First thing the #management accountant should do is refresh on what the pricing models available are (#cost plus, Value based pricing, Target pricing, etc.) and what the #opportunity cost of the new sale would be. Since the question is not what should the price be, but what is the minimum price we will focus on the cost side of the equation.
The starting point of any pricing discussion has to be that our #price must be high enough to cover reasonable fluctuations in sales volume and be high enough to cover your #fixed and #variable cost (*).
What matters is to know whether you can produce the additional volume from the existing cost base (so no increase in #fixed costs or capacity is required to produce those additional parts). The following situations are important in determining the new price:
Situation 1: Capacity Available
If your company can get produce all the products, and has sufficient production capacity, then, the minimum price per unit it should charge for its products is the variable cost per unit. Minimum margin in this scenario is thus the #contribution margin (Price – Variable cost).
Situation 2: Capacity in NOT Available at current volume or cost levels
If your company can produce all the products, but has no sufficient production capacity or needs to increase their fixed costs to produce them, then, the minimum price per unit it should charge for these new products is the variable cost per unit + fixed costs per unit at current production levels. This makes sense as you now need to employ more fixed #manufacturing #expenses to make more units and you need to recover these by the margin of the sales of the new product. Minimum margin for this scenario is thus the contribution margin (Price – Total Mfg cost).
Situation 3: Capacity is available but for a different product than you currently produce
If your main product has too little capacity, then for each unit of the substitute product the minimum price should be the variable cost of the main unit plus the lost contribution margin of the substitute product. You should not sell and produce this new product if the substitute product if the selling price is below this value.
Where Sales gets Confused
Many of your sales managers will agree with the above concepts if you lay it out (especially number 1 and 2, number 3 hurts a bit… but I am sure you will manage to explain). But now we come to year 2 of sales and you reassess your fixed costs per unit. In situation number 1, where you quoted at variable costs in year 1, in year 2 you will now suddenly have a negative margin on this particular product you quoted at variable cost in year 1 as it now gets #overhead costs allocated and appears on your Dog list (the list of parts with negative margins). Lets look at this situation a bit more in detail.
Suppose for an existing unit: Variable cost 5 + Fixed costs 20.000/(2 hours x 1000 units) 10 = Total Cost 15. Selling price could be as advised anywhere above the Variable cost, lets suppose we sold it for 7.50 per unit. Contribution margin still looks good at a 2.5 (or 33%)
In year 2 if you actually ongoing the additional 100 units of this new product. Margin for this product would be:
Selling price: 7.5
Variable cost: 5
Fixed Cost 20.000 / (2 hours x 1100 new total units): 9
Manufacturing Margin: -6.5
Now note that this -6.5 on this newly sold product is offset by the other products as the existing products will see a manufacturing margin improvement in Year 2 as their fixed costs per unit reduced as well. (remember their fixed cost per unit went from 10 to 9).
Now lets look at the option above if we would not have quoted the contribution margin and we would have foregone the sale.
If you had not quoted you would have lost the sales 7.5 – 5 variable cost = 2.5 x 100 units = 25, so clearly contributing to the bottom line..
Fixed costs would still be in the old situation 10 a 1000 units versus 9 at 1100 units in the new situation, so overall no impact there.
You should always quote at variable cost if capacity stays the same and if fixed costs do not increase. Although this will hardly be the case, so think twice if you have taken all variables into #account.
If you do not have capacity or need to expand your fixed costs to meet the new volume demand, you should quote at full product cost.
If you have capacity but want to quote for a substitute product from existing capacity, take into consideration the foregone contribution margin of your existing product portfolio.
And finally it is important to remember when and why a product was quoted at a variable cost. If you do not remember this reason you may decide to get rid of the product and increase the fixed costs per unit on your existing product base (assuming fixed costs do not change) and forgo the contribution margin that you gained from this additional sale.