Calculate selling prices, using alternative approaches tocosting and pricing..
and to think about the circumstances where each approach mightbe appropriate. This will illustrate the impact that different waysof measuring ‘cost’ can have on decision-making.
The relevant cost, however, often depends on the timescaleinvolved. In the short term, fixed costs may be unavoidableregardless of the course of action taken, in which case only thevariable costs are relevant to the decision. In the longer term thelevel of most costs can be adjusted (and hence become avoidable)and so, for decisions with longer-term implications, fixed costsbecome relevant also. A long-standing controversy in settingselling prices based on cost, is which cost figure should be used:full cost, including fixed costs (absorption costing) or variablecost (marginal costing)? The case of Peter Smith requires you tofocus 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 figuresfor 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 ofstrings) of each product produced.
Currently the company uses a full cost plus approach to settingselling prices, adding a 30% profit mark-up to full cost. The ChiefExecutive, however, is very worried about the low level of salesand the resulting unused production capacity (the company is onlyoperating at about 70% of capacity). It has been suggested to herby the company’s accountant that an alternative approach topricing, based on marginal costing, be adopted. The justificationprovided by the accountant was that it was necessary to reduceprice in order to generate more sales and any price that exceedsthe variable cost would produce a positive contribution towardsfixed costs which would be incurred anyway, regardless of the levelof sales.
Task
Calculate the selling price per pack for each product, using,firstly, the current absorption costing approach and then, theproposed marginal costing approach. Remember that the differencebetween the two approaches is simply that with absorption costing afixed cost per unit (pack) must be calculated and then the variablecost per unit added in order to arrive at a full cost figure. Onceyou have calculated the cost per pack, simply add the specifiedpercentage of the cost figure as the profit mark-up. With themarginal cost approach, the logic, in this case, would be toconsider any price significantly in excess of the variable cost aspotentially acceptable. With the current absorption costingapproach, a fixed, customary percentage is added to full cost asthe profit mark-up.
If your calculations are correct, you should have noticed justhow much difference the different costing approaches can make tothe 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 simplereport with the title: Comparing absorption and marginal costing.Also add any description to help me the student understand theanswers you give. (idiots guide, assuming a basic knowlege of cashaccounting already exists)
