Cost may be defined as a resource foregone to accomplish an objective, which, for the purpose of this article may be redefined as dollars and cents spent to offer a service or build, manufacture and offer a product to the market. Cost is spent in hopes of return on investment, and therefore, the pricing of the service and product should be right to cover the cost and return profits. This is all much easier said than done.
Major Pricing Strategies
Before further discussion about costs and how they affect pricing, let’s just list the three major pricing strategies: 1) cost-based, 2) competition-based, and 3) value-based. In cost-based pricing, price is determined based on the incurred costs and required markup. In competition-based pricing, the price of the similar products determine the end-price, and in value-based pricing, the value of the service or product to the customer determines the end-price, regardless of the cost. Usually a combination of the three strategies would be required for the best estimate. For example, with all the free cloud storage and email services available through Yahoo and Google, no provider can ask for even a cent to offer email and cloud storage services to individuals, regardless of the cost to build the solution or their value to customer. Babysitting services on the other hand, may not cost at all to the babysitter, yet the babysitter will charge parents for his or her service. And, we know of many different instances when purchasing the same product at a specific store could cost much more than purchasing the same product from a store of a different brand or in a different neighborhood. Now, we may return to the initial topic and discuss how cost of a product should be determined, and how it would affect the pricing strategy.
Cost Object, Cost Pool, Cost Accumulation, Cost Assignment
Anything, including product, service, process, activity or other for which costs should be determined and measured is a cost object. Therefore, the first step to determine the cost is to identify the cost object.
Costs may be direct or indirect. Direct costs can be easily traced to the object. For example in a furniture manufacturing plant, labor cost for the hours spent on a specific piece of furniture as well as cost of wood to make the furniture set are direct costs. However the glue or the coating which may be used for more than one piece of furniture cannot be traced to any one piece of furniture. Costs incurred for the resources that have been shared among diverse cost objects are indirect costs. Indirect costs cannot be easily traced and need to be accumulated and allocated. Other examples of such costs are machinery depreciation for equipment in the manufacturing plant, used for making the furniture set, the lease of the manufacturing plant, or the salary of a supervisor.
Therefore cost object should be identified, costs for the object should be accumulated, direct costs should be traced to the specific job, while indirect costs will be allocated, and both allocated and traced costs will be then assigned to the object. Cost assignment is the process of determining and linking the right amount of the accumulated costs in the cost pool to a distinct cost object. The measure of the benefit for the cost objects that used the shared resources of the indirect cost is the cost allocation base. For example the lease for a plant which is used to manufacture three different lines of furniture may be allocated based on the space of the plant required for each different production line. The cost allocation base in this case would be square meter or required space.
This should be noted that an indirect cost to a specific cost object may be a direct cost to another cost object. This is why being clear on the cost object is critical. It is equally important to differentiate between significant and insignificant indirect costs. Insignificant indirect costs do not need to be allocated and can be easily added to a pool and considered in the end price of all products.
Expert management accountants help the organization understand and select the right costing system to determine its pricing strategy, marketing strategy as well as profitability of different products and make decisions regarding the optimized production volume and even discontinuing a specific non-profitable product.
Fixed Cost, Variable Cost, Cost per Unit
Variable cost changes proportionate to the change in the output within a relevant range. For example in a furniture manufacturing plant, the amount of wood required is directly linked to the volume of output furniture. So, cost of wood would be variable, and the cost per unit will remain unchanged, but as more units are manufactured cost increases. It should be noted that often if larger volume of material is purchased, a volume discount is applicable. This means that the variable cost (per unit) may change if the volume exceeds a specific amount.
Fixed costs, however, do not change as the production volume changes. Cost per unit will change and will decrease as the volume production increases. The best example for fixed costs would be the lease for the manufacturing plant. At $1,000 monthly lease, cost per unit will be $10 if 100 pieces of furniture are manufactured, but will be $100 if only 10 pieces of furniture is produced. Again, the notion of relevant range applies. For example one plant would have the capacity for producing 200 pieces of furniture, but to manufacture piece 201, a second plant is required.
In general costs could be in four different categories: direct/variable, direct/fixed, indirect/variable or indirect/fixed.
Some costs could be semi-variable or semi-fixed, or mixed. The best example would be cellphone plans. Consider cellphone plan as the cost object. Cost to those plans are mixed. For 5 GB of data, the cost is fixed and at $20. But if usage exceeds 5 GB, cost will be variable, and subscriber pays (for example) 1 cent per KB.
Cost of furniture is also mixed and comprises from fixed and variable components; Wood is a variable direct cost, and plant lease is indirect fixed cost.
This explains why for a Software as a Service or Computer games profits will materialize as volume increases. Variable costs are much lower compared to the fixed costs, and as the number of users increases then cost per unit will decrease accordingly.
Breakeven point (BEP) will be reached when enough volume has been sold to cover all fixed costs. After reaching the breakeven point, manufacturer turns profits. For example if direct cost per unit of furniture is $10 and plant is leased at $1000, if every piece of furniture is priced at $20, then manufacturer needs to sell 100 pieces to reach at the breakeven point. Selling the 101st piece will turn $10 of profit. If only 99 pieces are sold, manufacturer will incur a loss of $10.
Cost Drivers
If cost is a function of a unit of activity or volume, then that activity or volume is the cost driver. This means that a change in the unit of that activity or volume, changes the cost. In the furniture manufacturing plant, cost drivers were the solid wood, where square feet is the cost driver, as well as plant lease, for which space is the cost driver. Now, if you have a tax accountant, for example, the cost driver might be his or her different activities; i.e. $50 for personal tax files, and $500 for business tax files, for example. For a real estate agent, however, the cost driver would be the price of the real estate sold, as their commission is in percentage of the total transaction price.
Summary:
For the best pricing and product strategy, cost objects, costs and their nature and cost drivers should be carefully and clearly identified. Without a close study on the incurred costs, decisions regarding priorities, products, services, resources and customer care will be far from sound, and may cause detrimental issues to the survival of the business.