Costing and Pricing Decisions
Costing and Pricing Decisions
One of the core functions of a manager is making decisions in order to run an enterprise in the most effective and efficient manner while generating profits. Decisions are made to achieve different specified objectives in an organization. Resources are used to attain certain objectives such as producing a specific product or service. Without appropriate and accurate costing and pricing decisions, it becomes challenging to accomplish the targeted objectives. Costing entails ascertaining costs using appropriate processes and techniques in order to identify costs of services and/or services. Costs vary with scale, rate of production, and scope, variety of various products. Most of the empirical studies evaluating costing and pricing decisions report that there are various approaches to costing and pricing decisions, but appropriateness of each approach tends to vary with the nature of costs, industry disparities, and other related aspects. However, because of lack of sufficient understanding about different approaches and their appropriateness, managers end up making wrong decisions.
Thus, the paper will discuss the major differences in costs allocations (joint costs, sunk costs, and opportunity costs) and pricing decisions (cost-plus pricing, target costing, and activity-based pricing); their appropriateness in the context of the nature of costs, industry differences, and competitiveness; and relate the implications for firm’s profitability.
Terzioglu & Chan, (2013, pp. 34) defined joint cost as, “the cost incurred to produce two or more outputs using the same input.” Joint cost allocation is long-lasting issue facing many accountants, especially in service industries; due to desire by management to assess product/service performance and make appropriate pricing decisions.
Joint costing approach is inappropriate and challenging to implement in service industries such as healthcare and hotel. This is because such industries have comparatively huge sums of joint costs and interconnected products, in which determining specific costs incurred for each individual service is very challenging (Terzioglu & Chan, 2013). For instance, a hotel incurs joint costs in producing variety of products and services. In this case, it is difficult to identify costs incurred for each individual product or service.
Sunk costs involve costs that have been incurred thus they cannot be altered. However, it is informed that sunk costs have intensive impact on firm’s profitability and success. While customers’ ability to upgrade by purchasing a new product determines success of a product and/or service, sunk costs can deter the upgrading and buying. Previous studies report that there are two types of relationships, exchange and communal, which customers develop with a brand (Liu & Chou, 2013). Exchange relationship is more concerned with value, while communal relationship focuses in satisfying one’s needs. In the latter, customer are less likely to evaluate gains versus losses unlike in exchange relationship, whereby customers often assess net-value they gain from purchasing a certain product or service. Thus, sunk costs tend to influence demand and profitability of brands in which their relationships with customers are based on exchange relationship. Since they cannot be changed, these costs are irrelevant in making effective decisions, especially in ongoing projects.
Opportunity cost refers to a decision making approach that entails selecting the more apposite choice, particularly for ultimate decision making. Firm’s income or profitability can be used to evaluate opportunity cost (Tajidan & Sjah, 2015). Opportunity cost is an appropriate tool for evaluating any type of costs, both monetary and non-monetary costs. For instance, consider a case whereby a firm plans to upgrade its product by either establishing its own packaging plant or outsourcing the service from outside parties. If the first chooses the first option, it certainly needs more direct costs such as additional employees, costs of inputs, and indirect costs such as those associated with depreciation of machines. The motivation of constructing a packaging facility is based in the gains, especially the profits. However, this is not appropriate; the firm should also evaluate how construction of the facility will impact the environment and the general society. Such evaluation is also conducted if the firm opts to outsource the function. In this case, the firm should adopt and implement the alternative with the most surplus and least disadvantages. This apparently implies that opportunity cost approach is appropriate for making effective decisions since gains and losses are not usually based on money only. Managers need to abandon sunk costs and adopt opportunity costs in order to make effective decisions.
