Exercise 18.18 - Cost-Based Pricing

Otero Fibers, Inc. specializes in the manufacture of synthetic fibers that the company uses in many products such as blankers, coats, and uniforms for polie and firefighters. Otero has been in business since 1985 and has been profitable every year since 1993. The company uses a standard cost system and applies overhead on the basis of direct labor hours.

Otero has recently received a request to bid on the manufacture of 800,000 blankets scheduled fo rdelivery to several military bases. The bid must be stated at full cost per unit plus a return on full cost of no more than 10 percent after income taxes. Full cost has been defined as including all variable costs of manufacturing the product, a reasonable amount of fixed overhead, and reasonable incremental administractive costs associated with the manufacture and sale of the product. The contractor has indicated that bids in excess of $30 per blanket are not likely to be considered.

In order to prepare the bid for the 800,000 blankets, Andrea Lightner, cost accountant, has gathered the following information about the costs associated with the production of the blankets.

Direct material

$1.70 per pound of fibers

Direct labor

$6.50 per hour

Direct machine costs*

$10.00 per blanket

Variable Overhead

$3.00 per direct labor hour

Fixed Overhead

$8.00 per direct labor hour

Incremental administrative costs

$2,450 per 1,000 blankets

Special fee**

$0.50 per blankets

Material Usage

6 pound per blanket

Production rate

4 blankets per direct labor hour

Effective tax rate

35%

*Direct machine costs consist of items such as special lubricants, replacement of needles used in stitching, and maintenance costs. These costs are not included in the normal overhead rates.

**Otero recently developed a new blanket fiber at a cost of $750,000. In an effort to recover this costs, Otero has instituted a policy of adding a $0.50 fee to the cost of each blanket using the new fiber. To date, the company has recovered $125,000. Lightner knows that this fee does not fit within the definition of full cost, as it is not a cost of manufacturing the product.

Required:

1. Calculate the minimum price per blanket that Otero Fibers could bid without reducing the company's operating income.

2. Using the full-cost criteria and the maximum allowable return specificed, calculate Otero Fibers' bid price per blanket.

3. Without prejudice to your answer in Requirment 2, assume that the price per blanket that Otero Fibers calculted using the cost-plus criteria specified is greater than the maximum bid of $30 per blanket allowed. Discuss the factors that Otero Fibers should consider before decideding whether or not to submit a bid at the maximum acceptable price of $30 per blanket.