The two stages in the calculation of a typical costing can be complemented and completed by a third stage that converts the costing into a desired price – the addition of required margin. Thus we have a three-stage process:
Cost plus pricing revisited
■ calculate the ‘direct’ cost – those costs which are clearly identifiable with the product or contract;
■ add on the ‘indirect’ costs – an apportionment of general fixed overheads;
■ add on a profit margin to arrive at the required price.
It should be recognized that a costing of this kind becomes progressively less precise as you move through the process; it also becomes less and less comparable with what competitors may be calculating and therefore a less useful guide to their likely pricing behaviour.
We will not dwell on the first stage – the direct costs – because these are likely to be relatively straightforward and dependent on the nature of each product, service or contract. There is, however, one important assessment to make in parallel with your calculation of direct costs – your view on the comparative cost levels of key competitors. As mentioned in the previous chapter, you need an assessment of their advantage or disadvantage in buying power of raw materials, their utilization of labour, their efficiency of production, their distribution and other operating costs. The more that these differences are considered as the costing progresses, the more the final result is likely to be used in the right way.
The tendency to pass on relative cost inefficiencies to customers by means of cost plus pricing is one of its biggest dangers and is sure to end in tears. Conversely, the passing on to customers of relative cost efficiencies may result in a lost profit opportunity and a price that does not reflect true value.
It is in the latter two stages of the costing – the addition of overhead and the calculation of required margin – that problems arise and this is an area where there is much misunderstanding. We will illustrate the problems with an example of a new product introduction; we have to simplify to make some general points.
The key simplifying assumption is that there is a standard unit of product and that the new product can be measured in the same terms.
Product x
Direct costs – materials, labour, variable overhead £5.00 per unit
Units produced during most recent period 200,000
Total existing fixed overhead £600,000
Forecast volume for new product 15,000
Total capacity 300,000
The problems can be illustrated by listing the likely questions that should now be asked by those who are preparing the costing, for example:
■ How can we forecast the new product volume accurately when we don’t yet know the price? This is the classic circular and intractable problem of ‘cost plus’ pricing.
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■ Assuming that fixed overheads of existing products are now being costed at
£3.00 per unit (£600,000/200,000), do we now reduce their costing to a lower figure, for example, £2.79 (£600,000/215,000)?
■ Is this new rate of £2.79 also the correct rate for the new product?
■ Should the overhead rate be based on capacity rather than existing utilization?
■ What if the volume forecast for the coming period is more than 200,000?
These questions should illustrate the difficulty of establishing the ‘correct’ basis for fixed cost apportionment. However, it is much easier to highlight the problem than it is to provide the right answer. The best but by no means satisfactory way of solving the problem is to produce total overhead and sales volume forecasts for the coming period and, assuming that the latter is within realistic capacity utilization, to use this for the unit cost calculation. For example, assuming no change to overheads and a total volume forecast for all products of 250,000 units, the unit cost rate would be £2.40 (£600,000/250,000) and this would apply to both existing and new products.
Those who already have doubts about the cost plus approach and who also realize how unreliable volume forecasts can be will probably put away their calculator at this stage, deciding perhaps that market-based pricing is not so bad after all. Their doubts might be exacerbated by two further important questions that add even more to the complexity:
■ Should we include non-production items – sales, marketing, research, admin, etc. – in our definition of overhead, and if not, why not?
■ Is the ‘per unit’ apportionment method really an effective way of charging these and other costs to products?
The answer to the first question is undoubtedly yes – all fixed costs should be brought into a cost evaluation of this kind. However, it is interesting that, when you examine cost plus pricing systems as operated in many companies, it is common to find that the non-production costs are treated quite arbitrarily, almost as an afterthought. There may be great detail, even spurious accuracy, when arriving at detailed apportionments of factory costs; but then the other overhead costs – which are frequently a high proportion of the total – are lost within some vague and general mark-up on production cost. This is not logical; there is no difference in principle and if these other costs are to be included, they should be analyzed to the same degree of detail as those of the factory.
However, the inclusion of all fixed costs makes the answer to the second question even more likely to be ‘no’. The use of arbitrary apportionment methods like ‘per unit’, ‘percentage of sales’ or even ‘per labour hour’ is not likely to reflect the true way in which resources are used by new and existing products. One man
Cost plus pricing revisited
– Professor Robert Kaplan of Harvard Business School – has highlighted this problem through his advocacy of the technique of activity-based costing.
ACTIVITY-BASED COSTING
Like many successful management concepts of the 20th century, ABC is an essentially simple and common sense approach. It was used by good financial analysts way before Kaplan provided that important service delivered by the best academics – he gave the technique a label and a memorable acronym. More importantly, he alerted management to the dangers of relying on conventional costing methods and accepting them as absolute truths.
Kaplan’s work was not aimed at pricing alone but, by implication, this was a key element of his thinking. He claimed that the arbitrary allocation of overhead costs often led to products being costed inaccurately. This in turn led to price levels that did not reflect the true utilization of resources; it also led to inaccurate perceptions of product profitability. He criticized particularly the early approaches to product costing in manufacturing organizations, which required overheads to be charged to products on the basis of labour hours. He said that this may have been an appropriate basis for costing in the early days of manufacturing, but as factories become more automated and more complex, more sophisticated methods of costing are required.
The principles of ABC are simple. Each cost heading is looked at individually and the true ‘driver’ of cost is identified. For cleaning costs, the driver would be the space to be cleaned; for supervision costs, the number of people to be supervised; for depreciation costs, the number of machine hours in operation; and so on. This is not rocket science, merely common sense and the ideal practice of good financial analysts well before Kaplan provided the label. However, these analysts were frequently concerned about the cost effectiveness of the process because analysis to that level of detail is time consuming and expensive.
This issue of cost effectiveness is the key problem with ABC and this has held back its widespread application in business. If ABC is to be carried out properly, it requires time and much more detailed information about cost behaviour than is commonly available in an average business. A substantial investment of resources therefore has to be made and this can be justified only if there is a significant pay- off as a result of the analysis. Each business has to decide whether in its own unique context the benefits of ABC evaluations justify this investment.
Two interesting changes of emphasis have taken place, which have extended the application of ABC to different contexts and different businesses. First has been its extension to non-production costs, thus helping to provide a more accurate and
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effective means of bringing these items into the cost and profitability evaluation processes. Second has been the move towards placing ABC in a strategic rather than an operational context, seeing it as a means of providing more accurate long-term profitability evaluations rather than guidance for day-to-day decisions.
This fits very well with the fourth and last of the possible uses of cost plus pricing mentioned earlier – to provide insight for a strategic review of the business. An ABC costing can tell you what, in an ideal world and in the long term, you would like the price to be to cover full costs and achieve required profit objectives. It can provide calculations of current and likely future profitability under a number of different scenarios. This can concentrate the mind on the range of long-term strategic options, which might involve cost reduction, ways of increasing prices or even exit from the market.
Such evaluations can be carried out without ABC methods, but if so there will always be doubt about the validity of the answers. Advocates of ABC will quote examples where the traditional arbitrary methods proved to be so wrong as to be misleading, even worse than having no information at all. One food company in the Netherlands discovered from an ABC analysis that half its product range in one category was pricing below full cost when previously it was thought to be highly profitable. The lesson they learnt from the experience was that such costings should be carried out properly with ABC or not at all.