Cost-plus pricing is a very common pricing method because a firm calculates average total cost and then mark up the price to yield a target rate of return (Brickley, Smith, & Zimmerman, 2009, p. 211). It can be very beneficial for a firm to use this method because it is like a guarantee on the rate of return. In this case, Bhagat benefits from the cost-plus pricing because the newly decided raise will not affect their bottom line. Their contract specifically states that labor is included. Questions Two
There may be problems with cost-plus pricing for some firms on the other side of the contract because now their bottom line is affected with a labor increase. However, this is in their contract and something that was mutually agreed on. This can create a problem in the relationship of those bound because a firm such as Bhagat can take advantage of the contract and increase their labor costs knowing it would be covered by the other. Questions Three
Depending on the contract specifications, Gina should contest the price if the increase took place in the middle of the contract or if the labor cost details are not included. The contract specifies that Rich Manufacturing Company will pay Bhagat’s production costs but the particulars are left unspoken. Gina can contest the price increase if the contract does not include specific price increases with labor and should because her company’s profit is now in jeopardy. Rich Manufacturing Company could be paying an additional $150,000 to $300,000 more than normal with this labor cost increase. Questions Four
This increase will be justified in the long-run because the price increase for Rich will require an adjustment in their total cost and will have immediate effects. With time, the increase will balance out and the firm will have adjusted their costs to permit a positive outcome. Firms can lose money in the short run yet still find it optimal to stay in business (Brickley, Smith, & Zimmerman, 2009, p. 181). Questions Five
A $3 increase in price of machine parts will affect Gina’s own production decisions because this increase will create increased costs elsewhere. This part increase will lead to an increase in the part’s total cost which could affect the demand of the part and decrease the total sales. Gina will have to decide if it is more beneficial to absorb the cost difference now or to increase the total cost of the part.