Berg & Sons build custom-made pleasure boats that range in price from $150,000 to $1,500,000. For the past 30 years, Ed Berg Sr. has determined the selling price of each boat by estimating the cost of direct materials, direct manufacturing labor, an allocated portion of total overhead (which includes nonmanufacturing cost), and adding a 20% markup to the total of this cost. For example, a recent price quotation was determined as follows:
Direct materials
$ 60,000
Direct manufacturing labor
96,000
Total overhead
24,000
Total estimated cost
180,000
Markup, 20% × $180,000
36,000
Selling price
$216,000
The total overhead figure is determined by budgeting total overhead costs for the year and allocating them at 25% of direct manufacturing labor costs.
If a customer rejects the price and business is slack, Ed Berg Sr. often reduces his markup to as little as 5% of total estimated cost. The average markup for the year is expected to be 15%.
Ed Berg Jr. just completed a course on pricing in which contribution margin was emphasized. He feels this approach will help in determining the selling prices of his company's boats.
Total overhead for the year has been budgeted at $3,600,000 of which $2,160,000 is fixed and the remainder varies in proportion to direct manufacturing labor costs.
a. Assume the customer in the example rejects the $216,000 quotation and also rejects a $189,000 quotation (5% markup) during a slack period. The customer counters with a $180,000 offer. Compute the minimum selling price Ed Berg Jr. could quote without decreasing or increasing operating income.
b. What is the main disadvantage of emphasizing contribution margin in pricing decisions?