Cost, Pricing and Return

Cost Information – Cost information includes all the various types of costs a company may incur in producing or distributing a product or providing a service. Cost information is critical in product mix and product pricing decisions. For example, if a company cannot reduce costs in order to match competitor pricing for the same or similar product, it may decide to eliminate that product from its line.

Cost information includes the variable costs, total manufacturing costs (both fixed and variable) and full costs (which include fixed and variable manufacturing and selling and administrative costs). Variable costs (such as raw material costs, direct labor costs, and selling costs) reveal cost-volume-profit relationships that will be important if different volume levels are possible. With full costing, a per unit cost can be misleading as volume changes. For example, variable costs may be $5 per unit and fixed costs $3 per unit with 1,000 units but $6 per unit with 500 units. Typically in making decisions, multiple costing approaches will generally be used in cost analysis and pricing decisions.

Target costing requires full understanding of cost information. Target costing is the process in which a company tries to achieve a maximum target cost in order to be able to be profitable in the long run. It is used increasingly as companies have less affect on pricing. For example, copper producers must focus almost exclusively on processing costs since the market determines the price of the copper sold. Managing direct and indirect costs to reduce costs and remain competitive is the key to target costing.

Pricing Strategy – One of the major decisions faced by many organizations is pricing, including pricing for new products and pricing for competitive products. A number of factors besides production costs influence pricing including competitors, customer expectations, and legal requirements (for example, the illegality of predatory pricing and discriminatory pricing).
Beyond these factors, however, accountants assist in the pricing strategy decisions by providing information on the costs to produce a product or service. From there a company can decide its pricing approach. Generally a company will either decide upon target costing or a certain margin above price (known as cost-plus pricing, where costs can be defined as variable costs, total direct costs, or full costs). Of course, companies with different types of products may have different price strategies for each. Consider pricing on airlines. Clearly, pricing is a function of covering costs plus some desired margin for many seats. However, in competitive markets the margin is lower, pricing generally must match competitors. If competitors have lower operating costs (such as Southwest Airlines), trying to duplicate pricing often squeezes the margins of competitors. Where demand is higher (such as first class, holidays, last minute tickets), pricing is more a function of what the market will allow.

Return – Return is a measure of income or profit from an investment. The investment might be a passive one such as investing in an equity security of a company or the investment might be part of a plant and equipment investment that will generate revenue and profits. Since investments are outflows of cash and other assets and there is a limited amount of cash and assets, return is a way to measure and prioritize the allocation of these asset resources. For example, assume you have $1,000 to invest. How do you decide where to invest the $1,000? Expected return is one attribute that you will analyze.

Expected return will generally be expressed in terms of future cash inflows. The expected future inflows must be sufficient to justify the investment. Capital budgeting and other types of analyses frequently utilize tools that focus on net returns for a given investment. The result is information about investment and return that facilitate the decision about where to invest.
Time Value of Money - The time value of money refers to the fact that a dollar in hand today is worth more than a dollar promised at some future time. A dollar in hand today can be invested in an interest-bearing account that would grow in value over time. This explains in part why the value of money is related to time. The trade-off between money now and money later depends on, among other things, the rate of interest you can earn by investing. If not invested, the time value of money shrinks by the rate of inflation. At a minimum, money must be invested in order to keep pace with the rate of inflation.

Capital Budgeting - Capital budgeting is the total process of generating, evaluating, selecting and following up on capital expenditures. Capital expenditures can be new equipment, new software, new hardware, new buildings, or any project that is expected to last more than one year. Capital budgeting is an extremely important aspect of a firm's financial management. With limited resources, capital budgeting requires analysis of all potential capital projects and expenditures with decisions regarding which projects will be done first, next, or not at all.
Although capital assets usually comprise a smaller percentage of a firm's total assets than do current assets, capital assets are long-term (at least 12 months but usually much longer). Therefore, a firm that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time.