Question

Imperial Devices (ID) has offered to supply the state government with one model of its security screening device at “cost plus 20 percent.” ID operates a manufacturing plant that can produce 66,000 devices per year, but it normally produces 60,000. The costs to produce 60,000 devices follow.
Production costs: Total Cost Cost per Device Materials $ 4,500,000 $ 75 Labor 9,000,000 150 Supplies and other costs that will vary with production 2,700,000 45 Indirect cost that will not vary with production 2,700,000 45 Variable marketing costs 1,800,000 30 Administrative costs (will not vary with production) 5,400,000 90 Totals $26,100,000 $435

Based on these data, company management expects to receive $522 (= $435 × 120 percent) per monitor for those sold on this contract. After completing 500 monitors, the company sent a bill (invoice) to the government for $261,000 (= 500 monitors × $522 per monitor). The president of the company received a call from a state auditor, Materials $ 75 Labor 150 Supplies and other costs that will vary with production 45 $270 Therefore, the price per monitor should be $324 (= $270 × 120 percent). The state government ignored marketing costs because the contract bypassed the usual selling channels. Required What price would you recommend? Why? ( Note: You need not limit yourself to the costs selected by the company or by the government auditor.)

please provide interpretation of the answer in 4-5 sentences

Answer 1

This problem demonstrates the ambiguity of cost-based contracting and, indeed, the measurement of “cost.”

Recommended prices may range from the $324 suggested by the state government to the $522charged by Imperial Devices. The key is to negotiate the cost-based price prior to the signing of the contract. Considerations that affect the base costs are reflected in the following options:

Options:

A.        Only the differential production costs could be considered as the cost basis.

B.        The total cost per device for normal production of 60,000 devices could be used as the cost basis.

C.        The total cost per device for production of 66,000 devices, excluding marketing costs, could be used as the cost basis.

D.        The total cost per device for production of 66,000devices, including marketing costs, could be used as the cost basis.

	Costs		Unit Cost Options (One Unit = One Device)
				A		B		C		D
Materials (variable)................................................	$75.00		$75.00		$75.00		$75.00		$75.00
Labor (variable)................................................	150.00		150.00		150.00		150.00		150.00
Supplies (variable)................................................	45.00		45.00		45.00		45.00		45.00
Indirect costs (fixed)....................................................	2,700,000		N/A		45.00	a	40.91	b	40.91
Marketing (variable)................................................	30.00		N/A		30.00		N/A		30.00
Administrative (fixed)....................................................	5,400,000		N/A		90.00	c	81.82	d	81.82
Per device cost basis.......................................................			$270.00		$435.00		$392.73		$422.73
Per device price (Cost + 20%).............................................................			$324.00		$522.00		$471.28		$507.28

a $45.00 = $2,700,000 ÷ 60,000 units.

b $40.91 = $2,700,000 ÷ 66,000 units.

c $90.00 = $5,400,000 ÷ 60,000 units.

d $81.82 = $5,400,000 ÷ 66,000 units.

We believe the most justifiable options exclude marketing costs and reflect the potential production level of 66,000 devices. These are Options A and C. (As stockholders in Imperial Devices, we would prefer Option C.) Also, depending on the resolution of the term “cost,” we may want to consider whether the 20 percent markup in the next contract is sufficient.