Question

Please tell me how to solve the following questions 1 to 5.

Problem statement:

Gina Picaretto is production manager at the Rich Manufacturing Company. Each year her unit
buys up to 100,000 machine parts from Bhagat Incorporated. The contract specifies that Rich will
pay Bhagat its production costs plus a $5 markup (cost-plus pricing). Currently, Bhagat’s costs
per part are $10 for labor and $10 for other costs. Thus the current price is $25 per part. The
contract provides an option to Rich to buy up to 100,000 parts at this price. It must purchase a
minimum volume of 50,000 parts.
Bhagat’s workforce is heavily unionized. During recent contract negotiations, Bhagat agreed to a
30 percent raise for workers. In this labor contract, wages and benefits are specified. However,
Bhagat is free to choose the quantity of labor it employs.
Bhagat has announced a $3 price increase for its machine parts. This figure represents the
projected $3 increase in labor costs due to its new union contract. It is Gina’s responsibility to
evaluate this announcement.

Questions:

1) Why do many firms use cost-plus pricing for supply contracts?

2) What potential problems do you envision with cost-plus pricing?

3) Should Gina contest the price increase? Explain.

4) Is the increase more likely to be justified in the short run or the long run? Explain.

5) How will a $3 increase in the price of machine parts affect Gina’s own production decisions?

Answer 1

Answer:

1) many firms use cost-plus pricing for supply contracts because:

Cost plus pricing concept is a simple method to evaluate profit and operations.

With this, the additional increase in cost of production can be easily transferred on pricing of the good eventually to the customer who buys it.

So here in this case for Rich manufacturing,

Bhagat is the supplier of machine parts and she knows that her total cost is $20 per unit and plus $5 markup per unit.

This means that Bhagat knows that she is going to earn $5 from selling each unit.

With the increase in $3 labor cost, the new price would be $28 which can be transferred to Rich to pay extra $3 per unit.

2) potential problems that envision with cost-plus pricing are:

Below are the potential problems that can be envisioned with cost-plus pricing -

a. The dynamic nature of production costs which depend on fluctuating resource costs, material costs and any breakdown costs etc. makes it difficult to frequently change the prices based on the costs.

b. Any contract signed at a fixed price will result in loss to the supplier in case the costs increase while the price on contract remains static. Similarly, reduction in production costs will lead to higher profits for the supplier as the customer purchases at the same agreed price.

c. Firms tend to limit their innovation considering the impact of the increased costs on the price. They take a more budgeted approach.

d. Cost plus pricing doesn't follow the market price and doesn't take into account the competitive consideration.

3. Gina contest the price increase:

Explanation:

Increasing the wages for the workers by $3 will increase the cost of production and in turn the price of the product.

This can have an impact on Bhagat’s sales of machine parts to Rich Manufacturing company,

since Rich Manufacturing has an option of going for the minimum purchase of 50,000 parts from Bhagat instead of the maximum limit of 1,00,000 parts.

Gina can definitely question and raise concerns on the increase in price.

However, what Gina needs to consider here is the rationale and its genuineness for the increase in price by Bhagat.

It completely makes sense to increase the price if it has not been increased in the last few years of the agreement or if it is due to changes in the economic environment of the country in which they are operating.

However, this also needs to be supported with increase in productivity and quality of work done by the labor.

On the other hand, if the increase in labor cost is due to pressure from the labor union, then Gina should consider her options for suppliers.

4.Increase more likely to be justified in the short run or the long run:

Explanation:

The given case highlights that Mr. B has to raise the cost of the machine parts By $3 each as there due to the new union contract.

When considering this increase in a short run it can be justifiable.

As per the optimal input mix when there is a change in the input the output can certainly change.

In a short term this cannot cause serious changes to the clients like Mr. G.

But when considering the long run it cannot be justifiable as lot of changes happen in between and the optimal input mis can be manipulated in the long run.

The quantities of the inputs can be varied in a long run and hence not justifiable.

5. A $3 increase in the price of machine parts affect Gina’s own production decisions:

The $3 increase can create animosity among Rich manufacturing and Bhagat incorporated; therefore, affecting any future contracts between both companies.

Furthermore, this increase will lead Gina and Rich manufacturing to consider such action and how this could affect their product’s overall price.

The $3 increase that has been passed down to Gina by the part's manufacturer need to be passed down to the consumer by raising the retail price of Gina's manufactured goods.

Consequently may affect Gina's own profit margin if her demand decreases due to her consumer's price elasticity

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