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Hi. Alan Stratton here from Cost Matters dot Com
Back in business school, my professor presented us with a case study. The core question of
the case was whether to take an order where the price was at a significant discount from
normal pricing and less than the full cost of the product. Of course the natural conclusion
was to refuse the order. Why? Who wants to sell their product at a loss?
Further reading into the case study then provided a few additional facts:
First This was a one-time order and not likely to be repeated.
Second The potential customer was very different from typical customers.
Third The company has significant excess capacity. Fourth The price is greater than the direct
or marginal unit costs When provided these additional facts, the
new decision was to take the order because it would contribute to profits. The marginal
revenue was greater than the marginal costs. Nice. Right! Let’s use marginal cost all
the time in cost management decisions. Forget full cost. As long as each order covers marginal
cost, profits will improve. Not so fast! There are significant implications in the additional
facts of the case study. On the first fact - One time order. Most businesses
depend on repeat customers. We spend a lot of money to identify and attract new customers.
Future orders from the same customer do not require the same levels of expensive marketing
and sales processes. Ideally, this new relationship will evolve into a long term relationship.
If it does, then what pricing expectations have been created with this customer? At this
pricing level, will the long term relationship be profitable?
On the second fact - Very different customer. This is actually a very interesting and pivotal
area to explore. On one side, the opportunity may signal a new market or channel to exploit
with existing products. In this case, the opportunity should be explored to determine
the potential, the environment, and how it fits with the business vision and strategy.
On the other side, most businesses have found a sweet spot in their market and attract customers
that fit in this sweet spot. We fine tune our processes to serve them. A very different
customer may create significant challenges that turn out to be very costly.
On the third fact - Significant excess capacity. This is a key requirement to the marginal
costing business case. Capacity cost is included in the full cost of the product. Capacity
cost is the ultimate fixed cost and will not change with the addition of this order’s
volume. However, this assumes that the business actually understands its capacity and how
it affects their cost structure. Often, capacity is the result of the interaction of many smaller
capacity units. Upon investigation, a bottleneck in a key process may impact the profitability
of the order. This order may push aside more profitable orders or require purchasing more
capacity to solve the bottleneck. On the fourth fact - Price greater than the
direct or marginal unit costs. Most businesses lack a good understanding of their cost structure.
Since cost is critical to the marginal cost decision, cost cannot be assumed. Most businesses
have a good knowledge of material costs and a reasonable understanding of direct labor.
However, these are not the only components of direct or variable cost. Over the past
few decades, overhead has grown to be a significantly larger portion of total cost. Overhead has
both fixed and variable components. The variable components will increase total cost with the
new order. But if these are not understood before the new order is accepted, they could
drive overall profitability lower rather than higher. Separating costs into fixed and variable
components is difficult and depends greatly on timeframe assumptions. In the end, overhead is an area where a cost
discipline such as Activity-Based Cost or ABC will greatly improve cost management.
With a thorough cost understanding, this decision could be contemplated based on its facts and
not on gross assumptions. Can marginal cost be used for decision making?
Should it replace full cost? Or, should it be discarded? The answer is to use both intelligently
and with a full understanding of their strengths and limitations. Neither can provide all the
information required. Marginal costing tends to be very short term in nature while full
costing tends to be longer term. Especially over the longer term, total revenue must exceed
total cost for profitable growth. Over the long term, if all orders are profitable only
on a marginal cost basis, bankruptcy is inevitable. Decisions should consider both sets of implications.
What is your experience with marginal cost in your company? Please share below.
To your business profitability, I am Alan Stratton from Cost Matters dot Com THANK YOU