Cost Based Pricing strategies

Importance of Costs in pricing• Costs information indicates whether the product can be

made and sold profitably in any price. • Apart from the production costs, costs for selling,

marketing, distribution and general administrative costs are very adequate to determine the profitability of a project.

• The most commonly used method to set prices is the “cost plus” and “mark up pricing” strategies.

• Cost for pricing must deal with the future.

Cost Classifications• It is important to clarify what is meant by direct

and indirect:– Directly traceable or attributable costs:Cost that can be readily determined as contributing to the product or service’s cost.– Indirect traceable costs Cost that can be objectively traced to a segment or product categories.

Cost Classifications

• Common costs support a number of activities or profit segments and cannot be objectively traced to a product or segment based on a direct physical relationship to that product or segment

• Opportunity costs reflect the “cost” of not choosing the best alternative or opportunity

Cost Classifications

• Cash costs can lead to cash (or out-of-pocket) outlays or bookkeeping (depreciation or amortization) entries

• Noncash costs do impact the cash flows but do not reflect actual monetary outlays in a particular accounting period

Cost Classifications

• How do costs vary with changes in activity rate?• DIRECT VARIABLE COSTS:

– Vary directly with activity level;– the major criterion of a direct variable cost is that it

be traceably and tangibly generated by, and identified with a particular activity.

– E.g., raw materials, sales expenses, utilities.

Cost Classifications

• How do costs vary with changes in activity rate?• SEMIVARIABLE COSTS:

– Costs that vary with activity rates, but are not zero at a zero activity rate. These costs consist of a base amount that is constant in relation to activity and a variable amount that varies directly with activity.

– E. g., data processing, supplies, maintenance.

Cost Classifications

• How do costs vary with changes in activity rate?• PERIOD FIXED COSTS:

– These costs do not vary with activity. They remain fixed over a period of time due to previous decisions. Some fixed costs may be traceable to specific activities by reasonable objective means. Other fixed costs are general and not easily traceable to an activity.

Breakeven Concept One Unit 10,000 units

Sales $20 $200,000

Variable costs

16 160,000

Fixed costs 2 20,000

Total costs 18 180,000

Profits 2 20,000

Breakeven Formulas

• Breakeven quantity:

• where BEQ = break-even sales quantity• FC = fixed costs• P = selling price• VC = variable costs

B E Q F C P V C [ ]

B E Q

B E Q

$ 2 0, [$ 2 0 ]

,

0 0 0 1 6

5 0 0 0

Breakeven Formulas

• Breakeven sales revenue

• where BES = break-even sales revenue• FC = fixed costs• PV = Profit-Volume Ratio:

B E S F C P V

P V

B E S

[$ 2 0 ] $ 2 0 .

$ 2 0 , . $ 1 0 0 ,

1 6 0 2 0

0 0 0 0 2 0 0 0 0

P V P V C P [ ]

Break-Even Analysis

A change in fixed costs affects only the break-even point

A change in the price and/or variable costs affects both the break-even point and the PV

An increase in prices and/or decrease in variable costs can offset an increase in fixed expenses (assuming volume remains unaffected)

Limitations of Break-Even Analysis

The assumption that variable costs remain proportional to volume at all output levels

The assumption that price is constant over relevant volume levels

Costs used the in the analysis may be relevant over a limited range of volume

Cost-Plus Pricing (Mark up pricing)

1. Cover costs Material Labor Capital resources Marketing

2. Mark-up Targeted return for shareholders

Costs + mark-up = Sales price

$1.00 + $0.50 = $1.50 (50% markup)

variable costs

fixed costs

Mark up priceMUP = UC/(1- ROS)

MUP = Mark up priceUC = Unit CostROS = Expected return on sales

UC= VC + FC/ Unit sales(not dollars)

• Cost based pricing method does not take into consideration supply/demand, or even market status.

• It is purely based on the cost of the production of the product dollars per unit of final product (raw materials, manual labour, etc..).

Target return pricingTRP = UC + ( R x I)/ US

TRP = Target return price

UC = Unit cost

R = Expected return on investment

I = Invested capital

US = Unit sales expected

Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production.

The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers.