Chapter 12.A, Problem 10P

To determine

Absorption Cost Approach:

It is cost based method of determining the price under which the price of a product is based on the cost of incurred on the product. In other words, all the costs are absorbed under absorption cost approach in fixing the price of the product.

1. Compute the unit product cost for the remodeled product.

2. Compute the markup percentage on absorption cost for the remodeled product.

3. What selling price would the company established for its remodeled product using markup percentage on absorption cost?

4. If the company sold only 10,000 units (instead of its planned sales volume of 12,000 units) at the selling price that you derived in requirement 3. What ROI did the company actually earn at this lower sales volume?

5. Assume that the company wants to raise the price of its newly remodeled product with the intention of achieving the product’s desired ROI at the lower sales volume of 10,000 units. Using absorption cost-plus pricing, what would be the revised selling price at this lower sales volume? How might customers react to this new price?

Explanation of Solution

1.

Computation of Unit Product Cost

Particulars	Unit cost
Direct Materials	$4.00
Direct labor	$3.00
Variable Manufacturing overhead	$1.00
Fixed manufacturing overhead ($66,000 / 12,000 units)	$5.50
Total Unit Product Cost	$13.50

2.Computation of markup percentage on absorption cost

  $\begin{array}{l}Markuppercentageonabsorptioncost=\hfill \\ \frac{\left(RequiredROIXInvestment\right)+Sellingandadministrationexpense}{UnitProductCostXUnitSales}\hfill \\ =\frac{\left(16\%X\$150,000\right)+\text{ (}\$1X12,000+\$45,000)}{\$13.50perunitX12,000Units}\hfill \\ =\frac{\$24,000+\$57,000}{\$162,000}\hfill \\ =\frac{\$81,000}{\$162,000}\hfill \\ =50\%\hfill \end{array}$

3. Computation of Selling Price per unit

Unit Product Cost	$13.50
Add: Markup on absorption cost	$6.75
Selling Price per Unit	$20.25

  $\begin{array}{l}*Markuponabsorptioncost=UnitProductCostXMarkuppercentageonabsorptioncost\hfill \\ =\$13.50X50\%\hfill \\ =\$6.75\hfill \end{array}$

4.The company earns a Return on Investment of 1% over its operating assets at Sales volume of 10,000 units

  $\begin{array}{l}ReturnonInvestmentat10,000units=\frac{NetOperatingIncome}{AverageOperatingAssets}\hfill \\ =\frac{\$1,500}{\$150,000}\hfill \\ =1\%\hfill \end{array}$

Currington Company Absorption Costing Income Statement
Sales revenue ($20.25 X 10,000 units)	$202,500
Less: Cost of Goods Sold ($14.60 X 10,000 units)	$146,000
Gross Margin	$56,500
Less: Selling and Administration expenses ($1 X 10,000 + $45,000)	$55,000
Net Operating Income	$1,500

*Computation of Revised Unit Product Cost at 10,000 units

Particulars	Unit cost
Direct Materials	$4.00
Direct labor	$3.00
Variable Manufacturing overhead	$1.00
Fixed manufacturing overhead ($66,000 / 10,000 units)	$6.60
Total Unit Product Cost	$14.60

5. Computation of Revised Selling price per unit at sales volume of 10,000 units

Unit Product Cost	$14.60
Add: Markup on absorption cost	$7.90
Selling Price per Unit	$22.50

Revised Unit Product Cost

Particulars	Unit cost
Direct Materials	$4.00
Direct labor	$3.00
Variable Manufacturing overhead	$1.00
Fixed manufacturing overhead ($66,000 / 10,000 units)	$6.60
Total Unit Product Cost	$14.60

  $\begin{array}{l}Markuppercentageonabsorptioncost=\hfill \\ \frac{\left(RequiredROIXInvestment\right)+Sellingandadministrationexpense}{UnitProductCostXUnitSales}\hfill \\ =\frac{\left(16\%X\$150,000\right)+\text{ (}\$1X10,000+\$45,000)}{\$14.60perunitX10,000Units}\hfill \\ =\frac{\$24,000+\$55,000}{\$146,000}\hfill \\ =\frac{\$79,000}{\$146,000}\hfill \\ =54.11\%\hfill \end{array}$

  $\begin{array}{l}*Markuponabsorptioncost=UnitProductCostXMarkuppercentageonabsorptioncost\hfill \\ =\$14.60X54.11\%\hfill \\ =\$7.90\hfill \end{array}$

The reaction of customers depends upon the type of customers. If the customers of Currington Company are loyal customers, the increase in the price would result in positive reaction and customers would continue to use the product. But in case the customers of the company are not loyal to the company and only care about the quality and price of the product, the increase in price could be bad move for the company resulting in loss of customers.