The bottom line on how to drive more informed pricing decisions

As a production manager, the challenge is always how to determine what product mix is optimal and how to price products to allow your company to achieve a desired profit margin – or better yet, maximize profit-making capabilities.

In determining a price point, you must first have a handle on your company’s material and labor costs, as these are both the direct and variable costs required to produce a given item. It is vital to have a firm handle on these costs in making short-term and long-term pricing decisions.

Short-term vs. long-term pricing decisions

When considering short-term pricing decisions, manufacturers will primarily focus on direct costs which are costs directly attributable to production. In contrast, long-term pricing and profitability decisions require companies to also include indirect costs and/or overhead costs.

Generally speaking, if the indirect costs stem from manufacturing operations (i.e. plant maintenance, rent, etc.), they are referred to as manufacturing overhead. If indirect costs are associated from non-manufacturing operations (i.e. admin supplies, G&A salaries, telephone, rent, heat, admin related depreciation, etc.), they are referred to as administrative overhead.

When evaluating long-term pricing, it is essential to understand how these costs impact pricing to insure the long-term success of a manufacturer.

The best costing method for facilitating pricing decisions

The answer to this question is largely dependent on the type of products a business produces and the amount of effort that goes into determining how to analyze the costs associated with that business, along with the desired rate of return for those efforts.

The answer to this question is largely dependent on the type of products a business produces and the amount of effort that goes into determining how to analyze the costs associated with that business, along with the desired rate of return for those efforts.

Consider these two costing scenarios:

I have a small shop where my use of one method of costing (method-A) results in a very accurate cost analysis to determine pricing, but it takes three people working 20 hours per week to establish those rates.

The alternative method of costing (method-B) is where my use create results are within a few percentage points of the same accuracy gained from method-A, but require only one person working four hours per week.

Perhaps it makes sense to give up a small amount of accuracy for the labor savings realized in method-B versus the more accurate costing that method-A requires. All manufacturing environments have a specific costing and pricing philosophy that guides them as to which costing methodology to employ.

When accountants talk about costing methodology it can mean one of two things:

  • First, there is the question of inventory costing
  • Second, there is the question of production costing

The distinction being made here is that these are not the same. Let’s take a minute to look at the costing for each of these two areas.

Inventory Costing

Inventory costing determines how purchased materials and materials Made-to-Stock (MTS) are priced. Most companies will employ one of the following types of inventory costing methodologies:

  • First-In, First-Out (FIFO)
  • Last-In, First-Out (LIFO)
  • Average or Weighted Average Cost
  • Specific Identification

These costing methodologies establish how inventory is costed (valued) each time new inventory is added to an inventory pool. As inventory items are sold and/or used in the production process, the cost of the sale/WIP (Work In Progress) assigned to the transaction is derived from the number of items from an inventory layer multiplied by the unit price of the inventory layer needed to satisfy the sale/manufacturing requirements.

Each method above determines the cost of the inventory that is assigned to Cost of Goods Sold (CGS)/Work In Progress (WIP).

FIFO establishes that the oldest layers of inventory (based on received date or manufacturing date) are used before the newer layers. Most companies employ this method as it is usually a better correlation of material costs associated with a sale.

LIFO establishes that the newest layers of inventory (based on received date or manufacturing date) are used up before the older layers. Few manufacturers employ this method. Additionally, it has been banned from use where manufacturers report their financial statements in accordance with International Financial Reporting Standards.

However, it does offer some validity when the cost of a manufacturer’s newest inventory is co-mingled with existing inventory and neither is easily discernible.

As an example, take a coal mining company that extracts inventory from several mines and subsequently trucks them to a single storage pit. As each load from each truck arrival is piled one on top of the next regardless of which mine it came from, when the company makes a sale they use the coal from the “top” of the pit, (i.e. newest coal first – or last in, first out).

In this scenario, LIFO would be a more accurate costing analysis as the top (newer) layers of coal will be sold before the older layers (the oldest stuff put into the pit is at the bottom, and will be sold last).

Average or Weighted Average essentially establishes that there is only one inventory layer in inventory. That layer is the “average cost” of all the items currently in existence in the inventory pool. Any time a new layer is added to inventory, a new “per unit output price” is computed and applied to any outbound inventory transaction until the next time that item is purchased and received into inventory. At that point, a new “outbound unit price” will need to be computed.

Specific Identification establishes that each inventory item is assigned a specific cost, and when it is sold or used in production the specific cost of the item(s) are assigned as CGS or WIP as appropriate. This methodology makes sense if you are purchasing items that are individually purchased and they are expensive, even if you are purchasing a group of the same item to which each item in the group carries a specific cost that should not be allocated (spread) across the group.

Note: In the absence of items which have high price tags and/or unique cost structures, maintaining this level of specific cost detail in inventory is unwarranted.

Production costing

There are a number of varying methods of production costing to choose from, each with their own benefits and drawbacks.

The major production costing approaches employed are:

  • Job Costing
  • Standard Costing
  • ABC Costing
  • Direct Costing
  • Target Costing
  • Process Costing

Job costing

Job costing (variable costing) involves taking materials, labor and overhead and accumulating them to a production process to create an item(s) for sale, or MTS to be sold later, or to be used in future production. Costs are accumulated via transactions that occur for:

  • Purchases/assignments of inventory to WIP
  • Specific labor at an employee rate
  • Level of assignment of manufacturing and administrative overhead absorbed by the product being produced

This type of costing is used primarily by Make-To-Order (MTO) production environments. The advantage of job costing is that it allows manufacturers to track the exact cost to build one or more products and it allows them to apply a markup to realize a desired profit margin for the product (albeit that realization of profit margin is rare). In this environment, direct costs are easily attributable to a product, and if a manufacturer has good control on their variable and overhead costs it can yield very accurate quoting/pricing.

