Analyzing Managerial Decisions
1.Why do many firms use cost-plus 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?
Why do many firms use cost-plus for supply contracts?
“Firms that use the technique calculate the total cost and then mark up the price to yield a target rate of return” (Brickley et al, 2009, p 211). “Often information on marginal revenue and marginal cost is difficult to obtain with precision, making it impossible to exactly determine the point of profit maximization. By using cost-plus pricing, you can simply include a desired rate of return in the mark-up” (Graham, 2013). The primary purpose is so highly used by firms is the ease. You do not have to be as accurate with your estimates, and you need to have knowledge of the market. Knowledge of the market will lead to the appropriate requirement for the actual cost of the product.
What potential problems do you envision with cost-plus pricing? The potential problem with “cost-plus pricing is it focuses on average rather than marginal cost. Because profit maximization requires marginal cost equals marginal revenue, cost-plus pricing may not result in profit maximization” (Graham, 2013, p 238). The main reason a company is in business is to make a profit, and if you miss the market you will not make money. Cost-Plus does not focus on demand, and this could result in an excess surplus of goods.
Should Gina contest the price increase? Explain.
Gina should contest the price increase. Rich Manufacturing has a contract with a $5 mark up for cost-plus pricing. This increase is Bharat Incorporated labor cost and not at Rich Manufacturing. Bhagat Incorporated’s costs are rising because of his labor is unionized, and they renegotiated their contract. The production company is still in the green as there is a $2 difference in the cost-plus pricing contract. The contract will need to be renegotiated in the interim, and they should come to a new agreement of terms. Is the increase more likely to be justified in the short run or the long run? Explain.
It would be hard to justify the increase in the short run. “The difference between marginal cost and average total cost may be sizable” (Graham, 2013). The operating cost of the products increased by $3. This means Rich Manufacturing would have to increase the overall cost of their product to maintain the profit maximization. The demand of goods in the short run will not increase and as the market has not changed because of the negotiations. In the long run, fixed cost do not exist, “all inputs and costs are variable” (Brickley et al, 2009, p 171) In the long run, it could benefit Rich manufacturing at the market could increase the demand and the contracted cost will enforce the parts to be sold, and increasing their profit.
How will a $3 increase in the price of machine parts affect Gina’s own production decisions? Gina will need to do cost estimation and determine the amount of fixed and variable costs in the products produced from these parts. Gina will have to decide whether to buy the fifty thousand parts instead of the one hundred thousand parts. Thus, creating a lack of supply in the market and hopefully increasing the demand. Then Rich Manufacturing can raise the price of their products. Then go back to Bharat Incorporated and buy more parts at the higher price while continuing to maximize profit. This decision can also slow the production of Gina’s plant and reducing the profit margin and then reduces the supply of goods in the market.