Question

McQueen is an engineering company that specializes in providing engineering facilities to businesses that cannot justify operating their own facilities in house. McQueen employs a number of engineers who are skilled in different engineering techniques that enable McQueen to provide a full range of engineering facilities to its customers. Most of the work undertaken by McQueen is unique to each of its customers, often requiring the manufacture of spare parts for its customers’ equipment, or the building of new equipment from customer drawings. As a result most of McQueen’s work is short-term, with some jobs being completed within hours while others may take a few days. To date, McQueen has adopted a cost plus approach to setting its prices. This is based upon an absorption costing system that uses machine hours as the basis of absorbing overhead costs into individual job costs. The Managing Director is concerned that, over recent months, McQueen has been unsuccessful when quoting for work with the consequence that there has been an increase in the level of unused capacity. It has been suggested that McQueen should adopt an alternative approach to its pricing based on marginal costing since “any price that exceeds variable costs is better than no work”.

With reference to the above scenario:

a) Briefly explain absorption and marginal cost approaches to pricing.

b) Discuss the validity of the comment “any price that exceeds variable costs is better

Answer 1

(a): Absorption cost approach to pricing is that method of setting prices in which price of a product include all the different variable costs that is attributable to it and a portion of all fixed costs. In this method all the costs are absorbed while determining the final price of the product. Cost per unit is computed using the formula: Variable cost per unit + ((Total overhead+administrative expenses)/no. of units produced). To this cost figure per unit an additional makeup for a profit is usually added.

Marginal cost approach to pricing is that method of setting price in which price of a product is set slightly above the variable costs that are incurred to produce it. In other words in marginal cost approach to pricing price of a product to equal the extra cost of producing an extra unit of output.

(b): The comment “any price that exceeds variable costs is better than no work” is valid and applicable in this case. This is because by setting prices that exceeds variable costs means that variable costs are covered while fixed costs are not considered while setting prices. This will mean that the unused capacity is not going wasted and that the company continues to earn contribution margin. This approach is ideal in this situation as it enables the company to earn incremental profits through its contribution margins.