Question

Cost-Based Pricing

Otero Fibers, Inc., specializes in the manufacture of synthetic fibers that the company uses in many products such as blankets, coats, and uniforms for police and firefighters. Otero has been in business since 1985 and has been profitable every year since 1993. The company uses a standard cost system and applies overhead on the basis of direct labor hours.

Otero has recently received a request to bid on the manufacture of 800,000 blankets scheduled for delivery to several military bases. The bid must be stated at full cost per unit plus a return on full cost of no more than 10 percent after income taxes. Full cost has been defined as including all variable costs of manufacturing the product, a reasonable amount of fixed overhead, and reasonable incremental administrative costs associated with the manufacture and sale of the product. The contractor has indicated that bids in excess of $30 per blanket are not likely to be considered.

In order to prepare the bid for the 800,000 blankets, Andrea Lightner, cost accountant, has gathered the following information about the costs associated with the production of the blankets.

Direct material	$1.70 per pound of fibers
Direct labor	$6.50 per hour
Direct machine costs*	$10.00 per blanket
Variable overhead	$3.00 per direct labor hour
Fixed overhead	$8.00 per direct labor hour
Incremental administrative costs	$2,450 per 1,000 blankets
Special fee**	$0.50 per blanket
Material usage	6 pounds per blanket
Production rate	4 blankets per direct labor hour
Effective tax rate	35%

^*Direct machine costs consist of items such as special lubricants, replacement of needles used in stitching, and maintenance costs. These costs are not included in the normal overhead rates.

^**Otero recently developed a new blanket fiber at a cost of $750,000. In an effort to recover this cost, Otero has instituted a policy of adding a $0.50 fee to the cost of each blanket using the new fiber. To date, the company has recovered $125,000. Lightner knows that this fee does not fit within the definition of full cost, as it is not a cost of manufacturing the product.

Required:

1. Calculate the minimum price per blanket that Otero Fibers could bid without reducing the company's operating income. If required, round your calculations and final answer to the nearest cent.
$ per blanket

2. Using the full-cost criteria and the maximum allowable return specified, calculate Otero Fibers' bid price per blanket. For computation of the allowable return, round the before-tax rate of return to two decimal places (for example, 15.468% rounds to 15.47%). Round your final answer to the nearest cent. Round all other intermediate computations to two decimal places.
$ per blanket

Answer 1

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1.     The minimum price per blanket that Otero Fibers, Inc., could bid without reducing the company’s net income is $25.03, calculated as follows:

        Direct materials (6 pounds × $1.70)........................        $10.20

        Direct labor (0.25 hour × $6.50)..............................            1.63

        Machine time ($10/blanket).....................................          10.00

        Variable overhead (0.25 hour × $3).........................            0.75

        Administrative costs ($2,450/1,000)........................            2.45

                Minimum bid price...........................................        $25.03

2.     Using the full-cost criteria and the maximum allowable return specified, Otero Fibers, Inc.’s, bid price per blanket would be $31.19, calculated as follows:

        Relevant costs (from Requirement 1)......................        $25.03

        Fixed overhead (0.25 hour × $8).............................            2.00

                Subtotal............................................................        $27.03

        Allowable return (0.1538* × $27.03)......................            4.16

                Bid price..........................................................        $31.19

        *0.10/(1 – 0.35) = 0.1538