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

Analyzing Managerial Decisions: Rich Manufacturing

Analyzing Managerial Decisions: Rich Manufacturing

Question
Analyzing Managerial Decisions: Rich Manufacturing

Gina Picaretto is production manager at the Rich 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-plus pricing)
. Currently, Bhagat’s costs per part are $10 for labor and $10 for other costs
. Thus the current price is $25 per part
. The contract provides and option to Ricoh to buy up to 100,000 parts at this price
. It must purchase a minimum volume of 50,000 parts
.

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
.

Bhagat has announced a $3 price increase for its machine parts
. This figure represents the projected $3 increase in labor costs due to its new union contract
. It is Gina’s responsibility to evaluate this announcement
.

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

A:

2- What potential problems do you envision with cost-plus pricing?

A:

3- Should Gina contest the price increase? Explain

A:

4- Is the increase more likely to be justified in the short run or the long run? Explain

A:

5- How will a $3 increase in the price of machine parts affect Gina’s own production decisions?

A:

Analyzing Managerial Decisions: Rich Manufacturing

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