Companies can encounter situations where they have temporary un-utilized capacity and are faced with the opportunity of bidding for a one-time special order in competition with other suppliers. In this situation only the incremental costs of undertaking the order should be taken into account. It is likely that most of the resources required to fill the order will have […]READ ARTICLE
Category: Cost Accounting
Instead of using the cost-plus pricing approach described in above example (Case A) whereby cost is used as the starting point to determine the selling price, target costing is the reverse of this process. With target costing the starting point is the determination of the target selling price. Next a standard or desired profit margin is deducted to […]READ ARTICLE
Customized products or services relate to situations where products or services tend to be unique so that no comparable market prices exist for them. Since sales revenues must cover costs for a firm to make a profit, many companies use product costs as an input to establish selling prices. Product costs are calculated and a desired prof it […]READ ARTICLE
Pricing decision for customized products or services is easy, it is a single customer with the pricing decision being based on direct negotiations with the customer for a known quantity, But for non-customized products, it needs full detailed plan of pricing decision, for example pricing of a shoe in show factory, is a non-customized product.
Customized Products: Sales of a single quantity (Or low quantity) to A single customer
Non-Customized Products: Sales of a thousands quantity (Or high quantity) to A unknown quantity of customers
A market leader must make a pricing decision, normally for large and unknown volumes, of a single product that is sold to thousands of different customers. To apply cost-plus pricing in this situation an estimate is required of sales volume to determine a unit cost, which will determine the cost-plus selling price.
This circular process occurs because we are now faced with two unknowns that have a cause-and-effect relationship, namely selling price and sales volume. in this situation it is recommended that cost-plus selling prices are estimated for a range of potential sales volumes. Consider the information presented in Example as below ( case ): (Please click on photo to zoom)
You will see that the Auckland Company has produced estimates of total costs for a range of activity levels instead of adding a percentage profit margin the Auckland Company has added a fixed lump sum target profit contribution of t2 million. The information presented indicates to management the sales volumes, and their accompanying selling prices, that are required to generate the required profit contribution.
The unit cost calculation indicates the break-even selling price at each sales volume that is required to cover the cost of the resources committed at that particular volume.
Management must assess the likelihood of selling the specified volumes at the designated prices and choose the price that they consider has the highest probability of generating at least the specified sales volume. if none of the sales volumes are likely to be achieved at the designated selling prices management must consider how demand can be stimulated and or costs reduced to make the product viable. if neither of these, or other strategies, are successful the product should not be launched. The final decision must be based on management judgement and knowledge of the market The situation presented in Example 5.1 represents the most extreme example of the lack of market data for making a pricing decision. if we reconsider the pricing decision faced by the company it is likely that similar products are already marketed and information may be available relating to their market shares and sales volumes Assuming
that Auckland's product is differentiated from other similar products, a relative comparison should be possible of its strengths and weaknesses and whether customers would be prepared to pay a price in excess of the prices of similar products. it is therefore possible that Auckland may be able to undertake market research to obtain rough approximations of demand levels at a range of potential selling prices. Let us assume that Auckland adopts this approach, and apart from this, the facts are the same as those given in above Example (Case A).
Now look at Case B in above example, The demand estimates are given for a range of selling prices. in addition the projected costs, sales revenues and profit contribution are shown. You can see that profits are maximized at a selling price of £80. The information also shows the effect of pursuing other pricing policies. For example, a lower selling price of 170 might be selected to discourage competition and ensure that a larger share of the market is obtained in the future.
Instead of using the cost-plus pricing approach described in above example (Case A) whereby cost is used as the starting point to determine the selling price, target costing is the reverse of this process. With target costing the starting point is the determination of the target selling price. Next a standard or desired profit margin is deducted to get a target cost for the product. The aim is to ensure that the future cost will not be higher than the target cost.
The stages involved in target costing can be summarized as follows:
Stage 1: determine the target price that customers will be prepared to pay for the product
Stage 2: deduct a target profit margin from the target price to determine the target cost
Stage 3: estimate the actual cost of the product;
Stage 4: if estimated actual cost exceeds the target cost investigate ways of driving down the actual cost to the target cost.
