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Cost allocations can create a death spiral. The death spiral is a perverse problem that arises when allocated costs contain fixed costs and users reduce their demand for a service department in response to a high allocated cost. As usage falls, total costs do not fall proportionately because of the fixed costs. This causes the costs allocated to the remaining users to rise further, and the remaining users will seek to outsource the service to less expensive external vendors.
Two specific cost allocation situations are described: multiple service departments and joint costs. When the costs of several service departments are allocated to operating divisions, wide variations in transfer prices can result depending on how the service department costs are allocated and the order in which they are allocated if a step-down method is used. These variations in transfer price can then cause user departments to alter their consumption of service department resources.
Joint costs arise whenever a single joint input such as a barrel of oil is split into several joint products such as gasoline, motor oil, and jet fuel. Beware of all product line profitability studies that rely on allocated joint or common costs, unless these costs are allocated using net realizable value (revenues less the costs beyond the split-off point).
In Chapter 8, process costing is described as an appropriate costing method when every unit of product is homogeneous. The types of products that occur in a joint process environment are dissimilar from each other, yet a significant portion of the cost cannot be directly traced to any one of the two or more products being produced. Joint processes create a different type of cost assignment problem. One input or process is used to create two or more types of output. The costs that result from the joint process must be allocated to the joint products because the costs are production costs, which must be inventoried and eventually included as part of cost of goods sold. Joint products are the result of a joint process. That is, two or more outputs result from the common set of inputs. Since the joint process cannot be split into the portions that each product causes separately, allocation of joint costs is used to assign these costs. Joint costs (or joint-process costs) are costs that arise from the common set of inputs. These are the costs that must be allocated among the joint products. Joint costs occur before the joint products emerge as separate, distinguishable products. Joint costs use batch and facility-level resources. The split-off point is the point at which individual products from the joint process emerge and can be identified as unique products. This is the point at which costs can be traced to a particular joint product. Costs occurring after the split-off point do not have to be allocated. It is also at the split-off point that a management decision must be made regarding what should be done with the joint products. Products can be sold at the split-off point, or they can be processed further. Some products are "final products" at the split-off point and do not require further processing. Other products are "intermediate products" at the split-off point. Such products can be sold to others, who complete the production process, making it into the "final product." These products could also be processed further, to the point at which they are "final products." For instance, a chemical company that produces coatings for cookware could make the final product, treated cookware. Alternatively, it could make the intermediate product, the coating for the cookware, and sell this intermediate product to a company that makes the cookware. Further processing costs (also called separate or separable costs) are costs that can be traced directly to one of the joint products. These costs occur after the split-off point. If products are not processed further, either they are already in their final form at this stage, or they are sold as intermediate products that are finalized by other organizations. If the products are processed further, there are costs associated with these additional processing activities. Managers should look at maximizing overall profitability by choosing the best set of joint products possible. If the mix is not profitable, the project should not even be pursued.
A "sunk cost" is a cost that you have already incurred and that you cannot recover.
People often have an irrational desire to use products for which they have paid a lot of money, or to continue following a plan that has required a great investment. They think that if they abandon the product or change their approach, they will be throwing money or time away. That's not true - the money and time have already been thrown away. Continuing to use a bad product or to follow a bad plan is only increasing the amount being thrown away.
Whenever you make a decision, it has to be made according to what you know now and upon reasonable expectations of the future. Hoping that bad results from a past decision will eventually "turn around" if you stick with that decision is wishful thinking of the worst sort. It always takes courage to admit you made a bad choice and that you need to change your mind, but it is the only thing to do. It takes even more courage to try to convince others that they made bad choices and need to accept the sunk costs, but that's something you sometimes have to do.
Unlike most costs discussed in economics, an opportunity cost is not always a number. The opportunity cost of any action is simply the next best alternative to that action - or put more simply, "What you would have done if you didn't make the choice that you did".
I have a number of alternatives of how to spend my Friday night: I can go to the movies; I can stay home and watch the baseball game on TV, or go out for coffee with friends. If I choose to go to the movies, my opportunity cost of that action is what I would have chose if I had not gone to the movies - either watching the baseball game or going out for coffee with friends. Note that an opportunity cost only considers the next best alternative to an action, not the entire set of alternatives. For a consumer with a fixed income, the opportunity cost of buying a new dishwasher might be the value of a vacation trip never taken or several suits of clothes unbought. The concept of opportunity cost allows economists to examine the relative monetary values of various goods and services.
Cost-plus pricing is a simple and easily controllable pricing strategy that can be used to boost profits in almost any business. Determine the expense associated with producing a product and add an additional amount to that number to generate profit. Cost-plus pricing is relatively simple, as it only requires the unit cost and desired profit margin for calculation. Unit cost consists of all fixed and variable costs associated with making a product and bringing it to market -including raw materials, labor, utilities, packaging, transportation, marketing, and overhead. Profit margin is the markup on each unit sold, which can vary for retail and wholesale sales. Cost-plus pricing is a straight-forward and effective strategy because it ensures that all costs are covered before profits are calculated. Unlike some pricing methods which hedge seasonal losses against profitable time-periods, cost-plus pricing has the added advantage of generating steady profit at an established, consistent rate. However, shifting market factors, competitor behavior, and consumer activity must be closely monitored to ensure that the profit margin used in cost-plus pricing is one that maximizes net gains and avoids arbitrary decision-making. As it is easier to retain consumers by scaling prices downward, an uninformed pricing decision has the potential to destabilize a business.
