Question

I have a client: XYZ company. XYZ makes bicycles in the high side of the market, $2,500 and above. In many ways they are used by the top riders in competitive races in the World. The variable cost to manufacturer is $1,000. The fixed cost are $500 per bicycle. Profit is $1,000. The manufacturing of the bicycles are in the same plant as the manufacturer of a very plain generic bicycle sold through COSTCO. The plain bicycle sells for $250 at WALMART. This label is called CHEAPBicycles. The volume for each products is as follows: Awesome Bicycle #1,000; CHEAPBicycles #200,000.   What do you think considering the statement that companies should always make and sell all products whose selling prices exceed variable costs with the assumption that fixed costs are irrelevant.

Answer 1

The given case relates to the technique of applying Marginal costing to pricing a product. Contribution of a product ( Selling price- Variable Cost) helps in recovering fixed cost. Any pricing below variable cost will lead to loss since there will be no contribution received from that. Hence as long as Company is able to recover variable cost the products can be manufactured and sold. A Fixed cost is a sunk cost and not relevant in decision making. Hence whatever company is able to charge above Variable cost helps in recovering Fixed cost to the extent possible.

The given case can be summarized as below

Assuming cheap bicycle can be sold for $ 250 and has a variable cost of $ 200 per Bicycle

As it is clear from above case since pricing is above variable cost it helps in giving huge contribution due to higher volumes. A Simulation analysis of above will show as long as pricing is above variable cost there will be positive contribution and beneficial to company. Hence company should manufacture the Bicycle and sell them.