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Explain the absorption and marginal cost approaches to pricing in general

Phoenix Engineering Ltd. is an engineering services company that specializes in providing engineering and fabrication services to other companies that do no operate their own in-house engineering departments for economic reasons. Phoenix employs engineers with a variety of skills so that it is able to provide the full range of services to its customers. Most of the work that Phoenix performs is unique to each customer and usually requires the manufacture of specific parts or the fabrication / creation of new equipment from customer drawings. As a result, most of Phoenix’s work is short term – some jobs take a few hours and others could take a few days. Until now, Phoenix has adopted a cost plus approach in deciding the price to charge its customer. This is based on an absorption costing system that uses machine hours as the basis for absorbing overhead costs into individual job costs. The Chief Executive Officer of Phoenix is concerned that over recent months, Phoenix has not been successful when bidding (quoting) for new projects with the result that there has been an increase in the level of unused capacity. A knowledgeable source has suggested to Phoenix that it should adopt an alternative approach to its pricing. According to this suggestion, Phoenix should base its price on marginal costs since “setting a price greater than variable costs is preferable to not having adequate business”. You are required to do the following: 1) Explain the absorption and marginal cost approaches to pricing in general. (10%) 2) In the case of Phoenix, with regards to the nature of its business, discuss with examples what types of costs would be included in calculating its fully absorbed cost but would not be considered while calculating its marginal cost. Make suitable assumptions. Explain your justification for each such type of cost. You are expected to illustrate your answer based on real-world observations of engineering service companies e.g. annual reports, internet based research or financial databases. Specify the sources of your research. (50%) 3) Discuss the validity of the comment in the case of Phoenix - “setting a price greater than variable costs is preferable to not having adequate business”. Justify your answer. (20%) 4) If Phoenix were already operating at full capacity, would Phoenix be justified in adopting a pricing approach based on marginal costs? If not, what alternative approach would be more appropriate. Justify your answer. (20%) Your answer should be no more than 3,000 words. This limit includes tables and captions but excludes footnotes, endnotes, tables of figures and references. A good answer will have demonstrated adequate reading of course material, recommended text and bear evidence of having understood an engineering service company business model and cost structure through published financial data and online information. Please refer to the School’s assessment guidelines on essay length, penalties for over-length and plagiarism / self-plagiarism.

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