manner of pricing a special order. This situation occurs because a company often receives a non-routine, special order for its products at lower prices than usual. In normal times, the company may refuse such an order since it will not yield a satisfactory profit. If times are bad or there is idle capacity, an order should be accepted if the incremental revenue exceeds the incremental costs involved. Such a price, one lower than the regular price, is called a contribution price. This approach is called the contribution approach to pricing, or thevariable pricing model. For example, assume that a company with 100,000-unit capacity is currently producing and selling only 90,000 units of product each year with a regular price of $2. If the variable cost per unit is $1 and the annual fixed cost is $45,000, the income statement looks as follows:For example, assume that a company with 100,000-unit capacity is currently producing and selling only 90,000 units of product each year with a regular price of $2. If the variable cost per unit is $1 and the annual fixed cost is $45,000, the income statement looks as follows:
The company has just received an order that calls for 10,000 units at $1.20, for a total of $12,000. The acceptance of this special order will not affect regular sales. Management is reluctant to accept this order because the $1.20 price is below the $1.50 factory unit cost ($1.50 = $1.00 + $0.50). Is it advisable to refuse the order? The answer is no. The company can add to total profits by accepting this special order even though the price offered is below the unit factory cost. At a price of $1.20, the order will contribute $0.20 (CM per unit = $1.20 - $1.00 = $0.20) toward fixed cost, and profit will increase by $2000 (10,000 units x $0.20). Using the contribution approach to pricing, the variable cost of $1.00 will be a better guide than the full unit cost of $1.50. Note that the fixed costs will not increase because of the presence of idle capacity.
