What cost can you sell at?

Factory (Photo credit: howzey)

In this post, I recount a conversation I had with a great mentor some years ago. It questioned my notion of what costs are relevant and how to set prices once a plant/factory is not at full capacity.

In a factory ( or any business perhaps ) when there is free capacity we can start to look at the make up of costs a little closer. Traditionally, management accounting would suggest we should at least cover all variable costs in the selling price. But think about it like this – if we have spare capacity, then perhaps the only additional cost is the material cost. Let’s assume we have a machine with a full crew, but not at full capacity. The fixed costs of the machine are just that – fixed, and we cannot avoid them. The labour costs are in effect fixed too, as workers will be paid. So, in this case, only the material costs are relevant. And this, any selling price above the material cost contributes to profit.

Yes, there may be many simplistic assumptions in the above. However, it made me think back then and I always give this example to my students. It is of course an example of throughput accounting, which I will mention next week.