E. Berg and Sons build custom-made pleasure boats that range in price from $10,000 to $250,000. For the past 30 years, Mr. Berg, Sr., has determined the selling price of each boat by estimating the cost of material, labor, and a pro-rated portion of overhead, and adding 20 percent to their estimated costs. For example, a recent price quotation was determined as follows:
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Direct materials
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$ 5,000
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Direct labor
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8,000
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Overhead
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2.000
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$15,000
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Plus 20%
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3,000
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Selling price
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$18,000
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The overhead figure was determined by estimating total overhead costs for the year and allocating them at 25 percent of direct labor. If a customer rejected the price and business was slack, Mr. Berg, Sr., would often be willing to reduce his markup to as little as 5 percent over estimated costs. Thus, average markup for the year is estimated at 15 percent.
Mr. Ed Berg, Jr., has just completed a course on pricing, and believes the firm could use some of the techniques discussed in the course. The course emphasized the contribution margin approach to pricing, and Mr. Berg, Jr., feels that such an approach would be helpful in determining the selling prices of their custom-made pleasure boats. Total overhead, which includes selling and administrative expenses for the year, has been estimated at $150,000, of which $90,000 is fixed arid the remainder is variable in direct proportion to direct labor.
1. Assume that the customer in the example rejected the $18,000 quotation and also rejected a $15,750 quotation (5 percent markup) during a slack period. The customer countered with a $15,000 offer.
(a) What is the minimum selling price Mr. Berg, Jr., could have quoted without reducing or increasing company net income?
(b) What is the difference in company net income for the year between accepting and rejecting the customer's offer?
2. What advantages does the contribution margin approach to pricing have over the approach used by Mr. Berg, Sr.?
3. What pitfalls are there, if any, to contribution margin pricing?