PRODUCT COSTING IN A NUTSHELL

 

Hello everyone!!

 Today, I have put forth maximum number of product pricing techniques for your understanding in a nutshell. It is very easy to understand and accountants do a meticulous job in identifying and segregating administration, production and selling overheads (Fixed & Variable) and allocate them to the cost of the product. Now, we will try to understand what costs will be considered to price your products:

 

1.  Throughput Accounting technique: The profit per unit is simply derived by subtracting sales from direct materials purchased. Now, we might be curious what happened to other costs? That is why costing technicians defined Throughput accounting ratio.

 

TPAR = Return per factory hour / Cost per factory hour.

 

Return per factory hour = (5CU selling price per unit – 4.5CU direct material cost per unit) / 3 hours to produce a single unit.

 

Cost per factory hour = 100000CU Total production costs / 30000 total labor hours

    Hence TPAR = 0.50. This indicates that operating costs are not covered due to the selling price being 5CU. If we increase it to 7, then the ratio changes to 2.52. Remember, TPAR > 1 will cover operating costs and when TPAR < 1, the current price of the product will not give us any profits. 

 

2.  Target Profit technique: The name itself suggests that the manufacturer demands a target profit. If the break-even sales in units is 10,000 with a selling price of 10CU/Unit, variable cost 5CU and fixed costs are 50,000CU, then when the manufacturer wants to make a profit of 100,000CU, he needs to sell 7,000 units to get that desired profit.

Formula = 50,000CU Fixed costs + Target profit 100,000CU / Unit selling price – Unit variable cost = 70,000 Units * 10 = 700,000 CU

If we analyse it further

700,000 Sales Revenue – (5*70,000) CU variable costs = 350,000 Contribution – 50,000CU Fixed costs = 300,000CU profit. This is in excess of desired profit. So the manufacturer will reduce the price per unit to 7.15CU in order to get a profit of 100,500CU.

 

3.  Life cycle costing technique: This is the aggregate of lifetime costs related to R&D, Marketing, distribution, customer service, warranties, liabilities, production and other related cost. In other words, ‘Total product costs incurred during its lifecycle / Total no of units produced during the lifecycle'. 

 

4.  Minimum Pricing technique: This is usually a very useful costing technique which includes incremental and opportunity costs. These costs are also termed as Relevant costs. An example of this is, when selling price is constant, the profit will reduce this month when raw materials cost increase by 10%. Similarly, you have skilled labor who can finish off the work 5hrs lesser thus saving you money on wages when compared to the new labor staff that you have to employ due to shortage of skilled labor. There are other factors which will increase production costs and these relevant costs are allocated to the product price.

 

5. Product Line Pricing technique: Conglomerates manufacture multiple range of products and the process of pricing these range of different products is called product line pricing. They may choose different pricing techniques for different products.  

 

6. Marginal or Mark-up pricing technique: Here, direct material, labor and variable production overheads are grossed and a mark up on it is added to achieve the desired profit. Fixed costs are completely ignored.

 

 7. Full Cost Plus & Absorption Cost technique: Here, all fixed and variable costs are added plus a mark up to it. It also includes any relevant costs/opportunity costs as discussed in Minimum pricing. Absorption pricing is a more sophisticated variant on this where costs are allocated more precisely. Each indirect cost will be treated separately and allocated accordingly

 8. Complementary Pricing technique: This is usually what we get in a supermarket. Buy an electric brush and we get a complimentary toothbrush head replacement. The consumers may or may not be charged for it directly as the manufacturers generosity depends upon the sales and profit margins. Many companies allocate that discount to the products performance obligation if one exists. For example, if we purchase a mobile phone, the manufacturer might offer a free accessory like a blue tooth. But he will allocate the discounted revenue to other performance obligations like increased cost of servicing. 

                                                               

 9. ROI Pricing technique: In other costing methods, mark up is added to recover costs and to recover profits. In this method, recovering capital investment i.e., working capital and for this purpose borrowing costs are considered. For example, 200,000CU was borrowed as working capital and its costs of financing is 4%, then, Full cost of product + 20%*200,000CU = ROI selling price of product. 

 

 10. Contribution-Margin Pricing technique: This is somewhat similar to Marginal cost of a product where all variable costs are included without fixed costs i.e., Direct material + Direct labor + Indirect variable + Direct variable costs + Margin gives the total price of the product. However, this method considers only Direct variable costs instead of Indirect variable costs. 

 

 

11. Differential Cost analysis: This is similar to Marginal product costing because when production increases by 100 units and so does its variable costs. This is used for analysis to find out what will be the unit price change, differential unit price along with change in output levels and from the unit price data, analysts try to find out the unit cost change i.e., old cost minus new cost.

 

12.   ABC costing technique: There are similarities between Absorption costing and this because they both use overhead absorption rates. However, the main difference is Absorption cost method uses predetermined overhead absorption rates only for machine and labor hours. ABC has more advantages and bit more accurate than the Absorption method because it can derive overhead driver rate for all activities and absorb them into all activities. Thus ABC system will analyses activities and costs accurately. It also shows us resource consumption and helps in allocating indirect costs to direct costs in order to get the total overhead cost per unit. 

