COSTING AND PRICING
The key principle of costing is to calculate the true cost of a product or service
while pricing is determined by demand, market conditions and factors which
influence pricing such as advertising, promotional activity and the ability to
differentiate from competitive or alternative products and services.
Costing is based on the simple principle of recovering cost.
Cost are classified as Variable or Fixed.
Variable costs are those costs which vary in direct proportion to output. For
every unit of output there is a clear unit of input - usually material and labour.
Fixed costs are those that exist regardless of the level of output or activity.
These will include rent and rates, insurance etc.
In reality many costs are semi fixed or semi variable. In other words there is a
degree of variability with output but a significant proportion of the cost is fixed.
Power, telephone, transport (for an in house fleet) are examples.
The critical issue is how to allocate the fixed costs to each unit of output.
Underpinning this decision is the ability to predict the level of output which will
be achieved in the future. In other words how much are we going to sell?
This creates the interface with the pricing policy and the need to understand
the price elasticity of demand (more later).
For costing to be effective there must be a clear and unambiguous
understanding of the cost structure of the business and what is actually
happening in the business, ie, levels of productivity, material yield,
The crucial is to decide how to allocate the fixed costs (or overheads) against
each unit of output/sales in order to recover 100% of the fixed cost over a
period of time and make an acceptable profit.
If a business has a single product or service, each unit of which consumes
exactly the same amount of variable cost, then the fixed cost charged to each
unit of output is the total fixed cost for the period divided by the number of
units sold during the period.
However, there are very few businesses that are this simple. Most will have:
Products at various stages of their product life cycle
Products which "consume" varying amounts of overheads, eg
Produced on expensive equipment with high running costs, varying
advertising expenditure, varying development inputs etc.
Products which face fierce competition and require additional customer
Activity Based Costing has been developed to cater for these variables. The
principles of ABC are straight forward. The overhead is allocated according to
the amount of activity which can be attributed to each product. It can be
simplified by looking at product groups as common areas of allocation.
NOTE: There is a lot more detail on ABC and other costing approaches if
Marginal Costing is another area which is important, particularly when faced
with competitive pricing considerations. Once a level of sales has been
achieved which recovers all the fixed costs for the period each additional unit
of sale "recovers" the full gross margin value. Businesses use this to either
drive "premium" profit or to enable aggressive discounting. Effectively this
point is reached when sales pass the break even point. Marginal costing as a
means of driving pricing policy should be approached with caution. Sales
fluctuate over time and if a discount is applied too soon losses can be
generated at a rapid rate. Good financial control throughout the business is
The following slides and notes (extracts from a Powerpoint presentation)
illustrate the use of Break Even Analysis in evaluating the relationship
between fixed costs, variable costs, sales volume and profit.
Slide 35 Break even analysis is a powerful
BREAK EVEN ANALYSIS tool which is based on very simple
• ANALYSIS TECHNIQUE TO
principles. Regardless of units of
ESTABLISH THE COST AND PROFIT production/sales there is a fixed
RELATIONSHIPS OF A PRODUCT OR
RANGE OF PRODUCTS
cost associated with the operation.
• BASED ON THE CONTRIBUTION OF This represents all of those costs
EACH UNIT OF SALES
which remain constant (or
relatively so) regardless of
whether production is zero or at
The Financial Aspects of Company Direction 35
maximum capacity. In addition
there are costs which are directly
proportional to output, ie the direct
materials consumed, the direct
labour to produce the output and
other directly proportional
elements such as shipping costs
etc. The third dimension is the
revenue generated by sales which
is directly proportional to output at
a constant unit sales value.
This is demonstrated graphically
Slide 36 £4,000
BREAK EVEN ANALYSIS
The break even analysis shown
represents the figures below.
Break even is achieved when 25
units are sold. As sales rise above
25 the gap between the sales
£1,000 revenue line and the total cost line
represents the profit being
0 10 20 30
40 50 60
generated. This is a simple
The Financial Aspects of Company Direction 36
example using straight lines - ie
assuming all unit costs and selling
prices remain constant. In practice
volume discounts may be applied
and volume throughput could
result in reduced variable costs at
higher levels. These would result
in curves being applied to the
This type of analysis is an
important tool in pricing policy by
simply showing the relationships
affecting profit. It might be used
to drive management action on
overhead costs, productivity etc.
Slide 37 At break even profit equals zero.
