9.2 Explain how activity-based costing can be useful for pricing decisions.

Activity-based costing helps managers in pricing decisions in two ways.

1. It gives managers more accurate product-cost information for making pricing decisions.
2. It helps managers to manage costs during value engineering by identifying the cost
impact of eliminating, reducing, or changing various activities.
9.13 ‘A customer profitability profile highlights those customers that management should drop to
improve profitability.’ Do you agree with this statement? Explain your answer.

No. A customer-profitability profile highlights differences in the current period’s profitability

across customers. Dropping customers should be the last resort. An unprofitable customer in
one period may be highly profitable in subsequent future periods. Moreover, costs assigned to
individual customers need not be purely variable with respect to short-run elimination of sales
to those customers. Thus, when customers are dropped, costs assigned to those customers may
not disappear in the short run.
9.18

KidsPlay Ltd manufactures and sells table sets. In 2018, it reported the following:

Units produced and sold 3000

Investment $3 000 000

Mark-up percentage on full cost 10%

Rate of return on investment 15%

Variable cost per unit $600

Required

1. What was KidsPlay’s operating profit in 2018? What was the full cost per unit? What was the selling
price? What was the percentage mark-up on variable cost to achieve the selling price? What are the
total fixed costs?

2. KidsPlay is considering increasing the annual spending on advertising by $200 000. The managers
believe that the investment will translate into a 10% increase in unit sales. Should the company make
the investment? Show your calculations.

3. Refer back to the original data. In 2019, KidsPlay believes that it will be able to sell only 2700 units at
the price calculated in requirement 1. Management has identified $185 000 in fixed cost that can be
eliminated. If KidsPlay wants to maintain a 10% mark-up on full cost, what is the target variable cost per
unit?
9.22

C & S Mechanical Ltd sells and services plumbing, heating and air-conditioning systems. C &
S’s cost accounting system tracks two cost categories: direct labour and direct materials. C & S
uses a time- and-materials pricing system, with direct labour marked up 90% and direct materials
marked up 40% to recover indirect costs of support staff, support materials and shared
equipment and tools, and to earn a profit.
During a hot summer day, the central air-conditioning in Brooke Lee’s home stops working.
C & S technician John Anderson arrives at Lee’s home and inspects the air-conditioner. He
considers two options: replace the compressor or repair it. The cost information available to
Anderson follows:
Labour Materials

Repair option 5 hours $140

Replace option 2 hours $240

Labour rate $30 per hour

REQUIRED
1. Calculate the price that Anderson should quote for each of the charges if he presents Lee
with the ‘replace or repair’ options.
2. Advise Lee on which of the two options she should choose, assuming that they are likely to be
equally effective for the three years that Lee intends to live in the home.
3. Advise Anderson on the option that he should recommend to Lee, (1) to maximise profit; (2) to
ensure that he acts ethically.
1. As shown in the table below, Anderson will tell Lee that she will have to pay $481 to get
the air conditioning system repaired and $450 to get it replaced.
2. If the repair and replace options are equally effective, Lee will choose to get the air
conditioning system replaced for $450 (rather than spend $481on repairing it).

3. C & S Mechanical will earn a greater contribution toward overhead in the repair option
($191 = $481– $290) than in the replace option ($150 = $450 – $300). Therefore, Anderson will
recommend the repair option to Lee, which is not the one she would prefer. Recognizing this
conflict, Anderson may even present only the repair option to Michelle Lee. Of course, he runs
the risk of Lee walking away and thinking of other options (at which point, he could present the
replace option as a compromise). The problem is that Anderson has superior information about
the repairs needed but his incentives may cause him to not reveal his information and instead
use it to his advantage. It is only the seller’s desire to build a reputation, to have a long-term
relationship with the customer, and to have the customer recommend the seller to other
potential buyers of the service, that encourages an honest discussion of the options.
The ethical course of action would be to honestly present both options to Lee and have
her choose. To have their employees act ethically, organizations do not reward employees on
the basis of the profits earned on various jobs. They also develop codes of conduct and core
values and beliefs that specify appropriate and inappropriate behaviors.
9.30

The management of Green Paper Delivery Ltd (GPD) has decided to analyse the profitability
of five new customers. It buys recycled paper at $20 per case and sells to retail customers at a list
price of $26 per case.
Data pertaining to the five customers are:
Customer
1 2 3 4 5
Cases sold 1 830 6 780 44 500 31 200 1 950
List selling price $26 $26 $26 $26 $26
Actual selling price $26 $25.20 $24.30 $25.80 $23.90
Number of purchase orders 10 18 35 16 35
Number of customer visits 3 5 12 4 12
Number of deliveries 12 28 65 25 35
Kilometres travelled per delivery 14 4 8 6 45
Number of expedited deliveries 0 0 0 0 3
GPD’s five activities and the related activity-cost drivers are:

Activity Cost-driver rate

Order taking $90 per purchase order

Customer visits $75 per customer visit
Deliveries $3 per delivery kilometre travelled
Product handling $1.20 per case sold
Expedited deliveries $250 per expedited delivery

REQUIRED
1. Calculate the customer-level operating profit of each of customers 1–5 above. Comment on the
results.
2. Identify and explain the insights that managers gain by reporting both the list selling price
and the actual selling price for each customer.
3. Advise management on the factors that it should consider before deciding whether to drop
one or more of the five customers.
[

Customer 4 is the most profitable customer, despite having only 70% (31,200  44,500) of the
unit volume of Customer 3. A major explanation is that Customer 3 receives a $1.70 discount
per case, while Customer 4 receives only a $0.20 discount per case.
Customer 5 is unprofitable, while the smaller Customer 1 is profitable. Customer 5 receives a
$2.10 discount per case, makes more frequent orders, requires more customer visits, and
requires more delivery miles and expedited deliveries than does Customer 1.

2. Separate reporting of both the list selling price and the actual selling price enables
Green Paper Delivery to examine which customers receive different discounts and how
salespeople may differ in the discounts they grant. The following table shows the discounts
given after ranking customers on the basis of the total volume of products sold.
Customer Number/Sales Volume Discount per case
3 (44,500 cases) $1.70
4 (31,200 cases) $0.20
2 (6,780 cases) $0.80
5 (1,950 cases) $2.10
1 (1,830 cases) $0.00
The reasons for the $2.10 discount for Customer 5 with a sales volume of only 1,950 cases and
the $0.80 discount for Customer 2 with only 6,780 cases should be explored.
3. Dropping customers should be the last resort taken by Green Paper Delivery. Factors to
consider include the following:
a. What is the expected future profitability of each customer? Are the currently
unprofitable (5) or low-profit (1) customers likely to be highly profitable in the
future?
b. Are there externalities from having some customers, even if they are unprofitable in
the short run? For example, some customers have a marquee-value that is “in
effect” advertising that benefits the business.
c. What costs are avoidable if one or more customers are dropped?
d. Can the relationship with the “problem” customers be restructured so that there is a
“win-win” situation? For example, could Customer 5 get by with fewer deliveries per
month?