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

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

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.

All questions should be answered for each case study. If calculations would enhance your commentary, it is strongly urged that you include these calculations. The length of a case study is determined by how well you include the requested
information. Succinct, complete answers that show that you have prepared your writing with thought and reflection are preferable to answers that ramble and are not reflective of the course content. A complete, well developed response can be given in one paragraph, several paragraphs or a page depending on the question and your ability to articulate your answer. If it requires more than one page that is acceptable as well. The written assignments will be critiqued on the technical part of your answer, the clarity and logical sequence of your response, and grammar and spelling. You are encouraged to use textbook concepts as you attempt to explain in your own words the
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