Lee High, the newly hired cost accountant, computes the variable cost and the fixed cost per unit at a volume of 500 units of Great Heath per week. He uses this information to develop some guidelines for pricing. His boss, Charlton Blackheath, endorses the guidelines and adds a feature: a higher commission on sales at a higher price. When both High and Blackheath are away, the file clerk, Adelaide Ladywell, accepts an order below the guidelines and is fired. Students are asked to develop an appropriate set of decision rules for pricing Great Heath, and to evaluate the decision made by Adelaide. 

TEACHING OBJECTIVES This case relates to these subjects:

1.The breakdown of costs into fixed and variable categories; 

2.The development and usefulness of contribution margin; and 

3.Pricing strategies. 

SUGGESTED STUDENT ASSIGNMENT 

1.Develop an appropriate set of decision rules for pricing the Great Heath. 

2.Evaluate the decision made by Adelaide Ladywell.

ANALYSIS 

1. Develop an appropriate set of decision rules for pricing the Great Heath. 

Table TN1provides detail on how Lee High put together his ―Useful Data on Great Heath‖ in the case. 10Table TN1Cost of Great Heaths Variable Fixed Cost of 500 units Manufacturing Cost Cost Cost Total Per Unit Direct materials$ .75-$ 375$ .75Direct labor1.25-6251.25Indirect labor.20$ 100200.40Indirect material 300300.60 Electricity.1075125.25Factory Insurance-125125.25Other overhead.50110360.72Total$ 2.80$ 710$2,110$ 4.22Administrative and Selling At $7.00 price.707811,1312.26Total shown by Lee High$ 3.50$1,491$3,241$ 6.48Added amount for rounding, etc..12Lee High‘s stated total cost per unit$ 6.60In the long run, Blackheath must price Great Heath at a level sufficient to cover all its costs. Accordingly, decision rules #1 and #2 presented in the case seem reasonable at first glance for Blackheath‘s typical business. However, note that these decision rules do depend on expected volume (the rules presented in the case assume an average volume of 500 units per week), so they would change with any change in expected volume. In addition, these decision rules assume that there is sufficient capacity to handle all business won. If Blackheath encounters capacity constraints, it would have to revisit itsdecision rules to direct the sales representative and office sales staff to choose those orders that offer the highest contribution margin. Finally, if Blackheath has excess capacity, it may be beneficial to relax the rules to allow sales representatives more flexibility in lowering the price, as Blackheath may benefit from taking on additional work at greater than its variable costs but lower than its full cost of $6.60 to use the excess capacity. The bottom line: the decision rules should depend on expected volume and capacity constraints. 

2). Evaluate the decision made by Adelaide Ladywell. Blackheath may want to review one-time special orders, such as the one with Maze Woolwich, on a case-by-case basis. If Blackheath has the capacity to handle a special order, it is beneficial to do so if the order is priced high enough to cover the variable costs associated with the order. Any contribution generated from the order can help Blackheath cover its fixed costs. Thus, for direct office sales, Blackheath should set a price greater than $2.80. For sales by its sales representative, Blackheath should set a price greater than 3.11 (price =[2.80 +0.10xprice]). If Blackheath does not have the capacity to handle the special order, it should accept it only if the price less the sales commission on the special order is greater than the price less the sales commission on the regular business it must displace to accommodate the special order. Of course, Blackheath should consider qualitative factors in making its decision, including the impact of displacing its normal business to accommodate a special order to ensure there is no longer-term impact on its regular business. These considerations may outweigh any financial analysis related to the special order itself. 11The $5.50 price per unit that Maze Woolwich requested is greater than the variable cost of $2.80 per unit. In addition, there is no indication in the case that the Maze Woolwich order will impact Blackheath‘s ability to service its regular business. Thus, Adelaide Ladywell‘s decision to accept the special order seems justified. TEACHING STRATEGY The instructor should begin by ensuring the class understands how Lee High computed his ―Useful Data on Great Heath‖ presented in the case. Once the class is comfortable with this data, the instructor can ask the class what they think of the decision rules Lee High proposed. Students usually support them because the prices suggested by the rules are what are necessary for Blackheath to break even. It is useful to do a calculation of breakeven at this point to ensure students understand the concept. For example, at a $7.00 price, one would have a $3.50 contribution margin per unit ($7.00 price -$3.50 variable cost per unit). Weekly sales of 426 units would be breakeven volume, just covering the $1,491 fixed cost ($1,491 fixed cost / $3.50 contribution margin per unit = 426 units). However, during the discussion, students will begin to realize that the proposed decision rules assume volume of 500 units per week, and are silent on the issue of capacity utilization. Important points to come out in the discussion at this point are:1.In the long run, Blackheath must price high enough to cover all costs.2.Decision rules for pricing will depend on expected volume.

3). Capacity constraints and excess capacity will affect the decision rules. After these points come out in the discussion, the instructor can suggest the class discuss Blackheath‘s thoughts about paying a higher percentage commission with a higher price per unit. Ask ―What do you think of Mr. Blackheath‘s decision that the sales representative sell at $8.00 at a 15% commission?‖ At the $8.00 price and 15% commission, variable costs total $4.00 per unit, and the contribution margin of $4.00 per unit covers the $1,491 fixed costs if Blackheath sells 373 units ($1,491 fixed cost / $4.00 contribution margin per unit). If the sales representative sells all 373 units, he will make $447.60 (at breakeven of 373 units). Alternatively, if he sold the break-even volume at $7.00, he would make only $298.20. Clearly, he should prefer the $8.00 price per unit and 15% commission. In fact, the sales representative would be better off at the $8.00 price if he sold anything over 249 units than he would be selling 426 break-even units at $7.00. However, at $8.00, whether he can sell breakeven of 373 units depends on the price elasticity of the Great Heath. The company would be less well off unless his $8.00 sales were at least 373 units. Thus, the company‘s interest and the sales representative‘s interest do not coincide completely. With sales between 249 and 373 units, the higher price with the higher commission would be good for the sales representative but bad for the company. At this point, the instructor can move the discussion to the special order. Ask the question, ―So, it looks like Charlton Blackheath did the right thing when he fired Adelaide Ladywell.

QUESTION: Prepare production budget Cost of production budget Prepare cash budget

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