Is the Managing Directors friend right in suggesting that marginal costing is an appropriate way to control costs and set a selling price?
The Shetland Wool Company is a small family-owned company that produces very high-quality hand knitted wool sweaters. It uses a relatively small number of casual employees who produce the garments in their own homes. These are then sold in small numbers to exclusive outlets. The current performance of the business is not good and the Directors have looked in some detail at the cost base. They have established the following information;
• The average cost of the wool used in a garment is £28.50
• The labour involved in producing a sweater is on average 30 hours
• Casual labour currently costs £5.50 per hour; however, the Directors feel that in order to maintain staff they will have to increase this next year by at least 5%
• The transportation costs involved in producing the sweaters together with the cost of delivery amount to £4.50 per sweater.
In addition to the above costs the company also runs a Head Office which costs £100,000 per year. The Directors require total salaries of £125,000 and each year they award themselves a 5% pay increase. The level of advertising is an issue on which the Directors do not agree. This year advertising spend is £115,000. Next year the Sales Director would like to advertise in airline magazines, he believes that this would increase sales from this year’s forecast of 2,000 sweaters. He estimates that if the advertising budget is increased to £285,000 then sales would increase to 5,000 sweaters. The Finance Director feels that this is not realistic and at the last Board meeting said "whatever we spend on that advertising thing we will never ever sell more than 3,000 sweaters". The Sales Director replied by saying "if we sold sweaters at £200 each, I could make annual sales of 10,000". Is the Managing Directors friend right in suggesting that marginal costing is an appropriate way to control costs and set a selling price? You should illustrate your answer with relevant calculations.
It is difficult to make a direct comparison of competing products. However high-quality knitted sweaters sell for between £200 and £400. The Shetland Wool Company has always assumed that the market is not particularly price sensitive and their reputation is for very high-quality garments.
The company`s current pricing policy is not very clear, in the past they have aimed for 200% of budgeted manufacturing costs at normal volumes. However, a friend of the Managing Director recently told her that this was not necessary. The friend said that all the company needed to concentrate on was its marginal costs. If it could keep these low and made sure that the selling price was a little bit higher the rest would all work out.
The Managing Director asks you for your help. You are required to write a report (1500 words) covering the costing and pricing issues set out above. In particular you should address the following;
1. Is the Managing Directors friend right in suggesting that marginal costing is an appropriate way to control costs and set a selling price? You should illustrate your answer with relevant calculations.
2. What other methods of costing might be appropriate? Your answer should be supported by appropriate theory.
3. You are asked to suggest a selling price for both the current year and next year. You should justify your price on the basis of costing and pricing theory. You are also required to produce a break-even analysis to support your suggested selling price.
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