Question

Calculate selling prices, using alternative approaches to costing and pricing..

and to think about the circumstances where each approach might be appropriate. This will illustrate the impact that different ways of measuring ‘cost’ can have on decision-making.

The relevant cost, however, often depends on the timescale involved. In the short term, fixed costs may be unavoidable regardless of the course of action taken, in which case only the variable costs are relevant to the decision. In the longer term the level of most costs can be adjusted (and hence become avoidable) and so, for decisions with longer-term implications, fixed costs become relevant also. A long-standing controversy in setting selling prices based on cost, is which cost figure should be used: full cost, including fixed costs (absorption costing) or variable cost (marginal costing)? The case of Peter Smith requires you to focus on these alternative approaches and their implications.

Peter Smith Banjo strings

Peter Smith produces three different types of guitar strings, which sell in packs of six strings. Monthly cost and output figures for each string type are as follows:

Table Product cost and output data

	Fine gauge	Medium gauge	Flatwound	Total
Total variable cost	£8,000	£18,000	£20,000	£46,000
Fixed cost*	£6,000	£6,000	£6,000	£18,000
Number of packs of 6 produced	4,000	4,000	4,000	12,000

* Total fixed cost is apportioned among the three products on a ‘units basis’, that is, according to the number of units (packs of strings) of each product produced.

Currently the company uses a full cost plus approach to setting selling prices, adding a 30% profit mark-up to full cost. The Chief Executive, however, is very worried about the low level of sales and the resulting unused production capacity (the company is only operating at about 70% of capacity). It has been suggested to her by the company’s accountant that an alternative approach to pricing, based on marginal costing, be adopted. The justification provided by the accountant was that it was necessary to reduce price in order to generate more sales and any price that exceeds the variable cost would produce a positive contribution towards fixed costs which would be incurred anyway, regardless of the level of sales.

Task

Calculate the selling price per pack for each product, using, firstly, the current absorption costing approach and then, the proposed marginal costing approach. Remember that the difference between the two approaches is simply that with absorption costing a fixed cost per unit (pack) must be calculated and then the variable cost per unit added in order to arrive at a full cost figure. Once you have calculated the cost per pack, simply add the specified percentage of the cost figure as the profit mark-up. With the marginal cost approach, the logic, in this case, would be to consider any price significantly in excess of the variable cost as potentially acceptable. With the current absorption costing approach, a fixed, customary percentage is added to full cost as the profit mark-up.

If your calculations are correct, you should have noticed just how much difference the different costing approaches can make to the selling price charged to customers!

Comment on the difference in cost and price: is it significant? In what circumstances would each approach be appropriate?

Record your results, spreadsheets and comments in a simple report with the title: Comparing absorption and marginal costing. Also add any description to help me the student understand the answers you give. (idiots guide, assuming a basic knowlege of cash accounting already exists)

Answer 1

70% capacity utilisation (12000 units)
Full-cost approach	Fine gauge	Medium gauge	Flatwound
Variable cost/pack(Total v.c./No.of packs)	2	4.5	5
Fixed cost/pack(Total F.c./no.of packs)	1.5	1.5	1.5
Total cost/pack	3.5	6	6.5
Markup(Total cost*30%)	1.05	1.8	1.95
Selling price/pack	4.55	7.8	8.45
Marginal cost approach
Variable cost/pack(Total v.c./No.of packs)	2	4.5	5

100% capacity utilisation --12000/70*100=17142 units
	Fine gauge	Medium gauge	Flatwound	Total
Total variable cost	11,428	25,713	28,570	65,711
Total fixed cost	6000	6000	6000	18000
No.of packs	5714	5714	5714	17142
Full-cost approach
Variable cost/pack(Total v.c./No.of packs)	2	4.5	5
Fixed cost/pack(Total F.c./no.of packs)	1.05	1.05	1.05
Total cost/pack	3.05	5.55	6.05
Markup(Total cost*30%)	0.92	1.67	1.82
Selling price/pack	3.97	7.22	7.87
Marginal cost approach
Variable cost/pack(Total v.c./No.of packs)	2	4.5	5
Any selling price above this will contribute towards covering the fixed costs ,
so, the more no.of units, the more the contribution towards the fixed costs.

Variable cost/unit remains the same under both approaches

whereas,

Fixed cost/unit is more when capacity utilisation is less than 100% & less when the latter is 100% utilised.

ie. More the no.of units produced & sold , less the per unit cost.

Variable cost is fixed/unit & varies in direct proportion to no.of units produced /sold.

This is reflected in setting the selling price/unit.

When lesser no.of units are produced& sold, selling price /unit is more , as each unit has to bear more of fixed costs.

whereas,

When more no.of units are produced& sold, selling price /unit is less , as each unit has less to bear of the total fixed costs.

In full costing , fixed MOH s are included as product cost.

But Under   variable costing, fixed MOH are treated as period cost.

Normally, for external use & reporting puposes, we use only full costing .

Variable costing is used for internal purposes only, like assessing the profitability of a particular line of products(when it breaks even with the fixed costs), taking decisions such as make or buy, continue/discontinue a line of manufcature,etc.--ie. It is used in managerial decisions.