Advanced: Calculation of cost-plus selling price and optimum selling price and their impact on profits Exejet Engineering Ltd manufactures a range of products for the aircraft industry including the Keroklene fuel filter for use in executive jets. A Keroklene fuel filter consists of a pump unit which contains a filter element. The pump unit has a life of five years, after which the entire fuel filter must be scrapped. The fuel filter element must be replaced at the end of each year.

The total market for this type of fuel filter is stable at a level of 2000 units a year, which Exejet shares with several competitors who supply equiva¬ lent units. However, customers must purchase replacement filter elements from the supplier of the original equipment as elements are not inter¬ changeable. The supplier who has the largest share of the market has just set its prices for 2002; these include complete fuel filter units at £390 and replacement filter elements at £80 each.

Pump units are manufactured to Exejet’s speci¬ fication by a sub-contractor at a delivered price of £305 each, but the filter elements are made in house. The budgeted cost of manufacturing 1250 filter elements in 2002 has been estimated as follows:

Complete Keroklene fuel filters are sold as a pump unit and a filter element packed together, so no assembly operation is required. Fixed costs associated with the packaging and sale of complete units and replacement elements are budgeted at £7000 for 2002, and are recovered on the basis of the direct labour hours used in the manufacture of filter elements.
Sales of the Keroklene fuel filter in 2001 are expected to be 250 complete units, a figure which has remained stable for several years and which generates a demand for 1000 replacement filter elements each year. Management are confident that the same volume will be maintained in 2002 provided that their traditional pricing policy of full cost plus 5%, rounded up to the nearest pound, is maintained. They also believe that any greater profit margin would render their product uncom¬ petitive in its limited market. However, the new management accountant feels that the 5% margin is too low and not necessarily appropriate for both complete units and replacement elements. He has therefore discussed pricing policy with Exejet’s sales manager.
The sales manager’s firm opinion is that, given the market leader’s prices for 2002, Exejet could capture 40% of the total market for complete units if it priced them at £280, but would lose sales of 5 units for every £1 charged above £280. He also believes that sales for complete fuel filter units would be unaffected by the price charged for replacement filter elements provided this did not exceed the price charged by the market leader by more than 20%. However, if replacement elements were priced at more than 20% above the main competitor’s prices then heavy sales losses for complete units would result.
Requirements:

(a) Calculate the selling prices for complete units and replacement elements that would result from the traditional pricing policy. (3 marks)

(b) Assuming that the sales manager’s views concerning the effects of price changes are correct, determine the optimum selling prices for both complete units and replacement elements. (7 marks)

(c) Calculate the change in profits that would result from using the new selling prices calcu¬ lated in

(b) above compared with the original prices calculated in

(a) above, for each year in the period 2002 to 2004. (5 marks)

(d) Outline any problems you foresee for Exejet in implementing the prices you have calcu¬ lated in

(b) above and suggest how they might be overcome. (5 marks)

(e) Discuss the reasons why many companies appear to determine their selling prices on a ‘cost-plus’ basis and evaluate the appropriate¬ ness of such a practice.LO1

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Direct labour: 1875 hours 18 750 Materials 43 750 Variable overhead 12500 Fixed overhead 5000 Total 80000