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COST ACCOUNTING AND PRICING POLICIES

There is abundant evidence that the cost accountants traditional approach has been strongly influenced by classical and neo-classical economic theory. With possible exception of specific order industries the general prescription that management should concentrate on those items which yield the largest markup is based squarely on the assumption of pure competition. Clearly in pure or near pure competition with unlimited demand for the firms product at going prices management is well advised to push - in a production sensethose items which yield the largest markup. The extension of this prescription to products to be sold in areas of imperfect competition seems to be just as clearly unwarranted. Businessmen and accountants, particularly have often argued that production and distribution cost accounting gives the key to decisions as to which lines, products, territories, etc. should be pushed through increased advertising expenditures and other sales pressure. The fact that sales effort is necessary in an indication that the products are differentiated and that the demand for each product is not completely elastic. Intelligent pricing and sales-pressure decisions must give full consideration to estimates of demand elasticities and to the probable reaction of demand schedules to changes in (and different types of) advertising and other selling methods. Cost accountants seem also to follow orthodox economics with regard to the necessity for long-run recovery of costs by firms that remain in business. It is easy to misapply the rules for long-run behavior to short-run problems , and it is perhaps to be expected that businessmen and accountants would assume that prices in the short-run should be high enough to cover total unit costs. Such an expectation seems justified because orthodox economists of the day tended to disregard the short-run and to assume that depressions were temporary and unimportant for over-all policy decisions. To be sure , during depressions distressed firms in their frantic search for solvency often found it necessary to use drastic pricing measures. If the more stable concerns followed with similar price reductions , the result was cutthroat competition , and businessmen rightly or wrongly wish to avoid

such competitive measures. The fear of cutthroat competition and the knowledge that successful businessmen covered their costs in the long-run no doubt worked together to support the pricing position taken by most cost accountants. The advent of the new economics of approximately 1930 left the philosophical supports for this pricing policy somewhat weakened. For approximately two decades economists, a few accountants and businessmen have been sure that the cost accountants intricate compilations are worse than useless if not downright nonsense. Robinson , Chamberlain , and their fellow economists had with devastating logic pointed out the limitations of perfect competition and along with other observations had offered a set of rules for pricing to attain maximum profit. An oversimplified statement of the fundamental rule follows : each producer should produce and sell until marginal costs are equal to marginal revenues , and for differentiated products marginal selling costs must be given consideration. The marginal-cost , marginal-revenue formula is of course short-run in nature and reflects the general viewpoint taken by the economic theorists of the time. Thinking economists were not without doubts regarding the generality of the rule, and certainly Robinson and Chamberlain were properly cautious. Even the most inflexible were willing to admit the difficulty of estimating entire demand schedules, marginal cost structures, and the softness or hardness of demand schedules in response to various amounts and types of selling effort. More serious assaults on the foundations of the simple rule were not long in coming. At the very beginning of the trend (1930) Evans pointed out the possible influences of current prices on demand and costs of the future. It is clear that a businessman who maximizes profit for each short period, for example a season, may not maximize his profit over the life of the enterprise. To the extent that customers speculate wisely when prices are low the demand for the product in the immediate future may shrink, and it is highly probable that a price that leads to large profits today will lead to increased wages and other costs in the future. Costs and demand should be represented by surfaces extending along an axis representing time. The businessmans problem is then to maximize the volume representing profits through time. Most economists have been guilty of gross oversimplification.

