Firstly i will begin with pricing decisions by showing what models and concepts can affect how you price your products. Before we get to the actual pricing models, here are some of the concepts that you need to consider:
Positioning - How do you want your electrical products positioned in the market? For example do want the prices of your products to be a key part of how they are positioned? If you produce lower spec electrical goods then you want the price of these goods to be cheaper than your competitors. However, if the products you produce are of high calibre and are aimed at the wealthy section of the market then charging lower prices to gain higher sales will damage your image. You therefore have to be really careful how you position your products with their pricing because price by itself is not a key factor in determining whether a customer buys the products or not. Research will have to be done to decide what price points are acceptable as price either side of these points will discourage customers from buying your products.
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Demand - How will your pricing affect demand? You need to understand the concept elasticity of demand, which relates to how many products you will sell if you change the prices. You must realise that if you drop the price this doesn't mean sales will increase or vice versa. You need to beware of the consequences if you increase/decrease your prices. For example will it spark a price war, will customers see the value of your products etc
Environmental factors - Find out what external factors may affect your pricing.
As we said earlier, there is no "one right way" to calculate your pricing. Once you've considered the various factors involved and determined your objectives for your pricing strategy, now you need some way to crunch the actual numbers. Here are four ways to calculate prices:
Cost-plus pricing - Using yourÂ current absorption costingÂ approach, all that is required is calculate the cost, determine the profit you want, and then set your price. The problem with this approach is that it ignores demand but assumes you can still set a price that will give you a profit. However the absorption cost model relies on a forecast for products sold; therefore you cannot calculate your product cost or mark up price without this forecast. You are assuming the customer will buy your products no matter what price you charge. Within your market, if you charge too high a price then your customers have a choice not to buy from yourselves and go elsewhere resulting in the forecast of your sales to be too high. If you take this approach you will see the company operating at a loss because the forecasts are based on selling a higher amount of units. Managers think this model is safe, however from the above information you will be able to see it is only safe if customers buy the amount of products your company forecasted.
Target return pricing -Â Many companies have less control over price than they would like to think. The market determines prices, and a company that attempts to ignore this does so at its peril. Using this technique will help you to have control over the cost of your products from the design stage. This will be done by setting a price for the cost to produce the products once you have found the market price for that product. This will give your employees more satisfaction as they will feel more involved as they are set with the task of designing the products to meet the target cost. The barriers from different departments of your company will also be broken as they will all have to work together to reach the target cost. This model will also make you more orientated towards customer wants and needs as you have to sell at market value. However if you rely on producing excellent products this approach could affect your image as you may be forced to use parts that are of poor quality therefore producing poor quality products. The cost of implementing this new model will be high and will involve a lot more complex data.
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Value-based pricing - Price your product based on the value it creates for the customer. This is usually the most profitable form of pricing, if you can achieve it. The most extreme variation on this is "pay for performance" pricing for services, in which you charge on a variable scale according to the results you achieve. Let's say that your widget above saves the typical customer $1,000 a year in, say, energy costs. In that case, $60 seems like a bargain - maybe even too cheap. If your product reliably produced that kind of cost savings, you could easily charge $200, $300 or more for it, and customers would gladly pay it, since they would get their money back in a matter of months. However, there is one more major factor that must be considered.
Direct Competitor Pricing - Almost all marketing decisions, including pricing, will include an evaluation of competitors' offerings. The impact of this information on the actual setting of price will depend on the competitive nature of the market. For instance, products that dominate markets and are viewed as market leaders may not be heavily influenced by competitor pricing since they are in a commanding position to set prices as they see fit. On the other hand in markets where a clear leader does not exist, the pricing of competitive products will be carefully considered. Marketers must not only research competitive prices but must also pay close attention to how these companies will respond to the marketer's pricing decisions. For instance, in highly competitive industries, such as gasoline or airline travel, competitors may respond quickly to competitors' price adjustments thus reducing the effect of such changes.
Primary Product Pricing - As we discussed in theÂ Product DecisionsÂ tutorial, marketers may sell products viewed as complementary to a primary product. For example, Bluetooth headsets are considered complementary to the primary product cellphones. The pricing of complementary products may be affected by pricing changes made to the primary product since customers may compare the price for complementary products based on the primary product price. For example, companies that sell accessory products for the Apple iPod may do so at a cost that is only 10% of the purchase price of the iPod. However, if Apple were to dramatically drop the price, for instance by 50%, the accessory at its present price would now be 20% of the of iPod price. This may be perceived by the market as a doubling of the accessory's price. To maintain its perceived value the accessory marketer may need to respond to the iPod price drop by also lowering the price of the accessory.
Psychological pricing - Although timately, you must take into consideration the consumer's perception of your price, figuring things like:
Positioning - If you want to be the "low-cost leader", you must be priced lower than your competition. If you want to signal high quality, you should probably be priced higher than most of your competition.
Popular price points - There are certain "price points" (specific prices) at which people become much more willing to buy a certain type of product. For example, "under $100" is a popular price point. "Enough under $20 to be under $20 with sales tax" is another popular price point, because it's "one bill" that people commonly carry. Meals under $5 are still a popular price point, as are entree or snack items under $1 (notice how many fast-food places have a $0.99 "value menu"). Dropping your price to a popular price point might mean a lower margin, but more than enough increase in sales to offset it.
