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

CASE STUDY: Rich Manufacturing
Gina Picaretto is production manager at the RichBhagat has announced a $3 price increase for its

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-

machine parts. This figure represents the projected

plusÿoricinÿ. Currently, Bhagat’s costs per part are

Discussion Questions

$10 for labor and $10 for other costs. Thus the
current price is $25 per part.The contract provides
an option to Rich to bu y up to 100,000 pasts at this

price. It must purchase a minimum volume of

50,000 pasts.
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.

$3 increase in labor costs due to its new union

contract. It is Gings 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. Howwill a $3 increase in the price of machine
parts affect Gina’s own production decisions?