Chapter 23: Decision Analysis: Time and Materials

Time and Materials Pricing Time and materials pricing is a common method for service-oriented businesses. It involves setting prices for labor and materials, each incorporating overhead costs and desired profit margins. Here’s a breakdown of how this pricing method works: Steps for Time and Materials Pricing 1. Compute Time Charge per Hour of Direct Labor: o The time charge includes labor costs, non-materials-related overhead, and a target profit. This calculation sets the hourly rate for labor. 2. Compute Materials Markup Percentage: o The materials markup covers the overhead costs associated with handling materials and includes the target profit margin on materials costs. 3. Estimate Costs and Apply Markup: o Estimate the total direct labor hours and the costs of materials for the job. Combine the calculated labor charges and materials costs (with markup) to determine the total service price. Illustrative Example: Erin Builders • • • Time Charge per Hour: This covers direct labor costs, relevant overhead, and profit margin. Materials Markup: A percentage that includes overhead related to material handling plus target profit. Job Estimate: The job is expected to require 300 direct labor hours and $14,000 of direct materials. Using time and materials pricing, the calculated total price for the job is $35,800 (as shown in Exhibit 23.14). Comprehensive Decision Situations Below are specific managerial decision scenarios involving production, capacity, and pricing strategies: Production Decisions 1. Make or Buy Decision: o Situation: Green Co. considers making Part JJ (currently bought for $40/unit). Making the part would require $11 in materials, $15 in direct labor, and incremental overhead of $17 per hour. o Decision: Buy the part because producing it internally would result in a $3 per unit cost increase. 2. Sell or Process Further Decision: Situation: Gold Co. has produced 10,000 units for $75,000, sellable as-is for $100,000. Alternatively, they can be processed further for $80,000 and sold for $220,000. o Decision: Process further for an additional $40,000 in income. 3. Scrap or Rework Decision: o Situation: Packer Co. has 1,200 defective earbuds that cost $90,000. Selling as-is yields $66,000, or rework them for $30,000 to sell at $120,000. o Decision: Rework the earbuds for an additional $24,000 in income. 4. Sales Mix Decision: o Situation: Champ Co. has limited capacity (900 machine hours) for two scooter models. The Edge model uses 2 hours/unit, and the Razz model uses 3 hours/unit. Calculation of contribution margin per machine hour determines the most profitable mix. o Decision: Only produce the Edge for the highest contribution margin. o Capacity Decisions 5. Segment Elimination: o Situation: Badger Co.’s snowboard division shows a $5,000 loss, with $25,000 in avoidable fixed costs. o Decision: Eliminate the division, increasing income by $2,000. 6. Keep or Replace Decision: o Situation: Buckeye Inc. owns a machine with $95,000 book value, $26,000 in annual variable costs, and 5-year remaining life. A new machine costs $115,000 but cuts annual variable costs by $16,000. o Decision: Replace the machine, increasing income by $35,000. Pricing Decisions 7. Total Cost Pricing: o Situation: LA Surf sells surfboards with per-unit costs (materials: $55, labor: $35, variable overhead: $20, SG&A: $20). The company aims to produce 1,000 units and applies a 20% markup on total costs. o Decision: Set a selling price of $408 per unit. 8. Special Offer Pricing: o Situation: Marlin Co. produces fishing rods ($35/unit). A foreign company offers to buy 10,000 units at $22 each, with $2,000 incremental fixed overhead and $5,000 incremental SG&A costs. o Decision: Accept the special offer, which increases income by $48,000. Key Takeaways • • Time and Materials Pricing allows service businesses to cover costs and ensure profitability by including overhead and target profits in labor and materials charges. Decision-Making Rules: o Make or Buy: Choose the option with lower total costs. o Sell or Process: Process further if incremental revenue exceeds additional costs. o Scrap or Rework: Rework if the increased revenue justifies additional expenses. o Segment Elimination: Eliminate if it improves overall income. o Keep or Replace: Replace assets if the new option results in net savings or income gains. o Pricing: Use total cost and special offer analyses to set prices that meet financial targets while accounting for market conditions. By applying these frameworks, managers can make informed choices that align with the business’s financial goals and market strategy.