Cost allocation, downward demand spiral. Cayzer Associates operates a chain of 10 hospitals in the Los Angeles area. Its central food-catering facility, Mealman, prepares and delivers meals to the hospitals. It has the capacity to deliver up to 1,300,000 meals a year. In 2012, based on estimates from each hospital controller, Mealman budgeted for 975,000 meals a year. Budgeted fixed costs in 2012 were $1,521,000. Each hospital was charged $6.46 per meal—$4.90 variable costs plus $1.56 allocated budgeted fixed cost. Recently, the hospitals have been complaining about the quality of Mealman’s meals and their rising costs. In mid-2012, Cayzer’s president announces that all Cayzer hospitals and support facilities will be run as profit centers. Hospitals will be free to purchase quality-certified services from outside the system. Ron Smith, Mealman’s controller, is preparing the 2013 budget. He hears that three hospitals have decided to use outside suppliers for their meals; this will reduce the 2013 estimated demand to 780,000 meals. No change in variable cost per meal or total fixed costs is expected in 2013.

Required

1. How did Smith calculate the budgeted fixed cost per meal of $1.56 in 2012?

2. Using the same approach to calculating budgeted fixed cost per meal and pricing as in 2012, how much would hospitals be charged for each Mealman meal in 2013? What would their reaction be?

3. Suggest an alternative cost-based price per meal that Smith might propose and that might be more acceptable to the hospitals. What can Mealman and Smith do to make this price profitable in the long run?