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Week 5 (Midterm Exam)
Question #1. 25% High drug costs are often in the news. Consumer groups contend that the pricing for some drugs is “too high” considering that the costs to manufacture each dose in so low. They talk of price gouging and excessive profits. Pharmaceutical companies defend the price charged on the basis of nonmanufacturing costs such as research and development and others. The following is a generic value chain for a pharmaceutical firm:
- Which cost definition is being used by the consumer groups? The pharmaceutical companies?
- Which cost do you think should be included when comparing the cost of a drug with its price?
- If you were working as an executive for a pharma firm, how would you use the value chain to prepare a defense on your pricing practices?
- How could you use the information supplied by the value chain to improve the profitability of the firm when prices are set by the market? Give a real life example on how to approach this problem (for the pharma industry) from a management perspective. Answer:
- Consumer groups use traditional production cost to explain their concerns that the cost of production is very low, but the price of the drug is very high and consumer groups are only considering the primary activities of the value chain that comprise of chiefly operations (production), marketing and logistics (distribution). The most important component out of these, in the minds of consumer groups while calculating the expected price, is the production cost, which is the direct cost of raw material and labor. The pharmaceutical companies, on the other hand, realize that support activities of a value chain, majorly technological developments (R&D and design) consume a huge chunk of their financial resources, which can be categorized into the indirect costs. It causes the price of the drug to be higher to recover all these cost.
- Both the variable costs (raw material and labor costs per unit of medicine) and fixed costs distributed over the expected sales volume (R&D, design, marketing and
distribution) should be used to determine the cost of the drug. The expected price then can be calculated by assuming a certain profit margin over the cost.
- As a defense, A. I will come up with the sunk cost associated with each step of the value chain and the data of cost incurred before producing a single unit of drug. B. The detailed breakup of the recovery of cost W.R.T the period of time and volume of production, so that the cost will be distributed for the whole production of the particular drug. C. Plan of reducing the prices of the drug once the past investments is recovered and the breakeven in case of the particular drug is achieved. 4- The cost of the drug should be distributed over a period of time. Though, it can happen that in the initial years, there can be a higher recovery of investments. It will push to the increased sales and profitability part will increase. Further, there should be different prices in different marker and it should be on the basis of local economic, political and social conditions. For example, a new medicine for the cancer is invented, and then the company puts different prices to the medicine in US market, European nations, Asian countries and Africa. Here, the price is fixed on the basis of value chain cost method, but economic conditions and purchasing power of the population is also considered before fixing a price in the particular market. Question 2. CVP analysis with Changing Cost Structure. 25% Billot Telephone was formed in the 1940s to bring telephone services to remote areas of the US Midwest. The early equipment was quite primitive by today’s standards. All call were handled manually by operators, and all customers were on party lines. By the 1970’s, however, all customers were on private lines, ad mechanical switching devices handled routine local and long distance calls. Operators remained available for directory assistance, credit card calls and emergencies. In the 1990s Billot Telephone added local internet connections as an optional service to its regular customers. It also established an optional cellular service, identified as Home Ranger.
- Using a unit level analysis, develop a graph with two lines representing Billot’s cost structure. Be sure to label the axes and lines o In the 1940s o In the late 1990s
- With sales revenues as the independent variable, what is the likely impact of the changed cost structure on Billot’s: o Contribution Margin Percent
Where C=cost, x= (every 1000 customers). Taking a range of values for x=1,2,3...10 and calculating corresponding C values, we get the graph below. Excel has been used for these calculations. So the graph will be below :
A-Contribution margin percent : Because variable costs decrease, the contribution margin percent will increase. Contribution margin ratio= (revenue-variable expenses)/revenue The contribution margin will increase if there is a reduction in variable costs and expenses per unit.In the 1940s, variablle cost was higher therefore the CM percentage was lower compared to in the 1990s.Lower variable cost equals higher CM percentage. As per cost function, the variable expense has decreased during 1990s(7$ compared to 15$ in 1940s), hence contribution margin ratio has increased during 1990s. B-Break-even point : with an increase in fixed costs and a decrease in variable costs, the impact on the break-even point cannot be determined. If there is a change, the bep will likely increase because of downward pressure on prices. Break-even point shifts to the right if there is an increase in fixed cost and decrease in variable cost. To reduce a company’s break-even point you could reduce the amount of fixed costs. In the 1990s the fixed cost higher and variable cost was lower, causing the break-even point to shift to the right. 3- Operating leverage= (revenue-variable cost)/ (revenue -variable cost- fixed operating cost) Taking customers = 3000000000 and price as 20 and net income as flat over the years Operating leverage for 1940s = 3000000(20-15)/[3000000(20-15)-2000000]=15000000/(13000000)= 1.1538(approx) Operating leverage for 1990s = 3000000(20-7)/[3000000(20-7)-5000000]=39000000/(34000000)= 1.1471(approx) Therefore, I can say that change in the cost structure has reduced Billot's operating leverage. A high operating leverage means proportion of variable costs is higher compared to fixed costs. Less no of customers are required to cover total costs. Therefore, a high operating leverage results in lower profits and a low operating leverage leads to higher profits. As operating leverage has reduced during 1990s, it can be concluded that profitability has increased during that period.
