how costs can be used for pricing decisions

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5.4 Costs – Uses of Cost Information

Objective

To understand how cost information is used in a range of business decisions – especially pricing – and to be able to apply full‑costing (absorption) and contribution (marginal) costing techniques in line with the Cambridge AS Business syllabus.

1. Why cost information is needed

  • Ensures the selling price covers all relevant costs and delivers the desired profit.
  • Provides a basis for setting profit‑margin targets.
  • Allows comparison of alternative strategies (cost‑plus, market‑oriented, value‑based).
  • Supports decisions on product mix, make‑or‑buy, special orders and budgeting.
  • Helps identify where cost reductions or efficiency improvements are possible.
  • Links directly to budgeting (5.5) – cost data form the starting point for all budget preparations.

2. Cost classifications required by the syllabus

Classification Definition Typical example
Fixed costs (FC) Do not vary with the level of output in the short‑run. Rent, salaries of permanent staff.
Variable costs (VC) Change directly in proportion to output. Raw‑material purchases, piece‑rate labour.
Semi‑variable (mixed) costs Contain a fixed component plus a variable component. Electricity (base charge + usage charge).
Direct costs Can be traced directly to a specific product, service or department. Direct labour on a particular product line.
Indirect costs (overheads) Cannot be traced directly; allocated to products using a basis (e.g., machine hours). Factory supervision, depreciation of plant.
Sunk costs Costs already incurred and cannot be recovered; should not affect future decisions. Cost of a machine that has already been purchased.
Opportunity costs The benefit foregone by choosing one alternative over another. Profit that could be earned by renting out factory space instead of using it for production.
Total cost Sum of all fixed and variable costs for a given level of output. TC = FC + VC.
Average (unit) cost Total cost divided by the number of units produced. AC = TC ÷ Q.
Marginal (incremental) cost Additional cost incurred by producing one more unit; essentially the variable cost per unit. MC = ΔTC ÷ ΔQ ≈ VC per unit.

3. Full costing (absorption) vs. contribution (marginal) costing

Aspect Full (absorption) costing Contribution (marginal) costing
Definition All production costs (fixed + variable) are allocated to units produced. Only variable costs are assigned to units; fixed costs are treated as period costs.
Cost per unit Unit cost = (Total Fixed + Total Variable) ÷ Units produced. Unit cost = Variable cost per unit only.
Typical exam use Long‑run profitability, inventory valuation, price‑floor calculations. Short‑run decisions – make‑or‑buy, special orders, product‑mix, break‑even analysis.
Decision‑making focus Ensures all costs are recovered over time. Highlights contribution margin that can cover fixed costs and profit.
Limitations Allocation of overheads can be arbitrary; may hide the impact of fixed costs on incremental decisions. Ignores the need to recover fixed costs in the long term; risk of under‑pricing if fixed costs are high.

4. Uses of cost information for decision‑making

  1. Pricing decisions – cost‑plus, target‑profit, break‑even and contribution‑margin pricing (see Section 5).
  2. Product‑mix selection – compare contribution per unit or per limiting factor (e.g., machine‑hour) to choose the most profitable mix.
  3. Make‑or‑buy (outsourcing) decisions – compare the relevant (avoidable) cost of producing in‑house with the supplier’s price.
  4. Special‑order evaluation – accept if incremental revenue > incremental cost (variable + any extra fixed cost).
  5. Budgeting – cost data feed into:
    • Incremental budgets (adjust previous year’s figures).
    • Flexible budgets (costs varied according to actual activity levels).
    • Zero‑based budgets (all costs justified from scratch).
  6. Performance monitoring & variance analysis – compare budgeted costs with actual costs; calculate:
    • Material price variance = (Standard × Standard price) – (Actual × Actual price).
    • Labour efficiency variance = (Standard × Standard hours) – (Actual × Actual hours).
    Positive (favourable) variances indicate cost control; negative (unfavourable) variances signal a need for investigation.

5. Pricing methods that use cost information

  1. Cost‑plus pricing

    Formula:
    Selling Price = Unit Cost (full costing) + Markup

  2. Target‑profit pricing

    Formula:
    Selling Price = (Total Fixed Costs + Target Profit) ÷ Expected sales volume + Variable Cost per unit

  3. Break‑even pricing – the lowest price that covers all costs.

    Break‑even quantity:
    QBE = F ÷ (P – V) where F = total fixed costs, P = price per unit, V = variable cost per unit.

  4. Contribution‑margin (marginal) pricing – set a price that yields a required contribution per unit.

    Contribution per unit: C = P – V
    Desired contribution‑margin ratio: (C ÷ P) × 100 %

6. Break‑even analysis in pricing decisions

Break‑even analysis helps answer:

  • What is the minimum price that avoids a loss?
  • How many units must be sold at a given price to achieve a target profit?
  • What is the effect of a change in fixed or variable costs on the required sales volume?

Numerical example

Assume:

  • Fixed Costs (F) = $120 000
  • Variable Cost per unit (V) = $30
  • Desired selling price (P) = $50

Break‑even quantity:

QBE = 120 000 ÷ (50 – 30) = 6 000 units

If a profit of $60 000 is required:

Qtarget = (120 000 + 60 000) ÷ (50 – 30) = 9 000 units

7. Using cost information for budgeting & variance analysis

  • Incremental budgeting – start from the previous year’s budget and adjust for known changes (e.g., a 5 % increase in raw‑material prices).
  • Flexible budgeting – prepare a set of budgets for different activity levels; compare actual activity with the appropriate budget line.
  • Zero‑based budgeting – each cost centre must justify every expense, using cost‑driver analysis to allocate resources efficiently.
  • Variance analysis – identify the cause of differences between budgeted and actual costs:
    • Price variance (material, labour)
    • Efficiency (or usage) variance
    • Volume variance (fixed‑cost absorption)

8. Limitations of cost‑based pricing and of cost information

  • Ignores market demand, competitor prices and perceived customer value.
  • Relies on accurate cost allocation; arbitrary overhead allocation can distort product profitability.
  • May lead to over‑pricing when costs are high, reducing sales volume.
  • Does not consider strategic objectives such as market penetration, brand positioning or long‑term growth.
  • Focusing solely on cost can produce “cost‑centric” thinking, overlooking opportunity costs and potential revenue benefits.

9. Integrating cost data with market considerations

  1. Calculate the minimum acceptable price using a cost‑based method (cost‑plus, break‑even, contribution).
  2. Research competitor prices, customer willingness‑to‑pay and market trends.
  3. Adjust the price up or down to reflect:
    • Brand strength and positioning.
    • Strategic objectives (e.g., market‑share growth, product‑life‑cycle stage).
    • Non‑price competition (service, quality, innovation).
  4. Monitor actual costs, sales volume and market response; revise the price or cost structure as needed.

10. Summary flowchart (text description)

Flow of information for pricing decisions

Cost data → Cost classification (fixed, variable, direct, indirect) → Choose costing method (full vs. contribution) → Select appropriate pricing technique (cost‑plus, target‑profit, break‑even, contribution‑margin) → Combine with market research (competitor price, customer value) → Set final selling price → Review performance (sales, variance) → Adjust cost structure or price as required.

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