BREAK EVEN ANALYSIS Therefore, at break even:
SALES REVENUE-VARIABLE COSTS
Contribution - Fixed Costs
= CONTRIBUTION = Zero
Sales revenue equals price
CONTRIBUTION - FIXED COSTS
multiplied by quantity.
This is not just a string of algebra
The Financial Aspects of Company Direction 37
with pictures. It is a serious
analysis tool which underpins the
logic and thinking of any senior
executive. From this basic model
various outputs can be achieved
depending on the problem. So, for
Quantity at B/E = Fixed Costs
divided by contribution per unit
In real life it is unlikely that a
business will sell only one product
or service, or if it does, that it sells
it at only one price. However, the
basic principles still hold good.
All established businesses have a
core of fixed costs and they incur
variable costs in line with the level
of business activity. Every sale
has a contribution (positive or
negative) associated with it. It is
not until the aggregate
contribution equals the fixed costs
of the business that break even is
achieved and thereafter additional
contribution is contribution to
Slide 38 With these three pieces of
THE BASIC INFORMATION information you only need to
• THE FIXED COSTS FOR THE
know the sales figure to know
BUSINESS whether the business has made a
• THE LEVEL OF CONTRIBUTION profit or loss in any given trading
• THE BREAK EVEN LEVEL OF SALES period and the approximate size of
that profit or loss.
In a real business situation there
The Financial Aspects of Company Direction 38
may be several (or hundreds) of
products each with a different
variable cost and selling price thus
producing different contributions.
To simplify analysis a weighted
average contribution can be
calculated. For this to be valid the
sales mix must be established and
Slide 39 This type of analysis, either
P R IC E £32.50 £16.25 £53.00 £ 27.80 £12.50
product by product, or by product
V A R IA B L E C O S T
C O N T R IB U T IO N /U N IT
£5.00 group where there are large ranges
S A L ES M IX 500 250 50 600 700 2100
W EIG H T ED
of products, is useful to identify
C O N T R IB U T IO N P ER
P R O D U C T L IN E
£4,750 £1,938 £525 £ 6,300 £3,500 £17,013
where the highest levels of actual
W EIG H T ED A V ER A G E C O N T R IB U T IO N £8.10
contributions come from. In
isolation it is useful. If used as an
on going monitoring tool it can
The Financial Aspects of Company Direction 39
identify trends, shifts in product
mix and the impact on
profitability. In this dynamic
application it can help with
strategic pricing decisions and
even whether a product should be
discontinued, have more
promotional expenditure applied
There is an implication that the
only limiting factor is the volume
of sales. This is often not the case
and a specific factor such as
available factory space, the
capacity of a special machine or
process and the availability of
certain skills may be a limiting
factor. Introducing additional
factors for assessing contribution
then becomes necessary, eg
contribution per labour hour or
machine hour etc.
The first principle is to understand the true costs of the business and what
factors influence these costs.
If the product or service is part of an existing market structure then price
which can be charged is partly driven by competitive pressures. In commodity
markets price is determined almost exclusively by market conditions and
competitive pressures. Small premiums can be justified by high quality and
outstanding customer service.
The focus in such businesses operating in mature markets is to maintain the
highest standards of quality and service for the chosen price points and then
attack internal costs and efficiencies to achieve the lowest possible cost base.
This is a characteristic of a cash cow as defined by the Boston Consulting
With a new product or service pricing becomes more problematic particularly
if there are no competitive pressures. In these situations it is important that
there is a clear vision and strategy for the future which anticipates the real
costs of launching, supporting and developing the product or service and
looks realistically at the product life cycle. Bear in mind that product life
cycles are generally getting shorter as the pace of technological change
accelerates and customer expectations develop.
The S Curve applies to all products and services. Predicting its shape is an
important part of pricing policy.
NOTE: More details on S curves and product life cycles are available.
If we look at the extreme situation of a new business which has developed a
new market for a brand new product how would we approach the pricing
The issues are:
Getting the product accepted
Maintaining a market share in the face of competition (competition can
be significant from alternative products which are not the same, ie
Making a profit
When a new product is launched on the market the pricing policy lies between
the two extremes of market penetration and market skimming.
Market penetration pricing is a policy of low prices from launch in order to
maximise penetration in the early stages. Short term profits are sacrificed for
the sake of long term profits and market share. This policy will tend to
discourage rivals from entering the market. The approach tends to shorten
the initial period of the product life cycle bringing the growth and maturity
stages as quickly as possible. This relates to a high elasticity of demand for
The business may deliberately build excess capacity and set prices low. As
demand increases the spare capacity will be used up and unit costs will fall.