Fair pricing - Sometimes it simply doesn't matter what the value of the product is, even if you don't have any direct competition. There is simply a limit to what consumers perceive as "fair". If it's obvious that your product only cost $20 to manufacture, even if it delivered $10,000 in value, you'd have a hard time charging two or three thousand dollars for it -- people would just feel like they were being gouged. A little market testing will help you determine the maximum price consumers will perceive as fair.
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iii)volume based cost drivers v non volume based cost drivers
Absorption costing or full costing fixes the cost of a finished unit in inventory as the sum of cost of direct materials, wages of direct labor, and both variable and fixed manufacturing overheads.
Cost of a product unit under absorption costing = cost of direct materials + direct labor + variable manufacturing overheads + (fixed manufacturing overhead costs/units produced).
Activity-based costing (ABC) identifies activity centers in an organization and assigns costs to product units based on the number of activities used by each product unit. ABC ascertains the purpose of each activity or service and assigns the cost of such activity or service to the product or service unit that demands such activity.
Difference in Approach
The major difference between absorption costing vs. activity based costing is the approach. Absorption costing allocates costs to product units, whereas activity based costing traces the costs of product units.
Absorption costing is the traditional cost accounting method that focuses on the product or service when fixing costs. It works under the simple approach of assigning resources to products or services directly.
Activity based costing is a modern cost accounting approach that focuses on activities as the fundamental cost. ABC presumes that products or services consume activities, and activities consume resources. It thus, works to convert indirect costs into direct costs.
Absorption costing divides equally the fixed overhead costs with the number of product units whereas activity based costing identifies the actual proportion of fixed overheads costs incurred by the product unit.
Comparing absorption costing vs. activity based costing, the latter follows a more scientific approach. Price fixation in absorption costing depends on the inventory. The higher the inventory, the lower the product cost and lower the inventory; or the higher per-product cost. Price fixation in activity based costing bases calculations to derive the actual overheads incurred on a unit, and does not vary with change in inventory levels.
Activity based costing, however, faces serious challenges in practical application, for appropriating some of the fixed overheads such as the chief executive's salary on a per-product usage basis, is next to impossible. Moreover, process of data collection, data entry, and data analysis required to divide the fixed overhead costs among units based on usage, requires substantial resources and remains costly to maintain. Absorption costing that divides all fixed overhead costs with the number of units produced is a simple and easy approach and free from such complexities.
Absorption costing complies with the generally accepted accounting principles (GAAP) whereas the Financial Accounting Standards Board (FASB) and Internal Revenue Service (IRS) do not accept ABC for externally published financial statements. Firms that follow activity based costing, therefore, need to maintain two cost systems and accounting books, one for internal use, and another for external reports, filings, and statutory compliance.
Difference in Scope
Absorption costing helps ascertain the overall profitability or efficiency of the manufacturing system but fails to provide the real cost of individual product units.
Activity based costing mirrors the functioning of the enterprise and contributes to strategic decision-making processes. ABC provides the real cost of individual product units and, thereby, helps identify inefficient or non-profitable products that eat into the profitability of other highly profitable products. ABC also helps price products equitably, allowing breaking down of product or service into sub-components or offering "top ups" based on customer needs.
Comparing absorption costing vs activity based costing, activity based costing improves the quality of management accounting information, especially in large and multi-product operations where conventional overhead allocation methods such as absorption costing may produce misleading results. Absorption costing, however, remains more suitable for small firms and enterprises with homogeneous products or services.
Variance analysis is usually associated with explaining the difference (or variance) between actual costs and the standard costs allowed for the good output. For example, the difference in materials costs can be divided into a materials price variance and a materials usage variance. The difference between the actual direct labor costs and the standard direct labor costs can be divided into a rate variance and an efficiency variance. The difference in manufacturing overhead can be divided into spending, efficiency, and volume variances. Mix and yield variances can also be calculated.
Variance analysis helps management to understand the present costs and then to control future costs.
Variance analysis is also used to explain the difference between the actual sales dollars and the budgeted sales dollars. Examples include sales price variance, sales quantity (or volume) variance, and sales mix variance. A difference in the relative proportion of sales can account for some of the difference in a company's profits.
Standard costing is an important subtopic of cost accounting. Standard costs are usually associated with a manufacturing company's costs of direct material, direct labor, and manufacturing overhead.
Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences between the actual costs and the standard costs, and those differences are known as variances.
Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes aware that manufacturing costs have differed from the standard (planned, expected) costs.
If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant the company's actual profit will be less than planned.
If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit.
The sooner that the accounting system reports a variance, the sooner that management can direct its attention to the difference from the planned amounts.
Purposes of Standard Costing
Providing a prediction of future costs that can be used for decision-making purposes
Providing a challenging target
Assisting in setting budgets
Acting as a control device
Simplifying the task of tracing costs to products for profit measurement and inventory valuation
Sales volume variance (adverse)
Increase in selling price
Direct materials usage variance (adverse)
Careless handling of materials
Consider interplay of variances - how might materials usage/materials price variance, and labour rate/labour efficiency variances affect each other?