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COSTING AND PRICING The key principle of costing is to calculate the true cost of a product or service while pricing

is determined by demand, market conditions and factors which influence pricing such as advertising, promotional activity and the ability to differentiate from competitive or alternative products and services. Costing is based on the simple principle of recovering cost. Cost are classified as Variable or Fixed. Variable costs are those costs which vary in direct proportion to output. For every unit of output there is a clear unit of input - usually material and labour. Fixed costs are those that exist regardless of the level of output or activity. These will include rent and rates, insurance etc. In reality many costs are semi fixed or semi variable. In other words there is a degree of variability with output but a significant proportion of the cost is fixed. Power, telephone, transport (for an in house fleet) are examples. The critical issue is how to allocate the fixed costs to each unit of output. Underpinning this decision is the ability to predict the level of output which will be achieved in the future. In other words how much are we going to sell? This creates the interface with the pricing policy and the need to understand the price elasticity of demand (more later). For costing to be effective there must be a clear and unambiguous understanding of the cost structure of the business and what is actually happening in the business, ie, levels of productivity, material yield, breakdowns etc. The crucial is to decide how to allocate the fixed costs (or overheads) against each unit of output/sales in order to recover 100% of the fixed cost over a period of time and make an acceptable profit. If a business has a single product or service, each unit of which consumes exactly the same amount of variable cost, then the fixed cost charged to each unit of output is the total fixed cost for the period divided by the number of units sold during the period. However, there are very few businesses that are this simple. Most will have: Multiple products Products at various stages of their product life cycle Products which "consume" varying amounts of overheads, eg Produced on expensive equipment with high running costs, varying advertising expenditure, varying development inputs etc. Products which face fierce competition and require additional customer support.

Activity Based Costing has been developed to cater for these variables. The principles of ABC are straight forward. The overhead is allocated according to the amount of activity which can be attributed to each product. It can be simplified by looking at product groups as common areas of allocation. NOTE: There is a lot more detail on ABC and other costing approaches if required. Marginal Costing is another area which is important, particularly when faced with competitive pricing considerations. Once a level of sales has been achieved which recovers all the fixed costs for the period each additional unit of sale "recovers" the full gross margin value. Businesses use this to either drive "premium" profit or to enable aggressive discounting. Effectively this point is reached when sales pass the break even point. Marginal costing as a means of driving pricing policy should be approached with caution. Sales fluctuate over time and if a discount is applied too soon losses can be generated at a rapid rate. Good financial control throughout the business is crucial. The following slides and notes (extracts from a Powerpoint presentation) illustrate the use of Break Even Analysis in evaluating the relationship between fixed costs, variable costs, sales volume and profit. Break even analysis is a powerful Slide 35 tool which is based on very simple BREAK EVEN ANALYSIS principles. Regardless of units of ANALYSIS TECHNIQUE TO ESTABLISH THE COST AND PROFIT production/sales there is a fixed RELATIONSHIPS OF A PRODUCT OR cost associated with the operation. RANGE OF PRODUCTS BASED ON THE CONTRIBUTION OF This represents all of those costs EACH UNIT OF SALES which remain constant (or relatively so) regardless of whether production is zero or at maximum capacity. In addition there are costs which are directly proportional to output, ie the direct materials consumed, the direct labour to produce the output and other directly proportional elements such as shipping costs etc. The third dimension is the revenue generated by sales which is directly proportional to output at a constant unit sales value.
The Financial Aspects of Company Direction 35

This is demonstrated graphically

Slide 36
4, 000 3, 500 3, 000

BREAK EVEN ANALYSIS

2, 500 FIXED COSTS 2, 000 VARIABLE COST TOTAL COST SALES VALUE 1, 500

1, 000

500

0 0 10 20 30 OUTPUT/SALES UNITS 40 50 60

The Financial Aspects of Company Direction

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The break even analysis shown represents the figures below. Break even is achieved when 25 units are sold. As sales rise above 25 the gap between the sales revenue line and the total cost line represents the profit being generated. This is a simple example using straight lines - ie assuming all unit costs and selling prices remain constant. In practice volume discounts may be applied and volume throughput could result in reduced variable costs at higher levels. These would result in curves being applied to the lines. This type of analysis is an important tool in pricing policy by simply showing the relationships affecting profit. It might be used to drive management action on overhead costs, productivity etc.