There may even be scope for further price reductions as unit costs fall. Early
losses (or low profits) will enable the business to dominate the market and
have the lowest costs.
The above thinking is partly driven by the simple but important graphical
This is another example of the vital importance of why it is so important to
understand and control the cost base of the business.
Market skimming is the achievement of high unit profits very early on in the
The business charges very high prices when the product is first launched.
There is heavy expenditure on advertising and sales promotion to win
As the product moves through its product life cycle - growth, maturity and
decline - prices are progressively lowered. The early profit is therefore
Skimming is suitable :
When the product is new and different
If demand elasticity is unknown (it is easier to reduce prices than raise
High initial cash flows are important at the possible expense of long
term profit maximisation
To help to identify different market segments for the product each
prepared to pay progressively lower prices.
The high initial prices may attract competitors who see the market as
lucrative. The big risk comes from a competitor prepared to take the risks of
market penetration which could immediately negate the premium of the
Between these two extremes of policy are a wide range of options. Most of
these options are determined by the ability to identify clear segmentation
opportunities, ie niches of the market which can be identified and targeted
with a specific product offering and pricing policy.
A further consideration is evaluating the benefits of a new product to the
customer. A new paint is developed for jet aircraft. The paint is lighter and
thinner than conventional paints and improves the aerodynamic qualities of
the aircraft. It also lasts twice as long between applications.
At cost price the value of the product for each painting of an aircraft is
£10,000. What do you charge for it?
Bear in mind:
There is a 2% reduction in fuel cost for the aircraft.
Painting a jet takes 6 days and needs to be done at least once per year.
Would £100,000 per application be expensive or cheap?
The following is an example of price elasticity of demand:
Activity from the Markets Study Guide
A supplier discovered that when it raised the prices of its products by 10% the
sales of its products fell be 20%.
1. Can you calculate the price elasticity of demand for the above case?
2. Is the demand for the product elastic or inelastic with respect to its price?
3. Would the firm's revenue have increased or decreased when the product's
price was raised?
Answers to the question:
% change in demand
1. Price elasticity of demand =
% change in price
= = 2
2. Demand for the product is elastic, ie it is greater than 1.
3. When demand is elastic an increase in price will result in a fall in the
quantity demanded and total expenditure (revenue) will fall.
Price Volume Revenue
Existing £100 1000 £100,000
New £110 800 £ 88,000
Conversely inelastic demand is where the % change in demand is lower than
the fall in price. With inelastic demand increases in price will create higher
- The value of demand elasticity can be anything from zero to infinity.
- If the value is less than 1 demand is inelastic, ie the quantity demanded
falls by a smaller percentage than price.
- If the value is greater than 1 demand is elastic, ie the quantity demanded
falls by a greater percentage than price.
- the price elasticity of demand is relevant to total spending on the good or
service. Total expenditure is important to both suppliers (sales revenues)
and governments (tax revenues).
- When demand is elastic total expenditure will fall when prices rise.
- When demand is inelastic total expenditure will rise when prices rise.
There are several factors affecting price elasticity of demand - what are they?
- The availability of close substitutes. This enables customers to switch to
alternatives. Discuss various examples:
- The time period. Markets are constantly changing and consumers may
adjust their buying habits over a period of time when faced with a price
increase, finding substitute products or alternative suppliers. Inelastic
demand may become elastic over a period of time.
Discuss various examples:
- Competitor pricing. If a competitor keeps prices unchanged in the face
of a price increase then the firm raising prices is likely to lose market
share, ie demand is elastic. If a price reduction is matched by the
competitors then it is likely to produce inelastic demand at lower prices.
And finally, one of the big users of PED thinking is government when setting
taxation on certain products. Three products tend be almost perfectly
inelastic, ie demand does not fall when prices rise:
Which is why these items are so heavily taxed.
But is this a sustainable policy. Tobacco and alcohol are both associated with
health issues – which require funding for treatment. The taxes help to fund
the state funded medical services. But if tax increases start to reduce
consumption then tax revenues will fall creating a potential gap between cost
of health services and the tax revenue generated. Bear in mind that alcohol
and tobacco related illnesses often continue long after a person stops/reduces
consumption. Food for thought……
Updated October 2010