Why do many firms use cost-plus pricing for supply contracts?

CASE STUDY: Rich Manufacturing

CASE STUDY: Rich Manufacturing

Question
CASE STUDY: Rich Manufacturing

Gina Picaretto is production manager at the RichBhagat has announced a $3 price increase for its

Manufacturing Company
. Each year her unit buys

up to 100,000 machine parts from Bhagat Incorporated
. The contract specifies that Rich will pay

Bhagat its production costs plus a $5 markup (cost-

machine parts
. This figure represents the projected

plusÿoricinÿ
. Currently, Bhagat’s costs per part are

Discussion Questions

$10 for labor and $10 for other costs
. Thus the

current price is $25 per part
.The contract provides

an option to Rich to bu y up to 100,000 pasts at this

price
. It must purchase a minimum volume of

50,000 pasts
.

Bhagat’s workforce is heavily unionized
. During

recent contract negotiations, Bhagat agreed to a

30 percent raise for workers
. In this labor contract,

wages and benefits are specified
. However, Bhagat is

free to choose the quantity of labor it employs
.

$3 increase in labor costs due to its new union

contract
. It is Gings responsibility to evaluate this

announcement
.

1
. Why do many firms use cost-plus pricing 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
. Howwill a $3 increase in the price of machine

parts affect Gina’s own production decisions?

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