So, should the business accept a special unprofitable order below total cost? At the first sight, it might appear to be unwise to accept a new order, or a new contract, that does not cover all the costs associated with producing one unit.
Should a firm accept a new order that does not cover full unit cost?
The business should accept the new order as long as additional contribution can be earned. This is because Indirect Costs (Overheads) must be paid anyway.
If contracts are accepted using prices below the full unit cost, this can lead to an increase in the total profits of the business. So, the overall profits will increase.
Also, new customers can be gained. Even though the business does not make a profit now, acquiring new customers can lead to further future orders that will create further value later.
When a firm is trying to enter a new market segment, then every customer matter. It is usually very difficult to find first customers.
Finally, if a firm has enough spare capacity, then Contribution-Costing Technique can assist managers in deciding whether to accept an order at below the full cost. It is usually better to earn any contribution from additional customers than to leave the factory, hotel rooms or shops empty.
Example 1: This is why hotels often offer very low rates to customers in off-peak seasons – to earn a contribution even though they are making a loss.
An example when the business should not refuse a new order or contract even below full costs
The following example illustrates this principle of using marginal costing in accepting new business.
A sole trader runs a cake shop and produces birthday cakes. Indirect Costs (Overheads) of this young female entrepreneur are USD$30 per day. This includes paying rent to the landlord from whom she rents her cake shop.
Usually, the sole trader makes three birthday cakes per day. She sells them for a regular price of USD$30 each cake. To make each cake, she incurs the Direct Costs of USD$8 per cake to buy milk, flour, butter, chocolate, sugar, cream, etc.
When working at full capacity producing three birthday cakes in one day, her daily profit will look like this:
She is able to make a daily profit of USD$46. The unit cost of producing one cake is USD$18:
One day she has orders for only two birthday cakes. However, later in the afternoon, a new customer contacts her and said that she wants to buy a birthday cake for her friend, but she only has enough money to pay USD$20 for that cake.
Should the sole trader accept this order? Indirect Costs (Overheads) of USD$30 have to be paid to the landlord whether her cake shop is busy working at full capacity or not.
Possibility 1: She does not accept the order. So, she sells two birthday cakes only at USD$30 each.
She will make a profit of USD$14. The unit cost of producing one birthday cake is USD$23.
Possibility 2: She does accept the order. So, she sells two birthday cakes at USD$30 each, and one cake at USD$20.
She will make a profit of USD$26. Therefore, she should accept to make that third birthday cake for USD$20. The unit cost of producing one cake is the same USD$18 as when producing and selling cakes at the regular price. Because she lowered the price for making that third cake, she will earn less profit that day.
When the business should not accept a new order that does not cover full unit cost?
Firstly, when high prices help to establish the exclusivity of a brand, then offering some customers lower prices could destroy that luxurious brand image.
Secondly, existing customers may learn that the lower prices are being offered to some other customers. They may demand similar or identical treatment. If all products sold by a business are sold at the contribution-cost price then this could make earning a profit very unlikely.
Thirdly, where there is no excess capacity. It is because the business only has enough capabilities to produce products and sell them at regular prices. When selling products at the contribution-cost price, they firm may be losing sales revenue based on the full-cost price.
Lastly, sometimes lower-priced goods or services may be resold into the higher-priced market segment. In fact, many businesses do use contribution-cost pricing, but try to make sure that there is no leak into the higher-priced market, e.g. airlines, railways companies, cinemas, amusement parks, etc.
Even though a positive contribution can be made by accepting an order, there are real dangers that other customers will find out that a lower price is being offered on the particular contract. Qualitative factors are important too for businesses and must be carefully considered by managers.