Target costing is a system under which a company plans in advance for the product price points, product costs, and margins that it wants to achieve. If it cannot manufacture a product at these planned levels, then it cancels the product entirely. With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability. Target costing is most applicable to companies that compete by continually issuing a stream of new or upgraded products into the marketplace (such as consumer goods). For them, target costing is a key survival tool. Conversely, target costing is less necessary for those companies that have a small number of legacy products that require minimal updates, and for which long-term profitability is more closely associated with market penetration and geographical coverage (such as soft drinks). Target costing is an excellent tool for planning a suite of products that have high levels of profitability. This is opposed to the much more common approach of creating a product that is based on the engineering department's view of what the product should be like, and then struggling with costs that are too high in comparison to the market price.
The same thing is true of product pricing. Three things can happen when establishing a product price. A price set too high is a lost sale that could have been profitable at a lower price. A price set too low is rewarded with unprofitable work. Only when a price is set appropriately does a company make both a sale and a profit. Just as activity-based costing and activity-based management revolutionized the cost accounting world, activity-based pricing will bring a disciplined approach to developing pricing. Activity-based pricing examines the relationships between price, cost and sales volume and how this relationship affects profitability. Pricing for Profitability joins the disciplines of marketing, economics, business strategy, engineering and cost accounting to achieve maximum profitability.
The advantages of using cost plus pricing are: It's Easy to calculate. Price increases can be justified when costs rise. Price stability may arise if competitors take the same approach (and if they have similar costs) Pricing decisions can be made at a relatively junior level in a business based on formulas
The main disadvantages of cost plus pricing are often considered being: This method ignores the concept of price elasticity of demand - it may be possible for the business to charge a higher (or lower) price to maximize profits depending on the responsiveness of customers to a change in price. The business has less incentive to cut or control costs - if costs increase, then selling prices increase. However, this might be making an "inefficient" business uncompetitive relative to competitor pricing; it requires an estimate and apportionment of business overheads. For example, total factory overheads need to be calculated and then allocated in some way against individual products. This allocation is always arbitrary. If applied strictly, a full cost plus pricing method may leave a business in a vicious circle. For example, if budgeted costs are over-estimated, selling prices may be set too high. This in turn may lead to lower demand (if the price is set above the level that customers will accept), higher costs (e.g. surplus stock) and lower profits. When the pricing decision is made for the next year, the problem may be exacerbated and repeated.
Remember to constantly monitor the variables involved in a cost-plus pricing system. As cost-plus pricing determines prices based on overhead and production costs, savings in these areas will be passed onto consumers, instead of being realized as additional profit. While there are circumstances in which lower priced products will gain an edge on competitors, this decision should be made by managers. Unless the profit margin is adjusted accordingly, breakthroughs in efficiency will not benefit the company.
Conversely, rising production costs increased the price of a product. Again, price increases should be a management decision, rather than one based solely on mathematics. It may be a better business decision to weather higher production costs, as opposed to making your customers pay higher prices for your product.
While many companies have struggled to use activity-based costing (ABC) in their cost reduction efforts, ABC applied to product pricing has made true believers out of most of the companies that have tried it. If your company is not already using Activity-Based Pricing, it may be at an extreme competitive disadvantage. Activity-Based Pricing is an area where financial managers can make an important difference in their company's bottom line. Make plans to learn more about ABP today.
The lack of research and development in understanding the nature of costs, industries, demographics, and competitiveness can result in low consumer reaction. The poor allocation of capital in regards to cost and pricing decisions in the corporation are a result of manufacturing products that will not make a profit or retain capital incurred during the process. Once thoroughly understanding the subtopics discussed, the corporation has the ability to work with cost allocations and product pricing decisions. The inputs focus represents how the subtopics coexist and can be present during the decision making process. By having all information for analysis prepared the corporation can allocate capital with low risk. In today's economy corporate decisions reflect on the ability to remain competitive in all aspects of the product life cycle. It remains evident that without the knowledge of local competition and the desired industry the corporation will not succeed. By understand the current environment the corporations upper management have the ability to make educated decisions when pertaining to costing and pricing decisions.
Costing and price decisions are important to the growing corporation. Each of these separate but coinciding factors is important in gaining profitable margins when the product has been successfully manufactured, marketed, and launched. In the following essay we will engage the issues that must be recognized during the development of the product. In identifying the following components of cost allocation and pricing, analysis can be conducted: Cost allocation and pricing decisions help to determine the profitability of a product. Various methods can be used to evaluate the effectiveness of the various methods for a specific company's individual needs. Cost allocation is necessary to maintain efficient use of resources, awareness of full cost direct and indirect, as well as maintaining proper accounting. Although not all factors in cost allocation are always at the forefront of consideration they are all reviewed, some are more important in various phases than others. The major cost allocations discussed are joint costs, sunk costs, and opportunity costs. Pricing decision includes cost plus pricing, Target costing, and activity based pricing and the disadvantages and benefits of each. The usefulness of full costs for product pricing, shows that full costs are economically sufficient for pricing when a decision-maker (DM) jointly solves the capacity planning and pricing problems, and has enough discretion in setting prices to ensure full capacity utilization in any demand state (the full capacity utilization condition). In practice, however, informational limitations and cognitive bounds may induce the DM to plan capacity using limited demand information, and update prices when additional demand information becomes available subsequently. There is no economic loss from such problem decomposition if the full capacity utilization condition holds. We use simulation experiments to assess the loss from this decomposition if this condition is not satisfied. We find that using simple full cost plus pricing as an input into capacity planning is cost effective provided the DM reacts optimally to realize market conditions, and has enough pricing discretion to ensure high capacity utilization.