Sweezy introduced the kinked demand curve that is common to oligopoly. If one producer raises his price and competitors fail to follow, his demand is certain to be highly elastic for prices higher than the going level. If a large producer lowers his price , others are likely to follow, and Sweezy concludes that the schedule is more inelastic for prices lower than the existing level. The marginal revenue curve is , of course, discontinuous, and the intersection of marginal cost with marginal revenue is indeterminate. Colberg and others have pointed out the complications resulting from joint costs and multi-process production. A coherent generalization of the economics applicable to specific-order production has apparently not been written. Many economists seem to have lost faith in the assumption that businessmen invariably try to maximize profits. Gordon calls attention to the tremendous motivating influence at least on the downswing of the cyclearising from fear of insolvency. On the practical level Dean and Eiteman have questioned the assumption that marginal costs per unit vary perceptibly with changes in output. Economists are examining critically the assumptions underlying the marginal approach, but the remaining body of marginal theory is worthy of the closest study by businessmen and cost accountants. In many cases the approach may be rejected. Ignorance however is not a proper cause for rejection. COSTS AS PARTIAL DETERMINANTS OF PRICE It should be emphasized that costs are often only one of many determinants of price. Clearly in pure competition the costs of an individual firm are not a factor to be considered in setting prices. If a stock of goods is already in existence and is not to be replaced for the current market, past costs are certainly not price determining. In other instances expected future costs of replacement are given more weight than the actual cost of existing stocks. It is sometimes assumed that short-run prices will not fall below variable costs, but there are so many exceptions that this generalization is practically worthless. If the costs of shutdown and resumption are important, it is obviously more profitable to price below variable costs for a short period than to stop production. If the products are differentiated and identified by

brand names, businessmen may sell far below variable costs in order to keep the brand names before the public. Contract suppliers, even when business is good, will sometimes bid a job at less than marginal cost with the hope of getting more profitable business from the customer at a later date. Finally in spite of the fact that altruism is not expected in a self-interest economy, some managers feel a responsibility for worker welfare and will continue to operate at prices for below variable cost. It seems clear that there is no discernible lower limit (except perhaps zero) to short-period prices. Some economists have assumed that the upper limit for short-run prices is determined by the demand schedules, and that in many cases businessmen will charge what the traffic will bear. In most cases this too turns out to be an oversimplification. High reported profits even in the short-run sometimes leads to the entry of new firms into the industry and thus decreases each concerns share of the long-run demand. Labor organizations are becoming more aware of reported income and are encouraged to press their demands for wage rate increases by large operating profits. Reynolds has suggested that a firms own variable costs are not as important as competitors costs in bringing about price increases. If the costs of only one firm had increased it is unlikely that a price increase would follow. The firm raises prices when it is able to, and it is able to when the costs of other producers have risen sufficiently that they will concur in a price increase. If prices are increased by all members of an industry without an increase in cost, there is danger that the larger profits will encourage the new firms or the enlargement of existing plants. There is little doubt that businessmen have tended to disregard the shortperiod pricing pronouncements of the economists. One explanation for their failure to follow these suggestions is that managers have been ignorant and have not understood the terms and logic of the marginal doctrine. In some cases ignorance is probably a factor, but, inasmuch as cost accountants have been preparing differential cost studies and firms on occasion have been quoting prices on variable costs for many decades, ignorance is probably not an important factor. Businessmen have been impressed with the difficulty of making accurate estimates of marginal revenues. The knowledge of some is no doubt limited to the fact that a firm can price itself out of the market and that a price

decrease not matched by competitors will result in increased volume to the firm making the cut. On the other hand it is reasonable to assume that most managers do experiment with demand elasticities in the neighborhood of their current prices. Some chains have attempted to find comparable markets and have compared the results of particular price experiments in each. It is the policy of many firms to ask their salesmen to estimate the increase in sales that might reasonably be expected if a price allowance of say 10% is made. Such estimates must, of course, take into consideration the probable reactions of competitors and are subject to serious error. The point to be emphasized here is that many organizations are fully aware of the importance of demand and are making attempts to measure its price elasticity and its response to advertising and sales pressure. In the distributive trades it is common to base prices on the largest of their variable costs merchandise cost. Tarshis has made use of Robinsons relationship between optimum price, marginal cost and the elasticity of demand and has concluded that successful firms no doubt approach the results of marginal-cost, marginal-revenue pricing through trial and error in setting markups. These relationships should simplify considerably the application of marginal techniques to pricing by permitting occasional comparisons of markup policies with estimated elasticities as determined by sales estimates for a few alternative prices. PRICING ON THE BASIS OF TOTAL UNIT COST The cost accountant has developed a costing policy which no doubt has been influenced by the pricing problems of management. The assumptions underlying cost distributions are comparatively simple and may be quickly reviewed. Specific jobs are charged with the costs for which they are directly responsible. For practical purposes variable costs maybe assumed to be equivalent to responsibility costs. Unless the job or order is extremely large and requires additional facilities, it is clear that the concept of responsibility cost is a short-run concept, and it is clear also that it is related to the notions of marginal and differential cost. Any first-rate cost accounting system is able to divulge reasonably accurate responsibility (marginal) costs. As a matter of fact, the accountant is