The first stage requires market research to determine the customers' perceived value of the product, its differentiation value relative to competing products and the price of competing products, The target prof it margin depends on the planned return on investment for the organization as a whole and profit as a percentage of sales. This is then decomposed into a target profit for each product that is then deducted from the target price to give the target cost. The target cost is compared with the predicted actual cost. if the predicted actual cost is above the target cost intensive efforts are made to close the gap.
Product designers focus on modifying the design of the product so that it becomes cheaper to produce. Manufacturing engineers also concentrate on methods of improving production processes and efficiency.
The aim is to drive the predicted actual cost down to the target cost but if the target cost cannot be achieved at the pre-production stage the product may still be launched if management are confident that the process of continuous improvement will enable the target cost to be achieved early in the product's life if this is not possible the product will
not be launched. The major attraction of target costing is that marketing factors and customer research provide the basis for determining selling price whereas cost tends to be the dominant factor with cost-plus pricing A further attraction is that the approach requires the collaboration of product designers, production engineers, marketing and finance staff whose focus is on managing costs at the product design stage. At this stage costs can be most effectively managed because a decision committing the firm to incur costs will not have been made. Target costing is most suited for setting prices for non-customized and high sales volume products, lt is also an important mechanism for managing the cost of future products.
The two principal systems for determining the inventory quantities on hand are the periodic system and the perpetual system. Both systems may be used simultaneously by companies with different classes of inventory.
The Periodic System
This system requires a physical count of goods on hand at the end of the period. A cost basis (i.e., FIFO, LIFO, etc.) is then applied to derive an inventory value. This system is widely used because it is simple and requires records and computations primarily only at the end of the period. It is not as useful as the perpetual system, however, in the planning and control of inventories.
The Perpetual System
This system calls for a continuous record of receipt and disbursement for every item of inventory. Physical counts of the quantities on hand are usually made at least once a year and reconciled to the perpetual records. Most large manufacturing and merchandising companies use the perpetual system to provide continuous control over the quantities and the investment in inventory.
Adequate supplies are assured for production or sale and costly machine shut-downs and customer complaints are minimized.
Inventory cost includes all expenditures relating to inventory acquisition, preparation and readiness for sale. Any purchase discounts are treated as reductions in the cost of inventory. Accounting for inventory costs for goods in process and finished
goods can be best accomplished by means of a good cost accounting system, a topic which will be treated in depth in later volumes of this series. In a manufacturing company, the two primary methods for accumulating costs are (1) by job order and (2) by process or operation.
Job Order Cost System
This system is generally used by companies which manufacture a number of different products in limited quantities. The costs for each job are accumulated separately on a job order cost record and are included in goods in process until the job is completed. The completed job and its associated costs are considered finished goods until the job is sold. Examples of companies using job order cost systems are printing shops and construction companies.
Process Cost System
This system is used where large amounts of similar units are produced on an assembly-line basis. The controlling factor is the cost center or department. Costs of raw material, direct labor, and manufacturing overhead are accumulated by cost center rather than by individual job. The unit cost is obtained by dividing total costs by the quantity produced for the week, month, etc. Examples of companies using process cost systems are steel mills, paper companies, and other
For proper budgeting and cost control it is necessary to make a distinction between fixed and variable total costs. Most costs fit easily into one category or the other; however, various items of factory overhead can be classified as semi variable costs and must be carefully examined to determine their relationship to changes in the volume of production. Fixed […]READ ARTICLE
The broad definition of cost accounting and nature of cost is the process of identifying, summarizing, and interpreting information needed for: Planning and Control Management Decisions Product Costing Note that product costing is number 3, since in most companies, the more important activities relate to planning and control and special decisions rather than to the more mechanical aspects […]READ ARTICLE
Cost Systems The cost classifications do not provide all required cost data. Most cost planning and control data can only be provided by an adequate cost system, designed so that individual supervisors, department heads, and executives can be held accountable for all costs which are their responsibility. The concepts of authority and responsibility are closely related to accountability […]READ ARTICLE
Cost Accounting Concepts A concept is a basic principle or assumption, as opposed to a procedure, for carrying out the concept. Cost accounting concepts may be separated into two groups: Planning Controlling 1. Planning: There are two key types of planning, as described below. Project Planning. The process whereby management, confronted by a specific problem, evaluates each alternative in order to […]READ ARTICLE