Pricing and Costing Methods Essay
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Organizations today more than ever before must ensure that they reduce costs as well, as the time used to avail products and services to the market. Since planning as well as the estimation of costs are critical to businesses it is important that organizations chose the best pricing and costing techniques. (Seonen, 2006). The implication here is that the fundamental goal of any business concern is to minimize its costs of operation while maximizing its returns to the shareholders.
In order to achieve this, there is need to put in place the best pricing policies as well as the most appropriate costing techniques.
This paper will attempt to examine the various costing as well as pricing methods that are available for use by business organizations. Traditional costs estimation methods like marginal and absorption costing will be looked at. Equally the newer costing method, the activity based costing will be discussed alongside other pricing methods. (Seonen, 2006) Pricing Methods Average cost pricing One example of pricing methods is the average cost pricing.
Average cost pricing as a cost method involves the calculation of average costs per unit. To obtain this, the total cost of goods available for sale is divided by the total units available for sale. The weighted average approach is applied to all the closing inventories. (Duffie, 1992) The disadvantage with this method is the fact that it ignores the effects of cost increases as well as decreases. This is usually due to the fact that cost of closing inventory calculated under this category is usually affected the prices paid in the entire year as well as the cost of the opening stock.
The method thus ignores more recent costs which are more reliable in income determination and decision making. Pricing methods Cost plus pricing: this is one of the pricing methods where by the price for a given product or service is the sum of the actual cost of the product or service plus a profit margin. This method of pricing is mostly used as an interim contractual measure. (Lintner 1965) The major advantage of this method is that it’s easy to calculate and need little information in computing the project costs and thus mostly used in pricing government contracts.
The other hand this method has come under sharp criticism for encouraging wasteful expenditures in government contracts coupled by corruption. The other pricing method is the option pricing method that is commonly used in the motor vehicle industry. (Birge, 1997 ) option pricing method is basically where by an organization prices its products in a way that it provides a base price for its products which in most cases is always low to attract customers who upon visiting the store find other product accessories that can be purchased and added to the product.
For example most vehicle manufacturing companies will provide a base price for their cars and use their showrooms to market other product parts like the car music systems, alarms e. t. c. Capital asset pricing model (CAPM) is another pricing approach that can be used in the financial sector, (Lintner 1965, pp. 12-39) it basically based on the investors ability to invest in many other fronts (divest) without additional costs, this approach is advantageous in that any future cash flows can easily be monitored with only knowing the investments correlation with the market, market risk premium as well as the risk free rates.
Comparable uncontrolled price method(CUP),this is a method that seeks to establish the ALP, through comparing the controlled and the uncontrolled transaction in relation to the asset or service that has been transferred, (Duffie,1992) this method is mostly used in provision of loan by financial institutions as well by other organizations that sell intangibles.
Resale price method, this is a method that seeks to evaluate the process of activities performed or done rather than the eventual output (product) (Lintner,1965,pp. 2-37)its commonly used in instances where the reseller do not add any meaningful value to the finished product and no physical changes are made on the product, the eventual resale price is determined by the resale price of a commodity then subtracting the gross profit margin achieved from the resale as well as all the expenses incurred, before arriving at the resale price of the commodity
Bid pricing: This is a method of pricing that is commonly used in the stock exchange markets. it basically involve the respective clients placing bids or prices they would like to purchase the stocks of shares, and with the buyers and the sellers, with the highest bidder purchasing the property, price movements at times in the stock market always leads to the uncertainty in the market prices. (Sharpe,1964,p. 425-442)
Target pricing: This is a method of pricing where business organizations price their products differently basing on the different market segments that they target with their products, the products may not necessarily have diverse differences to justify the difference in prices but the underlying idea is to maximize on profit in market segments that can pay higher prices for the product as this helps to cover on the lower segment, where the product may be priced lower. (Dominick,2008,p. )
The basic advantage of this pricing method is that it enables a company to earn higher profits without necessarily increasing production costs since it’s the same product that is sold to different target markets, Target pricing is generally common in the mobile phone industry where the same gadgets with minor modification are actually sold to different target markets at different prices Costing Methods Marginal costing This method also known as the direct coasting method has the main characteristic of charging all the manufacturing or product costs to the product irrespective of whether the costs are variable or fixed. Lucey, 1993)
This method is useful in pricing decisions that are short term in nature in determining the least price that can be charged to a product below which losses will occur. The implication here is that marginal or direct costing as a traditional costing method suffers from the major drawback of oversimplification because it tends to employ only the volume of the product. Job costing is the method of costing where the coast of a product or service is determined by allocating costs ton a particular unit, a batch or even to a lot of the product or service. It is more or less the same as batch costing.
Precisely, job costing method is applicable where good and services are produced as a result of a series of continuous operations. It is thus considered a product costing technique in which case emphasis is laid on the determination of the cost of a unit product. (Sobngwi, 2007) Absorption costing It has been the practice of many firms to charge manufacturing overheads on the basis of direct costs like direct labour. The technique used tended to differ in terms of details as well as allocation bases. Some systems employ a single base like total direct cost while others use several bases like direct labour and raw materials.
Absorption costing as a method of costing allocates all the costs to the objects of the cost. This usually happen based on direct costs or even physical output measures. Marginal cost allocations are important for many managerial decisions like the valuation of stock as well as calculation of profits. (Sobngwi, 2007) The method may however not be very appropriate for product range decisions since the net profit figure from this technique tends to be unsatisfactory base for product range decisions. Allocation of expenses between two departments may be difficult.
One department may for example have a fully developed product which could require only a little development resources while the other department could be in need of full development. In such a case dividing the costs will thus be inaccurate. This has the implication that there is uncertainty as to whether dropping one product line would lead to a reduction of the total expenses allocated to that product. (Bjornlund & Rossini 2005). Activity Based Costing (ABC) The activity based costing (ABC) was developed as a reaction to the shortcomings of the marginal and absorption costing methods.
This method gives a description of the activity in overhead departments which can be recognized by both the departmental managers as well being driven by cost factors. The cost factors are usually the characteristics of the products s well as other cost objects. ABC is usually a two step process. First, the costs of similar activities in various overhead centers are collected. In this case the total direct cost of each department is then charged to each activity based on its use of total capacity as well as the total of all the costs of all activities collected from all the departments in activity cost pools. Seonen, 2006)
Second, the cost drives of each cost pool are identified after which cost drivers are quantified and the allocations to product costs derived. (Seonen, 2006) There are usually many varieties of cost drivers to choose from in an attempt to explain the costs of an object. The bottom line however is that they have to be capable of being quantified in terms of both the cost pool as well as the cost objects. Conclusion There is always need for consistency as well as standardization of the methods of financial pricing and costing methods have been recognized. Adam et el,2003)
This has led to the innovations of many sets of guidelines for both economic evaluations and costs. In the final analysis therefore, variations in cost methods that are usually used in business organizations have raised many questions resulting into the inability to compare the results of various costing as well as pricing methods. However in order to achieve both the transferability as well be able to generalize results there is need to apply uniform cost pricing and estimation methods in order to minimize any chances of variations.