considerably in advance of the economist in this regard. Marginal costs for divers products and even for specific orders may be approximated through the use of bills of materials, standard labor estimates, and through the use of cost centers and common denominators of labor-hours , etc., for units of factory output. The merits of assigning fixed charges to product, territories, types of customers, etc., are not so clear cut. The cost accountants defense is often based on the ethical judgment that equity should be preserved among customers that each should bear his pro rata share of fixed overhead. It is usually assumed that if Job A receives twice the amount of benefit from the facilities whose costs are fixed, then Job A ought to bear twice as much of the fixed costs of these facilities. Certainly the need for preserving equity among customers has been emphasized by various federal and state lawsnotably the Robinson-Patman Act. The implied relationship between costs and prices remained in the background until the comparatively recent definition of discrimination in terms of prices not justified by differences in cost. The desirability of assigning fixed costs to products, size of order, territories methods of sale, etc., has been questioned many times. Do such distributions aid in the control of fixed costs? Do they determine whether to continue or to abandon a product or territory? Negative answers seem justified in both instances. Do these assignments aim in pricing for profit and financial security? Economists in general have returned an unfavorable verdict, but businessmen have long felt that such procedures have proved useful. The assignment of fixed factory costs to products and the quotation of prices related to these costs tend to stabilize prices throughout the industry at any given time. If businessmen are educated to set prices with reference to total unit costs, the cutthroat tendencies that are present in an economy in which there are numerous producers and numerous by-products are less likely to develop. Moreover, the assignment of fixed costs to lines and products tends to stabilize unit costs over the business cycle. Businessmen, in their search for simple rules to guide them through the bewildering complexity of relevant pricing factors, have expect in the field of distribution favored the cost accountants total unit cost with semi-flexible

markups. The marginal approach may or may not lead to greater long-run profits. Although the orthodox arguments (including those given above) for fixed cost assignments are usually applied to firms and industries operating at low levels of activity, it is possible to build a defense for such distributions during periods of high production. Suppose as a basis for illustration that a firm is operating at full capacity. A file of unfilled orders is on hand and salesmen are able to write more orders than the plant can fill. Management wishes some relatively simple rule that would permit its salesmen consistently to quote prices that will yield close to a maximum return. The usual approach that utilizes the contribution of the selling price over variable costs must be modified drastically before it can be applied with benefit. To illustrate, Job A may be quoted at a price that will yield $300 above the costs for which it is responsible and Job B may cover its variable costs and contribute $200 toward the recovery of fixed charges and the formation of profit. it does not follow of course that A should be accepted for production and that b should be rejected. If Job A requires twice as many hours of scarce factory facilities, it is clear that two B jobs contribute $100 more than one A and may be produced with no more utilization of limited factory time. This direct approach to the problem of accepting or rejecting orders may usually be applied to the problem of setting relative prices. For each item usually produced time estimates may be prepared and prices may be scheduled to yield identical contributions per unit of scarce factory time. The businessmans traditional tendency to quote prices on the basis of total unit costs as complied by cost accountants is in fact an imperfect approximation of the method outlined immediately above. The distribution of fixed overhead to jobs or product is normally on a time basis and the relative total fixed overhead charges to jobs do therefore measure more or less imperfectly the relative usage of the firms scarce factor of production. The obvious shortcoming of this procedure is that the fixed overhead rate is not an accurate measure of the contribution to profit made by an hours use of the factory. Unfortunately, markup is usually based on total unit cost so that the fixed burden rate plus the markup that is applied to the fixed burden is not large enough to accomplish the desired selection of products. That part

of the markup which is applied to direct labor and materials confuses the issue and tends to favor those jobs that use less direct cost. To the extent that facilities for handling materials and accommodating labor are limited the usual markup procedure based on total unit cost may provide a simple rule for pricing for high profits at full capacity.

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