 

 

13.   Economic pricing- Demand Supply equilibrium technique: The demand supply curve intersects at a point where total demand = total supply. This point of intersection defines the equilibrium price and equilibrium quantity.

 

 

14.   Economic pricing- Profit maximizing price technique: This uses linear programming and sought after by many analysts. This gives the price and quantity at which revenue is maximized. 

 

 

15.   Threshold costing technique: This is something we all know about how many products are being priced at 0.99CU. Example 2.99CU, 5.99CU, 12.99CU and this is called as threshold costing. 

 

16.   Real Estate pricing: 

a. The cost method: The value of the property is derived by adding any replacement costs + NBV of building + Market value of the land. (Indexation is mandatory)

b. Sales comparison method: This method uses similar prices of similar properties or competitors prices.

c. The Income method: Uses discounted present values of future income generated by the property.

d. The Net Operating Income (NOI)method: It is the value of annual gross revenues generated by the property minus its operating expenses. This NOI is then divided by required rate of return (Market cap rate) to appraise its value.

e. Hedonic Pricing method: This pricing method uses a regression model. For example all recent transactions and characteristics are regressed to get a benchmark value of each of these characteristics. Then an investor substitutes his preferences into the regression equation and he will be able to get the property value. For instance, after doing a regression analysis of an area the following are the benchmark value:

House price (Slope) = 100,000CU

Slope coefficients:

Square feet = 10 feet

Number of bathrooms = 15,000

Miles away from city centre = -20,000

Now the customer wants to have a 1,200 square feet home, 2 bathrooms and 5 miles away from the city centre. Input this info into the regression equation

100,000 + 10 (1,200) + 15,000 (2) – 20,000 (5) = 42,000CU is the property value.

17.   Loan Pricing techniques:

a. Risk Management Based pricing: Koch and Sinkey developed this pricing strategy which will include creditworthiness and risk of the borrower into loan price. So it adds risk as percentage to the loan's base price.

b. Cost-plus Loan pricing: This includes costs of raising loanable funds and its operating costs of running their banks.

Loan Price = Marginal cost of raining loan funds + Bank operating costs + Margin for default risk + Profit margin.

c. The Price Leadership method: This considers competition. The intense competition will reduce loan’s profit margins.

Loan rate = Base rate + Profit Margin + Default Risk Premium + Term Risk Premium

d. LIBOR Based pricing: Similar to the above, risk premium and margin is added to this loan

Loan rate = LIBOR + Default Risk Premium + Profit Margin which includes operating and administration costs.

e. The Mark-up method: This had started during the globalization era where many foreign banks started offering cheap credit to borrowers and reduced their profit margins slightly above the cost of funds raised

Loan rate =Interest Cost of Borrowing + Mark up for default risk and money market profits

f. Cost-benefit Loan pricing: This method first calculates loan revenues, then it imposes deposit reserve requirements and finally estimates before tax yield to the bank by dividing revenue / net proceeds drawn by borrower. This gives the loan tax rate in %.

g. Fixed Vs. Floating rate: The banks lock a fixed spread and charges it on the loan. Otherwise the bank will choose to maintain spreads and float them on the loan.

h. Prime Rate Based pricing: The national bank sets a LIBOR benchmark rates and this is called as Prime Lending Rate. It issues credit to creditworthy customer at this rate and higher rates for lower credit worthy customers.

Loan rate = PLR + Premium

i.         Finally SPOT & FORWARD rates used for pricing

18. Marketing Pricing technique: The below are few techniques developed to promote the products in various markets. A company uses the above valuation techniques to price the product and then reduces or increases the margin to suit their marketing needs.

a. Price Skimming: Skimming involves setting high prices when a product is introduced and then gradually lowering the price as more competitors enter the market. 

b. Penetration Price: Pricing for market penetration is essentially the opposite of price skimming. Instead of starting high and slowly lowering prices, you take over a market by undercutting your competitors. Once you develop a reliable customer base, you raise prices.

c. Premium Pricing: Premium pricing is for businesses that create high-quality products and market them to high-income individuals.

d. Economy Pricing: An economy pricing strategy involves targeting customers who want to save as much money as possible on whatever good or service they’re purchasing. Big box stores, like Walmart and Costco, are prime examples of economy pricing models.

e. When companies pair several products together and sell them for less money than each would be individually, it’s known as bundle pricing.

f. Value Based Pricing: Value-based pricing is similar to premium pricing. In this model, a company bases its pricing on how much the customer believes the product is worth. This pricing model is best for merchants who offer unique products, rather than commodities.

g. Discount Pricing: Sometimes firms offer bulk discount to their dealers and customers. They use a discount formula and input what discount rate they want to offer, say 2%. If the result is 15% and if this rate is below their costs of finance, say, 19%, it is profitable to allow discount on sale. 

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