A meeting of senior managers at the Newcastle Division has been called to discuss the pricing strategy for a new product.. In the last year a significant number of new products have failed to achieve their forecast sales volumes. The accountant has already stated that the profit for the year-end will be lower than budget and the main reason for this is the disappointing sales of new products. As a result, two different strategies are proposed.
Details of pricing strategies
A number of managers are in favor of this strategy as they believe it is important toreduce costs.
The second strategy is to have a much higher expenditure on advertising and promotionsand set a selling price of $190. With the higher selling price the annual fixed costs would
increase to $27,000,000. The marketing department is very clear that greater expenditure
on advertising and promotions is essential for this product.
The problem has been estimating demand, particularly elasticity of demand.
Managers are uncertain if demand is elastic (i.e. goes UP with a price decrease and DOWN with a price increase) or inelastic (demand is relatively stable whether prices go up or down).
Estimated demand (units)
150,000
160,000
180,000
200,000
210,000
Variable costs per unit
The managers estimate that the variable cost per unit is $35.
Overhead
Overhead is applied based on ABC. There are four activity pools:
ActivityEstimated CostsEstimated Activity Level
Set-ups$500,000100,000
Finishing $600,000 50,000
Product changes $100,000 25,000
Assembly $300,000 60,000
Actual activity was as follows:
Set-ups 10
Finishing 5
Product changes 10
Assembly 5
Service Costs
There are two production departments: Assembly and Finishing. Each of these two departments uses the services provided by the IT and Maintenance Departments, which both support the production functions and each others’ functions as well. Newcastle uses the step method of allocating these service department costs to the production departments. IT is allocated on the basis of hours of department operations and Maintenance is allocated on the basis of departmental Direct Labor hours. Maintenance is allocated first.
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The following costs pertain to the IT and Maintenance Departments’ total costs:
IT: $400,000
Maintenance: $200,000
Use the calculated OH costs calculated above in answering #C below.
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Production Department data:
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Assembly
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Finishing
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IT
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Maintenance
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Hours of operation
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10,000
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15,000
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30,000
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5,000
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Direct labor hours recorded
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8,000
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16,000
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8,000
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16,000
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Required:
a. Determine the amount of Maintenance costs allocated to the Assembly and Finishing Departments using the step method of allocating service department costs.
b. Determine the amount of IT costs allocated to the Assembly and Finishing Departments using the step method of allocating service department costs.
c. Determine the total overhead costs of the Assembly and Finishing Departments when this (step) method of allocating service department costs is used.
Questions
Question 1
What is the break-even for each alternative? Show calculations.
Question 2
What is the total product cost, excluding service department allocations, for each alternative?
Question 3
What is the total cost that should be attributed to each alternative, including allocated service costs?
Question 4
Explain how your answer would change if demand elasticity was:
a) elastic b) inelastic
