Cost Accounting Practices for Pricing Decisions

Lesson Transcript
Instructor: Mark Koscinski

Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.

Cost accounting helps businesses price their products and services. In this lesson, we'll explain how inventory costs affect pricing decisions and explore the differences between cost plus and market pricing strategies.

Cost Accounting & Pricing Decisions

Product pricing decisions are a very important aspect of any business and can be the hardest to make. Pricing a product one cent too high can result in lost sales if you are selling a product such as gasoline. We all know people who care which gasoline station has the lowest price per gallon, even if it is by pennies. Fortunately, there is help for managers that have to make these difficult decisions.

Cost accounting captures financial and non-financial data to produce accurate inventory costs. Management can use this information to help set competitive and profitable product prices. Good cost accounting provides necessary information, such as the break-even selling price of your products and how product costs change as volume increases or decreases.

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  • 0:02 Cost Accounting &…
  • 0:50 Inventory Costs
  • 1:20 Fixed & Variable Costs
  • 2:35 Pricing Strategies
  • 3:59 Changes in Sales Volume
  • 4:33 Lesson Summary
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Inventory Costs

First we need to understand how inventory costs are determined. Total inventory costs are the sum of direct materials, direct labor, and allocated overhead. Overhead includes costs necessary to manufacture the product but are not direct labor or direct material costs. Examples of overhead include electricity, supervisors' salaries, and machinery maintenance. Total overhead costs are allocated among a company's product lines.

Fixed & Variable Costs

Costs can be categorized as fixed or variable costs. Fixed costs do not change regardless of the volume of goods manufactured or sold. These costs are constant and are usually overhead expenses, such as rent, supervisory salaries, and factory property taxes. For example, property taxes are fixed for the year no matter what the volume of production or sales might be.

Variable costs rise and fall based on production volume. Direct labor and direct material are variable costs of production. Certain types of overhead costs can be variable costs as well. An example of this is factory electricity, which increases as production volume increases.

The impact of time on costs must be considered as well. Fixed costs remain fixed over the short run, generally thought to be one year. In the long run, production processes can be changed, and all costs can become variable. The recent trend towards transferring manufacturing to less developed countries produced a lower variable cost for products because of cheaper labor relative to the American market. Fixed costs were also lowered for these companies in the long run, as they shed unneeded production facilities.

Pricing Strategies

A variety of methods are used to set product prices. Using a 'let's hope for the best' pricing strategy should be avoided at all costs. This strategy could produce less than desirable bottom-line results. Other pricing methods, such as cost plus pricing and market pricing strategies, are much more successful.

Cost Plus Pricing

Cost plus pricing strategy adds a markup to inventory cost to create a profit margin. This margin must be sufficient to cover non-inventory costs, such as selling, general, and interest expenses, and provide an adequate profit for the business. The biggest advantage to cost plus pricing is its simplicity. Its major downside is it does not consider sales strategies or market conditions. A pure cost plus strategy may result in pricing the product too high or too low.

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