Why do many firms use cost-plus pricing for supply contracts?.
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 (costplus 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 an option to Rich 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?
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. How will a $3 increase in the price of machine parts affect Gina’s own production decisions?
In this case, we are put in the shoes of Gina, who is the production manager at Rich Manufacturing. Gina has just been told that the cost of one of her inputs to production is going to increase from $25 to $28 per part due to an internal labor negotiation that her supplier had with its union. The contract that Gina’s company has agreed to with the counterparty, Bhagat, is a cost-plus contract, which makes Gina’s company liable for the increase. The questions asked in this case are (a) Why do firms use cost-plus pricing, (b) What potential problems do you see with cost plus pricing, (c) Should Gina contest the price increase, (d) Is the increase more likely justified over the short or long-run, and (e) How will the increase in the cost of production affect Gina’s production process.
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