profit per print as follows:

Deluxe Standard
Prints/Year 1000 5000
Price per print $350 $210
Materials 100 65
Labor 75 50
Overhead (@$1.20/labor $) 90 60
Profit /print $85 $35

This analysis suggests that deluxe frames are more than twice as profitable as Standard frames. In
addition, it is easy to verify that Sonja makes total profit of $260,000 (= ($85 × 1,000) + ($35, 5,000))
at this volume and mix.

b) The following table provides the required income statement:

Deluxe Standard Total

Revenue $350,000 $1,050,000 $1,400,000
Materials 1,00,000 3,25,000 4,25,000
Labor 75,000 2,50,000 3,25,000
Labor related overhead 36,000 1,20,000 1,56,000
Batch related overhead 68,250 68,250 1,36,500
Product related
overhead 29,250 29,250 58,500
Product Profit $41,500 $257,500 $299,000
Facility costs 39,000
Profit $260,000
Profit/unit $41.5 $51.5

Notice that we have a labor overhead rate of $0.48/labor $, which we compute as the labor
related overhead cost of $156,000 divided by the labor cost of $325,000. Likewise, we have
20 batches each of the deluxe and standard products (1,000/50, 5,000/250). Thus, the cost
per batch is $136,500/40 batches = $3,412.50. Product related overhead is equally allocated
between the product lines. We do not allocate facility level costs as these are not
controllable at the product level.

c) Sonja might wish to reconsider her emphasis on deluxe frames. She also might wish to
consider other options such as raising the price of a deluxe frame. Finally, she could also
improve margins (and this might be smartest thing to do) by figuring out how she could
manage her costs.
 Practice Problem 10.49

Greg’s pricing scheme implicitly reflects a volume-based allocation of cost. In essence, by

charging the same amount per lawn, Greg is assuming that each lawn takes the same
amount of work (i.e., time to mow). However, lawns vary greatly in the time needed. Larger
lawns take more time than smaller lawns; a rough terrain consumes more time than a flat
lawn; the number of landscaping features (e.g., trees) also increases the time needed. These
variations mean that the each lawn consumes different amounts of capacity resources.
Greg’s pricing scheme must reflect this variation.

Greg’s flat pricing scheme does not reflect the variation in resources consumed. If he begins
with an average mix of lawns, the difficult to mow lawns will be under-priced and the easy to
mow lawns over-priced. Over time, homeowners with easy to mow lawns may get
competing offers for lower prices and switch. Indeed, homeowners with difficult to mow
lawns may find Greg’s services low-priced and flock to his service. Over time, the mix of
lawns mowed will comprise mostly of difficult-to-mow lawns with a corresponding increase
in time.

A manufacturing analogy is a firm using volume-based allocations to determine cost, and

using the estimated cost to price its products. Over time, this firm may well find its product
mix shifting away from easy-to-make, high volume products toward difficult-to make low
volume products.

Practice Problem 10.51

The current profit is 6,000 × ($16 - $14.017) = $11,898. With a 25% sales increase, the sales
level will be 6,000 + (6,000 × 25%) = 7,500 units. With 750 units per batch, there will be 10
batches. The next step is to compute the cost of making 7,500 units. The following table
presents the calculations:

Cost per unit

Item Detail / batch Total cost for 7,500 units
Unit Level expenses
Material Traced $ 0.52
Material related overhead 10% of materials cost 0.05
Direct labor 4.4
Direct labor related overhead 120% of direct labor cost 5.28
Machine related overhead ($16.50/mach. hr) 2.12
Total per unit 12.37 $92,775
Batch Level Expenses (10
Batches)
Setup $35 per hour $350
Production order $145 per order 145
Material moves $23.50 / move 188
Total per batch 683 $6,830
Product level Expenses 945
$0.01 per $ of unit level
Facility level Expenses costs 742
 Total cost $101,292
Cost per unit $13,506
The expected profit if both options are implemented = 7,500 × ($15.25 - $13.506) = $13,080.

Thus, expected profit is higher if the firm implements both actions.

Practice Problem 10.53

a) This problem is a useful exercise in illustrating how different cost objects consume the same
resources in different mixes.

Short long

Regular room rate $1,800 /day $3,600 $16,200

Spending on meals $450/day 900 4,050
Miscellaneous items $400/$2,500 400 2,500

Total revenue $4,900 $22,750

Variable cost $150/day 300 1,350
Room maintenance $300 per three days 300 900
Check in and check out $150/$250 150 250
Concierge service Varies 200 600
Guest spending on meals etc $450/day;Variable cost is 40% 360 1,620
Guest spending on miscellaneous services $400/ $2,500 for long-stay guests 160 1000
Profit per stay $3,430 $17,030
Profit per day $1,715 $1,892.22

b) The above analysis indicates that long-stay guests are more profitable than short-stay
guests. The difference in profitability arises from several factors: First, batch level expenses
such as the cost of check-in are spread out over more days. Second, the intensity of resource
usage (e.g., concierge) decreases as time passes. Third, the amount of money spent on
miscellaneous services increases as the hotel is able to cross-sell some items (e.g., laundry,
massages and so on.) However, the offset is that long-stay guests might also increase some
costs such as the welcome basket.

It appears that Vanessa might consider offering a 5-10% discount off the regular room rate to long-
stay guests. After all, maximizing utilization is the key to profits in the hospitality industry, which has
high fixed costs. (Note the ratio of profit to revenue).

Practice Problem 10.54

With the old scheme, we have:

Item Detail Amount

Number of packs 40,00,000
Packs per order 4
Number of orders 10,00,000
Kinds of drinks per order 2
% qualifying for discount
Revenue from shipping $2.99 / order $2,990,000
 Costs
Picking costs per pack of $0.10/package of
pods pods 4,00,000
Kinds of drinks 0.50/kind/order 10,00,000
Shipping costs $6/order 60,00,000
Net cost -44,10,000

With the new scheme, we have:

Item Detail Amount

Number of packs of Pods Assumed 40,00,000
Packs per order 4000000/600000 6.67
Number of orders Given (60% of current volume of 1 million orders) 6,00,000
Average Kinds per order 3
% qualifying for discount 50% of orders
Revenue from shipping $2.99 / order for 300,000 orders $897,000
Costs
Picking costs per pack of
pods $0.10/pack of pods 4,00,000
Kinds of drinks 0.50/kind/order 9,00,000
Shipping costs $6/order 36,00,000
Net cost -40,03,000

Thus, Anna’s idea saves $397,000 (=$4,410,000 - $4,003,000) for the firm. The key idea here is that
costs are not proportional to the volume of operations. A substantial portion relates to the number
of orders (indeed, this is the largest component of total shipping and handling costs). The promotion
reducing order volume to 400,000, saving substantially on shipping costs ($6.00 per order) while
foregoing $2.99 in revenue on 50% of the orders. This is the fundamental source of the gain from the
“free shipping” promotion.

Note: The solution assumes that the total number of packs stays at 4 million (the problem is silent on
this front). With this assumption, the revenue and cost per pack are not relevant. It is possible that
the promotion also increases total number of packs. Then, if the change is x packs, the incremental
gain is $4X, where $4.00 is the contribution per pack.

Note: The projected savings depend crucially on the number of orders dropping to 600,000 from 1
million currently. The average order size then has to increase to 6.67 packs per order (= 4,000,000 /
600,000 orders) from the current 4 packs per order. Some trial and error shows that Anna’s idea
would begin to lose if the number of orders (with the revised scheme) is more than 668,000. Thus,
the key assumption that the firm will need to validate pertains to the reduction in the number of
orders.