Ace manufacturing has entered into a supply agreement with KB toys. KB is very concerned about meeting competitive price points in a profitable way. As a result, they are looking to keep costs as low as possible while delivering a quality product on time. In order to win the contract for the new Chainsaw Toy, Ace agreed to a Fixed Price + Incentive Fee contract with a 50/50 sharing of any cost reductions. They have opened their books to KB and revealed a cost of $9.50 per unit.
Target Price: $10.85
Price ceiling: $11.00
Target cost: $9.50
What is the maximum the KB will pay under this agreement?
If Ace succeeds at taking 1.50 out of the cost, what will the selling price be? What will Ace's margin (profitability) be?
If Ace's costs go up by $0.50, what will be the impact on their profitability?
What are the pro's and con's of such a contract from Ace's perspective?