Research Paper: Costing and Pricing Decisions

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Costing & Pricing

Costing decisions can have an important impact on the company's profitability, so they need to be made carefully. There are a number of issues involved, including joint costs, sunk costs and opportunity costs, that need to be addressed. Practitioners take a number of different approaches to dealing with these concepts. This paper will examine some of those approaches and discuss the potential impact that each approach has on the firm's profitability.

Joint Costs. Joint costs are those that are shared between different business units or products. How joint costs are allocated can impact on pricing decisions and profits for the individual products in question. Managers use a number of different approaches to joint costs, including by output levels, time equipment is used, by a set overhead allocation formula or by any other means the company deems suitable. Firms sometimes set joint cost allocations to create favorable tax situations, allocating more costs to the partner or unit in a high-tax jurisdiction to lower profits there, simultaneously increasing profits in low-tax jurisdictions. There is evidence that tax authorities are seeking to curtail this practice, however (Willens, 2009). The purpose of setting a method for joint cost allocation -- if not done to reduce taxation -- is to most accurately reflect the usage of shared resources. This aids managers in making decisions regarding cost reductions, pricing, and the decision to discontinue products.

Sunk Costs. Sunk costs are those costs that have already been spent. In capital budgeting, sunk costs are ignored because they are unrelated to future cash flows, but sunk costs are important to financial and managerial accountants. Although it is not advisable, sunk costs are often used to make decisions about pricing and product continuation. Such an approach effectively prevents managers from pricing a product so low as to fail to recoup early investments, but it also can result in prices that are higher than necessary, which can have impacts on the product's competitiveness.

However, when sunk costs are used, this leads to the "sunk cost fallacy," as managers frame sunk costs as recoverable, which can lead to a company continuing to fund a failing project (Teach, 2004). Sunk costs can also impact on pricing decisions as managers price high in order to recoup sunk costs, again leading managers to continue with failing projects but also increasing the risk of failure in good projects because of the constraint it puts on the pricing decision.

Opportunity Costs. Where financial accounting does not consider opportunity costs, managerial accountants sometimes do. Opportunity costs are relevant during the decision-making process, where they represent other options for resources that should be considered. However, once a decision has been made to undertake a project, opportunity costs are no longer relevant -- they are effectively sunk costs that have not been incurred. It is a fundamental error to include opportunity costs beyond the initial decision as they are costs that have no actually occurred.

One area where opportunity cost is relevant is in working capital management. Firms need to consider the return they get on free capital vs. what could be earned by investing that money. Alternately accounts receivable represent opportunity cost because that cash could be put to work by the company if it was received. Again, however, these are initial investment decisions and once that decision has been made opportunity cost should be ignored. It is tempting to accept opportunity cost as a reasonable way of framing decisions (Frederick, 2011), but this should not be done once the decision has already been made.

Pricing Decisions. The simplest method of setting prices is the cost-plus method. This involves determining the cost of producing a product and bringing it to market, then adding a markup. The cost will be influenced by the choice of costing methodology, specifically with respect to joint, overhead and indirect cost allocations. The major benefit of cost-plus is that it provides a floor for the company's pricing options, which can impact the company's decision with respect to the product's viability (McKinsey, 2004). The major weakness of cost-plus is that it does not take into account the prevailing competitive environment. As a result, cost-plus is used in industries where price sensitivity of buyers is relatively low.

Target costing effectively reverse-engineers cost-plus. The company determines what price the market is willing to pay for a product, subtracts a profit margin and then aims to produce the product at that cost level (Banham, 2000). Target costing is common in Japan and has been adopted by some American companies as well, including Kodak, Boeing and Caterpillar (Ibid). This method is more customer-focused and has the advantage of compelling the company to understand its customers better. In addition, the company takes on products or projects based on a pre-existing knowledge of its ability to generate a profit. The downside of target costing is that it can convince companies to be optimistic about their ability to meet costs, only to see the firm fail to meet projections. Target costing is complex to implement in companies that lack cross-functional teams, however, and that has hindered its adoption outside of Japan (Ibid). Another risk in target costing is the temptation to massage cost allocations to bring a product under the target cost -- yet such an approach would leave other products with abnormally high allocations to cover.

Activity-based pricing seeks to set product prices on the basis of the activities that go into bringing the product to market. The concept gained popularity because it forced companies to understand the activities that went into producing their products and the cost of those activities (Katz, 2002). The technique has fallen out of favor somewhat but has value in helping managers to determine specific costs of products and services offered. This can help in virtually any price-setting system by giving managers a better understanding of the costs that truly go into a product. In addition, ABC can help managers to make better decisions with respect to maintaining products in the lineup, because the cost information for those products is better. The downside is that under ABC some fixed costs may appear as variable cost components -- they are allocated on the basis of the usage a given product has fro the resource, regardless of whether or not that resource represents a fixed cost.

Implications for Profitability. Because profitability is a financial accounting concept, there is no direct connection between the method of product costing used and the profit recorded. The connection lies in the way that product costing information is made, both in terms of what products/projects to pursue and the price that should be charged for those products. Each decision that management makes will have an impact on the firm's profitability. It is essential, therefore, that in order to maximize profitability that management have the best possible information at its disposal to make these decisions. This is why it is essential to understand the different systems for analyzing product cost and for making pricing decisions, and choosing the one that offers the most advantages and the fewest disadvantages. This should be done in context with the industry that one is in. For example, in a restaurant cost-plus is the norm because the basic fixed costs of any kitchen are roughly the same regardless of the menu -- it is the food costs that should therefore determine the cost of to the customer. In other industries, the equipment and real estate costs can vary considerably depending on the decisions that are made with respect to the products offered, so different pricing systems are used. Manufacturing companies can benefit from both target costing; service companies often benefit from activity-based costing.

It is recommended that firms carefully consider what costing and pricing systems they use in making decisions. Factors such as sunk costs and… [END OF PREVIEW]

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