Making a Deal. Can you ignore your overhead?

hankshakeIn a production environment, when the manager, the accountant and the top salesperson meet to discuss a special order, sparks sometimes fly, tempers explode, and both the customer and the company can suffer. You might think the writer is out to lunch when the suggestion of ignoring your overhead costs is considered possible, but please continue reading. Everyone knows that all costs must be recovered if a company is to succeed. However, if a customer requests special pricing for a particularly large order, the normal costing – pricing strategy would result in a substantially different price than what to customer is requesting. Let’s look at an example.

Widgets-Is-Us is well known in the industry, has a strong customer base, and production totals around 100,000 units per month. Per unit costs break down as follows:

Direct Material: $4.00

Inbound Freight: $0.75Total Direct Costs: $4.75

Indirect Costs:

Warehousing: $0.37

Insurance & Taxes: $0.28

Spoilage: $0.08

Utilities: $0.02

Billing: $0.01

Other Overhead Charges: $1.47Total Indirect Charges: $2.23

Corporate Overhead Charges: $2.28

Total Unit Cost: $9.26

Mega mart, a prime customer has approached the company with an offer to purchase 90,000 units, with delivery over the next six months, for their brand new Extraordinary Mega mart, opening in Houston. List price on this item is $37.00, with the lowest price for a 10,000 piece order set at $17.95, with the salesperson earning a 10% commission. Mega mart’s offer is $12.95 each with payment terms of 2%, net 10 days from verified pick up date. Mega Mart will use their own trucks to pick up each shipment as they are deadheading back to the distribution center. Now, would you accept the order?

Before you answer the question, you need a few more facts. First, the plant’s capacity is 100,000 units per month, but is operated at 80,000 units to avoid excessive wear and tear. Second, all pricing is based producing 80,000 units. Third, the salesperson, recognizing the potential coup for his or her career, is willing to accept a 6% commission on this order. Finally, sales over the previous 18 months have floated between 77,500 units to 82,500. Now, what is your decision?

If answered no, you are probably in the majority. However, you just lost a rather profitable order. First, since overhead charges are calculated based on normal monthly production runs, each additional unit produced costs you only $4.86, plus the sales commission of $0.777, plus the cash payment discount of $0.259 for a grand total of $5.896. Your net profit is $7.054 each, $105,810 per month or a grand total of $634,860. The key here is to identify those costs directly affected by the order. Direct materials will not change. Utilities, spoilage and billing will not change. All other costs are immaterial as they are covered by the standard production run. You may incur some additional repair and maintenance costs, but you could negotiate lower raw materials pricing. If a customer asks for a special order, with special pricing and terms, look at the whole picture, not just the numbers on the accountant’s ledger.

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