Slide 37

BREAK EVEN ANALYSIS WITHOUT GRAPHS


SALES REVENUE-VARIABLE COSTS = CONTRIBUTION CONTRIBUTION - FIXED COSTS = PROFIT

At break even profit equals zero. Therefore, at break even: Contribution - Fixed Costs = Zero Sales revenue equals price multiplied by quantity.
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The Financial Aspects of Company Direction

This is not just a string of algebra with pictures. It is a serious analysis tool which underpins the logic and thinking of any senior executive. From this basic model various outputs can be achieved depending on the problem. So, for instance, Quantity at B/E = Fixed Costs divided by contribution per unit In real life it is unlikely that a business will sell only one product or service, or if it does, that it sells it at only one price. However, the basic principles still hold good. All established businesses have a core of fixed costs and they incur variable costs in line with the level of business activity. Every sale has a contribution (positive or negative) associated with it. It is not until the aggregate contribution equals the fixed costs of the business that break even is achieved and thereafter additional contribution is contribution to profit.

Slide 38
THE BASIC INFORMATION
THE FIXED COSTS FOR THE BUSINESS THE LEVEL OF CONTRIBUTION ACHIEVED THE BREAK EVEN LEVEL OF SALES

The Financial Aspects of Company Direction

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With these three pieces of information you only need to know the sales figure to know whether the business has made a profit or loss in any given trading period and the approximate size of that profit or loss. In a real business situation there may be several (or hundreds) of products each with a different variable cost and selling price thus producing different contributions. To simplify analysis a weighted average contribution can be calculated. For this to be valid the sales mix must be established and monitored.
27.80 17.30 10.50 600

Slide 39

PRICE VARIABLE COST SALES MIX WEIGHTED

32.50 23.00 500

16.25 8.50 7.75 250

53.00 42.50 10.50 50

CONTRIBUTION/UNIT 9.50

CONTRIBUTION PER 4,750 PRODUCT LINE

1,938

525

6,300

WEIGHTED AVERAGE CONTRIBUTION

The Financial Aspects of Company Direction

This type of analysis, either product by product, or by product 7.50 group where there are large ranges of products, is useful to identify 5.00 where the highest levels of actual 700 2100 contributions come from. In isolation it is useful. If used as an on going monitoring tool it can identify 3,500 17,013 trends, shifts in product mix and the impact on profitability. In this dynamic 8.10 application it can help with strategic pricing decisions and even whether a product should be discontinued, have more promotional expenditure applied 39 etc. There is an implication that the only limiting factor is the volume of sales. This is often not the case and a specific factor such as available factory space, the capacity of a special machine or process and the availability of certain skills may be a limiting factor. Introducing additional factors for assessing contribution then becomes necessary, eg contribution per labour hour or machine hour etc.
12.50

PRICING The first principle is to understand the true costs of the business and what factors influence these costs. If the product or service is part of an existing market structure then price which can be charged is partly driven by competitive pressures. In commodity markets price is determined almost exclusively by market conditions and competitive pressures. Small premiums can be justified by high quality and outstanding customer service. The focus in such businesses operating in mature markets is to maintain the highest standards of quality and service for the chosen price points and then attack internal costs and efficiencies to achieve the lowest possible cost base. This is a characteristic of a cash cow as defined by the Boston Consulting Group. With a new product or service pricing becomes more problematic particularly if there are no competitive pressures. In these situations it is important that there is a clear vision and strategy for the future which anticipates the real costs of launching, supporting and developing the product or service and looks realistically at the product life cycle. Bear in mind that product life cycles are generally getting shorter as the pace of technological change accelerates and customer expectations develop. The S Curve applies to all products and services. Predicting its shape is an important part of pricing policy. NOTE: More details on S curves and product life cycles are available. If we look at the extreme situation of a new business which has developed a new market for a brand new product how would we approach the pricing issues? The issues are: Getting the product accepted Maintaining a market share in the face of competition (competition can be significant from alternative products which are not the same, ie substitutes) Making a profit When a new product is launched on the market the pricing policy lies between the two extremes of market penetration and market skimming. Market penetration pricing is a policy of low prices from launch in order to maximise penetration in the early stages. Short term profits are sacrificed for the sake of long term profits and market share. This policy will tend to discourage rivals from entering the market. The approach tends to shorten the initial period of the product life cycle bringing the growth and maturity

stages as quickly as possible. This relates to a high elasticity of demand for the product. The business may deliberately build excess capacity and set prices low. As demand increases the spare capacity will be used up and unit costs will fall. There may even be scope for further price reductions as unit costs fall. Early losses (or low profits) will enable the business to dominate the market and have the lowest costs. The above thinking is partly driven by the simple but important graphical representation: Cost

