Sprite Machinery makes small backhoes for light-duty work, like trenching fiber optic cables, landscaping, and for working in cramped quarters. Their variable costs are $10,800, their full absorption cost is $10,200, and their target profit margin is 40%, which means Sprite backhoes are priced at

Question

Sprite Machinery makes small backhoes for light-duty work, like trenching fiber optic cables, landscaping, and for working in cramped quarters. Their variable costs are $10,800, their full absorption cost is $10,200, and their target profit margin is 40%, which means Sprite backhoes are priced at $17,000. They sell their backhoes from Maryland south to Florida, and west to the Mississippi. They have no interest in expanding nationwide. They planned to make 200 units this year, which would fully absorb their factory overhead of $500,000. However, demand is down, and the plant has scheduled the manufacture of only 180 units. A Canadian cable company offers to purchase 15 backhoes at $12,000 each. Should Sprite sell at that price?

Accepted Answer

If they sell for less than their variable costs of $10,800, they will be selling at an actual loss. If they sell for less than their full absorption cost of $10,200, they will be taking a loss on paper, and they risk charges of predatory pricing. So taking these two rules together, the minimum should be $10,800.
The next question is whether such a sale would lower the price point expectations of their regular customers. Since the Canadian cable company is well outside their usual target market, and the cable company is not likely to resell backhoes to Sprite’s regular customers, this particular sale should not affect customer pricing expectations.
The economic analysis indicates that this offer should be accepted because it contributes $1,200 per unit to fixed costs ($12,000 - variable costs of $10,800); contributes $1,800 per unit to gross profits ($12,000 - full absorption cost of $10,200); and absorbs $37,500 of factory overhead, which would not otherwise be absorbed (15 units × $500,000 fixed manufacturing overhead/200 planned units).

Question 16.2: Sprite Machinery makes small backhoes for light-duty work, l...

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