In 2014, the cost of producing a foot of pipe was $0.30, and the selling price was $0.39 per foot. In 2015, production costs increased to $0.40 per foot, although the selling price remained at $0.39.
The increase in cost was obvious. Material and labor had remained fairly constant per foot of pipe, but overhead costs, which were $0.15 per foot in 2014, had increased to $0.25 in 2015.The problem was that most overhead costs were fixed, but output had decreased due to weak crop prices and a corresponding decrease in spending on irrigation projects. Bob Elger, CFO of Jensen, reviewed the data generated by the company’s process costing system.
In 2014, overhead costs in all of the company’s departments (mixing, extrusion, cutting, and packing) were $1,500,000, and pipe production was 10,000,000 feet. In 2015, overhead costs were still approximately $1,500,000, but pipe production decreased to 6,000,000 feet. At a recent meeting of the senior management team, Bob noted: “The problem is that we’re not making use of capacity. We could easily produce 15,000,000 feet of pipe given our state-of-the-art equipment, but we’re operating at less than 50% of capacity.”
Bob estimates that to sell 15,000,000 feet of pipe in the current market, the company would have to lower its price to $0.35 per foot, which is even lower than its current cost per foot of $0.40.Would decreasing the price be a good decision?