Direct Materials $ Direct Labor (5 hours at $11 per hour) $ 55 Overhead ($18 per direct labor hour) $ 90 Total cost per 1000 square feet $ She is quite certain about the estimates for direct materials and for labor. However she is not as comfortable with the overhead estimate. The estimate of $18 per direct labor hour was determined by dividing the total overhead for the 12 month period ($1,296,000) by the total direct labor hours (72,000). By using a regression of overhead on direct labor hours the following cost formula was obtained: Overhead = $52,400 + $9.25 DLH
- The overhead developed from the least square regression is different from her preliminary estimate of $18 per direct labor hour. Explain the difference in the two overhead rates
- Prepare a bid for a 50,000 square feet project under both cost formulas. Assume that the 50,000 sq ft job would use a month time of capacity and that the monthly fixed overhead is $52,400/12.
- Which one would you recommend to be used for the project?
- If management does not feel comfortable with the fixed/variable cost relationship that currently exists, could she do something about it? Come up with a managerial recommendation on how to deal with this situation?
- How far can a manager go into changing the microeconomics of a firm (i.e. Fixed to Variable costs ratio). Is there an industry effect that determines that ratio?
- Amazon’s Inc. success can hardly be questioned. How does Amazon’s strategy relate to this question? **Answer:
- Difference in the two overhead rates :** Company preliminary overhead application rate is determined based on total hours worked and the total overhead cost incurred without considering the cost behavior. Least square aggression method analyzes the cost into fixed component and variable component based on costs given at different data points. The difference in overhead rate is due to difference in analysis of cost. Overhead cost are important for many manufacturing company. Overhead cost are indirect manufacturing cost like indirect material, indirect labor lubricants, etc. Overhead cost can be fixed or variable or both.
Bid for a 50,000 square feet project under both cost formulas: Preliminary Estimation Method: Particulars Calculation Amount($) Direct Material ($390/1000) X 50,000 19, Direct Labor ($55/1000) X 50,000 2, Overheads ($90/1000) X 50,000 4, Total Cost per 50,000 sq feet 26, Therefore, Total cost as per preliminary estimation of 50,000 square feet is $26,750. Least Square Regression Method: Particulars Calculation Amount($) Direct Material ($390/1000) X 50,000 19, Direct Labor ($55/1000) X 50,000 2, Overheads 250 hours X $9.25 2, Total Cost per 50,000 sq feet 24, Therefore, Total cost as per Least Square Regression of 50,000 square feet is $24,563. 3. The preliminary estimation method is recommended to use as it is higher than the least square method. It will also give good return.
She could reduce certain fixed costs to improve cash flow is a possible way , but may require decisions like moving to a less expensive workplace or reducing the number of employees. Other fixed costs, like depreciation, on the other hand, won’t improve her cash flow but may improve the company’s balance sheet. One way she could reduce variable costs is by finding a lower-cost supplier for the company’s product.
These are the decisions that must be made by a firm’s top management using microeconomic data and formulas. The decision-making processes are determined by analysis of the information and the choosing the best-case scenario. More often than not, senior managers make the right decisions. It’s not unusual, however, for top managers to make a wrong decision, and sometimes a series of wrong decisions that may eventually prove fatal to their companies.
Variance Analysis for Connor Company Actual Results (1) Flexible- Budget Variances (2) = (1) – (3) Flexible Budget (3) Sales- Volume Variances (4) = (3) – (5) Static Budget (5) Output units Direct materials Direct manufacturing labor Direct marketing labor Total direct costs
$12,000 U
7 ,600 U
4 ,400 U
$24,000 U
$48,000 F
9 ,600 F
14 ,400 F
$72,000 F
$24,000 U $72,000 F
Flexible-budget variance Sales-volume variance $48,000 F Static-budget variance b. The Level 1 analysis shows total direct costs have a $48,000 favorable variance. However, the Level 2 analysis reveals that this favorable variance is due to the reduction in output of 1,200 units from the budgeted 10,000 units. Once this reduction in output is taken into account (via a flexible budget), the flexible-budget variance shows each direct cost category to have an unfavorable variance indicating less efficient use of each direct cost item than was budgeted, or the use of more costly direct cost items than was budgeted, or both. Hence, the vice president is not satisfied with the performance of the company. Because the original cost of production of the company is more than the budgeted cost. It shows the bad performance of the company. Revised performance report using flexible budget and static budget. Actual unit variable cost that exceeds budgeted unit cost for each direct cost category: Details Actual Budgeted Units Direct materials Direct manufacturing labor Direct marketing labor
Causes of these more aggregated (Level 2) variances can be identified by analyzing efficiency and price variances of each category of cost.
