MBA540: Managerial Economics
September 9, 2012
Saint Leo University
Prof. P. Wiseman
Gina Picaretto, a production manager at Rich Manufacturing, has been tasked to evaluate a $3 increase in the price of parts supplied by Bhagat Incorporated. The price increase is a result of a new labor contract entered into by Bhagat with a union (Brickley, Smith, & Zimmerman 2009). The contract between Rich Manufacturing and Bhagat Inc specifies that Rich will pay Bhagat its production cost plus a $5 markup (Brickley et al.2009). The current cost is $25 per part; the new cost will be $28 per part.
Analyzing Managerial Decisions: Rich Manufacturing
Why do many firms use cost-plus pricing for supply contracts? The easiest answer is that it’s an easy method to calculate. Managers simply target a rate of return. This method of pricing calculates “the average total cost of a product and then marks up the price to yield a target of return (Brickley et al.2009). One of the problems with cost-plus pricing is that demand for a product is ignored. According to Brickley et al.(2009), cost-plus pricing seems to ignore incremental costs and disregards the price sensitivity of consumers. Both of these factors are important and key to maximizing profits. In sum, a firm may not realize maximum profits by using cost-plus pricing. In this scenario, should Gina contest the price increase? Given the outline of the case, Gina has little recourse. There is a contact in place that obligates Rich Manufacturing to pay production costs plus $5. Labor is an inherent part of production, so there is no recourse if Rich Manufacturing continues to use Bhagat as a supplier. However, there are some options available to Gina. She could exercise the option to purchase up to 100,000 parts at the current price and store the parts. Moreover, she could attempt to find another supplier and not renew the contract...