Accounting: The Language of Business - Vol. 1 (Part 152)

If other people do not understand our behavior-so what? Their request that we must only do what they understand is an attempt to dictate to us. If this is being 'asocial' or 'irrational' in their eyes, so be it. Mostly they resent our freedom and our courage to be ourselves. We owe nobody an explanation or an accounting, as long as our acts do not hurt or infringe on them.

Erich Fromm

Differential Analysis and Product Pricing (Part G)

by

Charles Lamson

Choosing a Cost-Plus Approach Cost Concept

All three cost concepts [total cost concept (from part 151), and product cost concept and variable cost concept (from part 152)] produced the same selling price ($18.30) for Digital Solutions Inc. In practice, however, the three cost concepts are usually not viewed as alternatives. Each cost concept requires different estimates of costs and expenses. This difficulty and the complexity of the manufacturing operations should be considered in choosing a cost concept.

To reduce the costs of gathering data, estimated (standard) costs rather than actual costs may be used with any of the three cost concepts. However, management should exercise caution when using estimated costs in applying the cost-plus approach. The estimates should be based on normal (attainable) operating levels and not theoretical (ideal) levels of performance. In product pricing, the use of estimates based on ideal or maximum capacity operating levels might lead to setting product prices too low. In this case, the costs of such factors as normal spoilage or normal periods of idle time might not be considered.

The decision-making needs of management are also as an important factor in selecting a cost concept for product pricing. For example, managers who often make special pricing decisions are more likely to use the variable cost concept. In contrast, a government defense contractor would be more likely to use the total cost concept.

Activity-Based Costing

As illustrated in the preceding paragraphs, costs are an important consideration in setting product prices. To more accurately measure the costs of producing and selling products, some companies use activity-based costing. Activity-based costing (ABC) identifies and traces activities to specific products.

Activity-based costing may be useful in making product pricing decisions where manufacturing operations involve large amounts of factory overhead. In such cases, traditional overhead allocation using activity bases such as units produced or machine hours may yield inaccurate cost allocation. This, in turn, may result in distorted product costs and product prices. By providing more accurate product cost allocations, activity-based costing aids in setting product prices that will cover costs and expenses.

Target Costing

A method that combines market-based pricing with a cost-reduction emphasis is target costing. Under target costing, a future selling price is anticipated, using the demand-based methods or the competition-based methods discussed previously. The targeted cost is determined by subtracting a desired profit from the expected selling price. In contrast, the three cost-plus concepts discussed previously begin with a given cost and add a markup to determine the selling price.

Target costing is used to motivate cost reduction as shown in Exhibit 10. The bar at the left in Exhibit 10 shows the actual cost and profit that can be earned during the present time period for a particular product. The bar at the right shows that the market price is expected to decline in the future. Thus, to earn a profit, a target cost is estimated as the difference between the expected market price and the desired profit. This target cost establishes a product cost objective that will maintain competitiveness and profitability.

EXHIBIT 10 Target Cost Concept

Since the target cost is less than the current cost, managers must plan and remove cost from the design and manufacture of the product. The planned cost reduction is sometimes referred to as the cost "drift." Cost can be removed from a product in a variety of ways, such as by simplifying the design, reducing the cost of direct materials, reducing the direct labor content, or eliminating waste from manufacturing operations. Using the target cost concept in this way provides managers with a road map for making improvements and gauging the success of their efforts over time. Target costing is especially useful in the highly competitive markets that require continual product cost reductions to remain competitive. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1,006-1,007*

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