If Wilkerson were to cut costs based on contribution margin, it is actually using variable costing method. Under Variable costing method, products costs such as variable manufacturing costs are capitalized. In contrast, period costs such as fixed costs are expensed. In this particular case, direct material and direct labour are variable costs that will be capitalized. In fact, they are used in calculation of contribution margin that Wilkerson uses to price their products. Therefore, to cover only variable costs, Valve’s total variable cost is $26 per unit; Pump’s total variable cost is $32.5 per unit; Flow controller’s total variable cost is $32 per unit. Comparing to Wilkerson’s current absorption costing method, variable costing will have a lower operating income if the production units exceeds sales units since it’s building up the inventory. On the other hand, variable costing leads to a higher operating income since part of the fixed overhead can no longer be parked on the balance sheet.
In addition, after cutting price to just cover variable costs, the selling price for each product will be $26 per unit for Valves; $32.5 per unit for Pump; $32 per unit for Flow controller. Comparing to target selling price of these products, there is a significant drop in price that actual contribution margin is zero. One implication is that this price cut might gain some market share for Wilkerson in short time that more customers are exposed to Wilkerson’s products. In other words, it works similar to advertising expense. However, Wilkerson is not earning net income since contribution margin is zero. In fact, it is actually losing profit because fixed costs come in as period costs that lead to a negative income figure. From a long run perspective, this is not healthy for Wilkerson and industry over all.
Externally, other competitors may lose more market shares and profit; It is even possible that some of these competitors exist the industry until the new equilibrium of number of firms is reached. The reason is because it is majorly due to superior product quality of Wilkerson’s Valves. In addition, customers are likely purchase Wilkerson’s pumps and flow controllers once they accept its Valves. Another to mention is shareholders in this case. By cutting prices, external shareholders such as creditors and employees may be adversely affected since their interest is closely related to Wilkerson’s net income. In short run, this effect is tolerable.