Here is a simplified case study illustrating the importance of distinguishing between fixed and variable costs and between average and marginal costs.
Example. The Getalife Nutrition Company produces one basic health supplement. Its ingredients are guano, oregano and glue. Each supplement requires the use of an industrial sized blender-mixer and a machine that fabricates the supplement into capsules. Each machine must be operated by a skilled operator. The machines and their operators require factory space which must be rented and machinists must be supervised.
As a rule the company sells its supplement only under its own label. Towards the end of its fiscal year the mega grocery chain, Up Against the Wall Mart, has expressed interest in purchasing a large order to be marketed under its Sham store label. Moe, the comptroller, Larry, the plant manager and Curly, the lead machine operator get together to consider the minimum price they should accept.. They begin their analysis by looking at the following historical production cost information.
Looking at these numbers Moe says it is a “no brainer”. “Since the average total unit cost is $.102 we should not accept less than this amount.”
Larry disagrees. “The total average cost you are using includes fixed costs. The company will incur these fixed costs whether we accept the extra order or not. Therefore, we should look at only the direct extra costs we will incur by accepting the new order. According to the above data this unit cost was $.072 per unit. If we get a price higher than this figure we will still be better off even thought the price may not be equal to our total average fixed cost per unit.”
Curly concurs partially with Larry. “Larry, you are on the right track by ignoring the fixed costs, but on the wrong track by looking strictly at the variable historical average costs. The key question is what variable costs will be incurred if we take this big order. Now if the historical average costs represents the actual costs we will incur then fine. Let’s use these figures. But as I see it to get a big order done on the tight time frame that Up Against the Wall Mart will impose will require us to pay some overtime and so our direct labor costs will be higher than average. On the other hand if we get a very big order we will be able to buy much larger quantities of guano, glue and oregano than we usually do. This will give us larger volume discounts than usual. This means that our direct materials cost will be lower than our average historical costs. Based on my analysis this is what our direct unit costs will actually look like:
“On this basis we must get a price of at least .085 per unit”
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The above case study illustrates two principles of analyzing costs in making pricing decisions:
1. Only variable costs should be considered. Fixed costs should be ignored.
2. Only marginal costs, that is the costs of producing the next units, rather than the historical average unit costs, are relevant in pricing decisions.