Poor decision making may result when acceptable prices are determined by adding a fixed percentage to the "full cost" of a product when that "full cost" includes a unitized fixed cost. Is that any selling price above the contribution margin will add to the wealth of the firm. This being the case, is there a danger in the decision rule that states "always accept any offer that has a positive contribution margin?"

Wow, that's confusing.

OK, hmm... contribution margin is the sales price less the variable costs. The variable costs are those that will exist for each unit made. For a simple example, if you are making shirts, you are using material and it has a cost. Every time you make a shirt, you're using that same material and incurring that same cost. If you make one unit, you only get the cost once. If you make 100,000 units, you incur that cost 100,000 times. So regardless of how many you make, you'll have the sales price and the variable cost. So the contribution margin remains the same per unit. If that were all that existed, I could simply tack on say a 30% profit and be done with it.

But... you also have fixed costs to deal with. For instance, if the supervisor is on salary of $35,000 a year, that salary exists regardless of how many units made. If you don't make any shirts, you still have the $35,000 fixed cost. If you make 100,000 shirts... you still have the $35,000 fixed cost. So the fixed remains the same as a total.

I can take my fixed and figure it out per unit. But it will change depending on how many units made. If I only make one, then it was $35,000 per unit. If I make 35,000 units, that's $1 per unit. If I make 70,000 units, that's now down to only 50c per unit. So the more you make, the less per unit cost. But is it really any less cost? No. Still got to pay the $35,000 regardless.

The contribution margin is what is going to cover those fixed costs. Break even is when you sell just enough for the contribution margin to cover the $35,000, but without making any more than that. So you also need profit. Once you make enough units to cover fixed costs, every unit beyond that is now profit. So hopefully you're selling far beyond fixed costs and making lots of profit.

"Full" costs means including everything, including fixed. So if you merely add a percentage to that, it is not accounting for what happens at different unit amounts. Fixed costs can only be done for one very specific unit amount. If you sell a different number of units, it changes the whole thing, as shown in my example above, going from 1 unit to 35,000 to 70,000. If I'm selling 70,000 and I know that means fixed is 50c per unit, great. But if I based my prices on that and only sell 35,000 units, suddenly my fixed costs are $1 per unit and I'm now making 50c less per unit.

I hope that made sense. For people only beginning into this subject, it can get a little complicated to understand.