Cost-plus pricing is an approach based on cost for determining prices of services/goods. This approach involves deriving a price of a product by summing up costs for direct labor, direct material and overhead costs, as well as a markup. Manufacturers fund operating costs and make profits through adding a markup. This implies that increase in operating costs lead to higher markup, thus higher prices. Cost-plus pricing is widely employed in both private and public sectors. A study by Anggriani, (2013) on “the impact of Indonesian generic medicine pricing policy on medicine prices” revealed that the approach is widely used in health care sector, especially in the private facilities. The study reported that prices for unbranded generic medicines were higher in 2010 than in 2004, while the prices for lowest price generic (LPG) medicines were lower in 2010 compared to 2004. The disparity emerged due to intervention by the Indonesian government in regulating prices for LPGs.
Although cost-plus pricing approach seems appropriate in setting prices for services and products, it is actually inappropriate in setting prices for services. This is due to issues related to colleting accurate information about costs incurred in producing and offering each service.
Target costing is defined as the “set of management tools and methods aimed to design and develop activities for new products, which provides the basis for controlling subsequent operation phases and which makes sure that products achieve their goals in terms of profitability throughout their life cycle” (Briciu & CĂPUŞNEANU, 2013, pp. 458). The core objective of target costing is to determine costs incurred in producing a specific product in order to make pricing decision that will generate profit after selling the product.
It is an appropriate approach for businesses to determine costs of their products and services in a sense that it helps them to avoid losses. However, targeting costing approach is prone to impacts of different trends such as competition and government regulations among others. This approach is associated with increased competition in market. Studies report the approach is suitable for forecasting consumers’ demands and comprehending behavior of competitors in a marketplace. Thus, it is widely used to promote business competitiveness by many managers.
Activity-based pricing is somehow similar to cost-plus pricing, but they differ in a sense the activity-based pricing includes all resources incurred in producing a service or a product. That is, a firm would not charge arbitrary fee to fund all fixed costs, but it would include costs of all inputs such as administration costs, labor costs, and building costs. It is appropriate tool for determining all cost components of a service and/or product in entirety. Businesses use the approach not only to determine and do away with unprofitable services/products, but also to mitigate prices for overpriced outputs. Generally, it helps businesses to reduce costs and improve productivity as well as competitiveness (Kumar & Mahto, 2013). Nonetheless, calculating cost components, especially in service industries is very difficult.
In conclusion, making costing and pricing decisions are among core complex and demanding tasks that are facing many managers. The paper has shown that there are various approaches to costing as well as different approaches to pricing decisions. However, it is worth to note that appropriateness of each approach tends to differ with different aspects such as context of costs, industry disparities, and competitiveness. Thus, each different approach fosters diverse impact on a firm’s profitability.
Anggriani, Y., Ibrahim, M. I., Suryawati, S., & Shafie, A. A. (2013). “The impact of Indonesian generic medicine pricing policy on medicine prices.” Journal of Generic Medicines. Vol. 10, no. 3–4. Pp. 219–229
Briciu, S. & CĂPUŞNEANU, S. (2013). “Pros and Cons for the Implementation of Target Costing Method in Romanian Economic Entities.” Accounting and Management Information Systems. Vol. 12, No. 3, pp. 455–470.
Kumar, N. & Mahto, D. (2013). “Current Trends of Application of Activity Based Costing (ABC): A Review.” Global Journal of Management and Business Research Accounting and Auditing. Vol. 13, no. 3, Version 1.0, pp. 1-24.
Liu, H. & Chou, H. (2013). : Relationship Types and the Sunk Cost Effect.” Asia Pacific Management Review. No. 19, no. 3, pp. 239-251.
Tajidan & Sjah, T. (2015). “Producer Surplus as a Measure for Opportunity Cost: The Case of Corn Farming on the Hill of Mount Rinjani – Indonesia.” Advances in Management & Applied Economics. vol. 5, no.3, pp. 37-42.
Terzioglu, B. & Chan, S. K. (2013). “Toward Understanding the Complexities of Service Costing: A Review of Theory and Practice.”JAMAR. vol. 11, no. 2, pp. 29-44.