A long-term pricing policy should aim to recover more than the 'full cost' to ensure a reasonable return on capital employed. A firm cannot survive if it has to sell its products continuously below 'full cost'. Marginal cost may be used as a basis for short-term pricing decisions. Usually, marginal cost is used to determine prices for non-repetitive orders under difficult business conditions or to use spare capacity when acceptance of lower contributions and profit margins may be necessary. When capacity is unused, acceptance of an order with lower contribution helps partial recovery of the fixed cost. Factors to be considered in fixing selling prices when demand is below normal are the amount and the rate of contribution which the proposed selling price would yield; probability of securing an order with higher contribution during the period of execution of the order; proposed concession, when compared with the normal selling price on full cost basis; probable adverse effects on future sales. When one or more resources are scarce, (e.g. material is scarce), the first consideration must be to reserve the same for orders that would yield the highest contribution per unit of the scarce resource (the limiting factor). A decision to sell at a lower price might also have an adverse effect on the firm's general level of selling prices in its established market. This aspect should also be carefully examined before accepting an order with contribution lower than the normal contribution.
Other factors, which strongly justify acceptance of an order with lower contribution at the time adverse trade situations, are to: (a) hold together the skilled labour force; (b) keep the plant and machinery in operation and the workers busy; (c) utilize materials already received; (d) avoid costs involved in the closing and re-opening of the plant; (e) maintain the sales of complementary products at a satisfactory level; and (f) maintain position in established markets to avoid additional sales promotion expenses in reestablishing the markets.
Selling below full cost prices, even under a normal situation, may be adopted in order to: (a) introduce a new product, (b) execute an order in a special market segment (say, defense supply) which is immune from other market segments; (c) expand the export market; and (d) dispose of a product which deteriorates fast.
Example 6.14: The Everest Snow company manufactures and sells direct to consumers 10,000 jars of 'Everest Snow' per month at Rs. 1.25 per jar. The company's normal production capacity is 20,000 jars of snow per month. An analysis of cost for 10,000 jars is given below:
Direct material Rs. 1000
Direct labour 2475
Power 140
Miscellaneous supplies 430
Jars 600
Fixed expenses of manufacturing, selling and administration 7955
Total Rs. 12600
The company has received an offer for the export, under a different brand name for 1, 20,000 jars of snow at 10,000 jars per month at 75 paise a jar. Write a short report on the advisability or otherwise of accepting the offer.
Solution:
Statement of Contribution from the Export Order
Selling price per unit Rs. 0.7500 Variable cost per unit:
Direct labour Rs. 2,475/10,000 0.2475 Power Rs. 140/10,000 0.0140 Misc. supplies Rs. 430/10,000 0.0430
Jars Rs. 600/10,000 0.0600 (0.4645) Contribution margin per unit Rs. 2855 Contribution per month: Rs. 0.2855 x 10,000 Rs. 2855
Acceptance of the export order would result in incremental contribution of Rs. 2,855 per month. The following statement reveals monthly profit, with and without acceptance of order.
Present position Proposed offer Total (10,000 jars) (10000 jars) (20000 jars) Sale Value Rs. 12,500 7500 20000 Variable cost of sales @ Rs. 0.4645 (4,645) (4,645) (9290) Contribution 7,855 2855 10710 Fixed Cost (7,955) - (7955) Profit -100 2855 2755
It is advisable to accept the order provided:
(a) interest on incremental working capital would be lower than the total contribution from the export order;
(b) acceptance of the export order with lower contribution would not adversely affect the price in home-maker or the future sales;
(c) there is no possibility for dumping, i.e. re-export by the supplier; and
(d) there is no possibility of securing an order with higher contribution during the period of execution of the order.
Example 6.15: AB Ltd. manufactures three products X, Y, and Z. Standard selling process and costs have been established for 2003 as follows: .
X Y Z
Selling price per unit Rs. 28 Rs. 60 Rs. 125 Direct materials per unit 8 15 20 Direct wages per unit 10 20 50 Variable overheads per unit 5 10 25
Direct wages are paid at the rate of Rs. 2 per hour in each case. Fixed overheads are budgeted at Rs. 25,000 for the coming year.. In the short run, the company cannot increase its direct labour strength and as a result, only 35,000 direct labour hours will be available in the coming year. The company has commitments to produce 500 units of each product. It has been suggested that after meeting the minimum requirements for X, Y and Z, the balance of available direct labour hours should be used to produce product Z. You are required:
A) To prepare an income statement showing the expected results if the proposal is adopted.
B) Comment on the statement you have produced in (a) and prepare an income statement for any alternative policy, which you consider would be more profitable.
C) Basing your calculations on your suggestion in (b), show the company's break- even point in terms of units and sales value.
D) Show the sale value which is required to produce an after tax return of 10% on