Volume This is another example of the vital importance of why it is so important to understand and control the cost base of the business. Market skimming is the achievement of high unit profits very early on in the product's life. The business charges very high prices when the product is first launched. There is heavy expenditure on advertising and sales promotion to win customers. As the product moves through its product life cycle - growth, maturity and decline - prices are progressively lowered. The early profit is therefore skimmed off. Skimming is suitable : When the product is new and different If demand elasticity is unknown (it is easier to reduce prices than raise them)

High initial cash flows are important at the possible expense of long term profit maximisation To help to identify different market segments for the product each prepared to pay progressively lower prices. The high initial prices may attract competitors who see the market as lucrative. The big risk comes from a competitor prepared to take the risks of market penetration which could immediately negate the premium of the skimming policy. Between these two extremes of policy are a wide range of options. Most of these options are determined by the ability to identify clear segmentation opportunities, ie niches of the market which can be identified and targeted with a specific product offering and pricing policy. A further consideration is evaluating the benefits of a new product to the customer. A new paint is developed for jet aircraft. The paint is lighter and thinner than conventional paints and improves the aerodynamic qualities of the aircraft. It also lasts twice as long between applications. At cost price the value of the product for each painting of an aircraft is 10,000. What do you charge for it? Bear in mind: There is a 2% reduction in fuel cost for the aircraft. Painting a jet takes 6 days and needs to be done at least once per year. Would 100,000 per application be expensive or cheap? The following is an example of price elasticity of demand: Activity from the Markets Study Guide A supplier discovered that when it raised the prices of its products by 10% the sales of its products fell be 20%. 1. Can you calculate the price elasticity of demand for the above case? 2. Is the demand for the product elastic or inelastic with respect to its price? 3. Would the firm's revenue have increased or decreased when the product's price was raised? Tutorial Plan Answers to the question:

1.

Price elasticity of demand = =

% change in demand % change in price

20% 10%

2. 3.

Demand for the product is elastic, ie it is greater than 1. When demand is elastic an increase in price will result in a fall in the quantity demanded and total expenditure (revenue) will fall. Example: Price Existing New 100 110 Volume 1000 800 Revenue 100,000 88,000

Conversely inelastic demand is where the % change in demand is lower than the fall in price. With inelastic demand increases in price will create higher total revenues.

The value of demand elasticity can be anything from zero to infinity. If the value is less than 1 demand is inelastic, ie the quantity demanded falls by a smaller percentage than price. If the value is greater than 1 demand is elastic, ie the quantity demanded falls by a greater percentage than price. the price elasticity of demand is relevant to total spending on the good or service. Total expenditure is important to both suppliers (sales revenues) and governments (tax revenues). When demand is elastic total expenditure will fall when prices rise. When demand is inelastic total expenditure will rise when prices rise.

There are several factors affecting price elasticity of demand - what are they? Discussion - The availability of close substitutes. This enables customers to switch to alternatives. Discuss various examples: Food Synthetic fabrics

The time period. Markets are constantly changing and consumers may adjust their buying habits over a period of time when faced with a price increase, finding substitute products or alternative suppliers. Inelastic demand may become elastic over a period of time. Discuss various examples: Competitor pricing. If a competitor keeps prices unchanged in the face of a price increase then the firm raising prices is likely to lose market share, ie demand is elastic. If a price reduction is matched by the competitors then it is likely to produce inelastic demand at lower prices.

And finally, one of the big users of PED thinking is government when setting taxation on certain products. Three products tend be almost perfectly inelastic, ie demand does not fall when prices rise: Tobacco Alcohol Petrol/diesel Which is why these items are so heavily taxed. But is this a sustainable policy. Tobacco and alcohol are both associated with health issues which require funding for treatment. The taxes help to fund the state funded medical services. But if tax increases start to reduce consumption then tax revenues will fall creating a potential gap between cost of health services and the tax revenue generated. Bear in mind that alcohol and tobacco related illnesses often continue long after a person stops/reduces consumption. Food for thought

Richard Bostock Updated October 2010