One disadvantage that is generally attributed to job costing is that it normally results in a large amount of transaction level activity that is required to track all the different costs continually being assigned to the production process to arrive at accurate costing for a product. Not to mention it takes fairly sophisticated software applications to accurately manage and update production costs correctly. Additionally, overhead absorption to production activity can be elusive.

Bottom line: If you’re an MTO manufacturer, it’s imperative that your environment be able to track real-time costs per unit of production, as well as the ability to establish/manipulate overhead absorption as routinely as necessary without a lot of manual intervention, especially if you hope to accurately price products coming out of production.

Standard costing Standard costing is one of the most common costing methodologies employed by manufacturing operations. Standard costing methodology requires manufacturers to establish “standard” rates for materials and labor that are used in production and/or inventory costing.

Generally speaking, production management or the engineering department is responsible for coming up with the expected rates required for labor and duration times along with the material usage requirements required to produce a single unit. Cost accounting is usually charged with coming up with appropriate overhead rates of absorption per duration of production. The purchasing department is charged with coming up with the standard rates for purchasing related activities.

The advantage to standard costing is that manufacturers can produce goods to a set of standards and when actual rates or duration vary they can be monitored and compared by analyzing variances recorded at the production level. Standard costing allows manufacturers to examine trends and make the appropriate modifications to their standards as needed which helps with accurate pricing decisions.

This approach also makes it easier to budget and can quickly expose production anomalies to the cost accounting department. Standard costing works well in companies that repeatedly make similar products or companies that mass produce certain types of products.

There are also several disadvantages associated with standard costing. One you will hear frequently is the actual time and expense it takes to set and maintain standards assigned to production activities (i.e. engineering, materials, and overhead). Another is that invariably, as soon as you implement a standard it becomes somewhat obsolete.

However, the biggest disadvantage to standard costing is likely how a manufacturer determines that standard. If your company establishes standards that are essentially unachievable, then employees will become discouraged, which can negatively impact production. Conversely, if your standards are too relaxed employees may work to the standard which directly results in wasted productivity, and consequently, in lower efficiency and profitability.

Activity-based costing

Activity-based costing is a costing methodology that aligns a manufacturer’s resources and their activity to the company’s products and/or services as it relates to their cost consumption. Unlike job costing methods, activity-based costing incorporates more indirect costs into direct production activities to help drive pricing decisions.

When executed properly, activity-based costing can help manufacturers gain clarity into products that are profitable and those that are not, which is valuable in determining a product’s life cycle or identifying areas where process improvement could produce better yields for existing products.

Proponents of activity-based costing believe it is a more accurate way to tie overhead costs to revenue-producing activities, which in turn helps a manufacturer’s cost control activities as well as make better and more accurate product lifecycle decisions.

Opponents of activity-based costing feel that the amount of effort and the additional cost required to gain that level of cost clarity is not justified by the incremental benefits they would receive from it. For example, if your company produces relatively few products, the cost visibility and variability is generally not too difficult to attain and/or track.

However, as a manufacturer’s product mix expands, the more likely activity-based costing techniques will become more relevant and justifiable.

Direct costing

Direct costing is a costing methodology that only looks at variable costs (i.e. costs that increase or decrease proportionally with production output). It does not consider fixed costs. Direct costing has merit as an analysis tool for helping management make short-term pricing decisions.

The advantage to direct costing is that it helps managers who are not routinely tasked with having to make costing and pricing decisions achieve a fairly accurate “minimum” price that is required to sell incremental units of a given product.

The issue with this approach is that it is only useful for short-term decision making. It would be a fallacy to assume that this approach will result in accurate pricing and profitability for the long-term. For long-term pricing, you must have a good handle on overhead costs. Therefore, job costing, standard costing, or activity-based costing costing will yield more accurate results than direct costing for long-term pricing decisions.

Target costing

Target costing takes a different approach to costing. Unlike the other “primary” costing methods that look at historical information in determining a company’s costing philosophy, target costing attempts to predict future costs and how those costs impact product pricing and desired profit margins.

Obviously, this method is not a fundamental costing method that conforms to US GAAP or IAS standards, but it does offer value-added benefit, and ultimately, most manufacturers either directly or indirectly try to predict what’s going to happen and how that will impact the bottom line.

The advantages of employing a target-costing approach is self-evident. By trying to be proactive in product cost estimation, it stands to reason that these manufacturers have a better opportunity to achieve a desired profit margin. Products within the product family the manufacturer produces and sells that do not, or cannot, meet a desired product level become candidates to be discontinued.

The disadvantages of target costing are equally self-evident. It generally requires a larger staff to keep track of future trends which in turn makes these costing/pricing models more expensive to develop and can also extend a product’s development cycle time.

So what costing model should manufacturers choose?

The costing philosophy/model that is best for a manufacturer is largely a cost-benefit relationship decision, and there really is no wrong answer if it makes sense for your business. Manufacturers must weigh the burden of accumulating the costing information (whether it be historic information or attempts to predict the future) against what I would argue is the heart of the decision: the method’s ease of use in achieving a desired profit margin.

For manufacturers that produce relatively few products, or products that are engineered/MTO, prior cost information is updated relatively frequently and they enjoy virtually current costs, thus historical costs should be fairly accurate. As a result, job costing or direct costing may be a justifiable approach.

For manufacturers that have a wider array of products or mass produce similar products, being able to directly associate costs to a specific product can be very difficult, if not impossible (at a minimum not worth the time and effort to attempt to achieve it). For these environments, standard costing or activity-based costing would likely be a better approach.

Regardless of which costing method works best, each has virtues that can help drive accurate pricing decisions. In today’s software marketplace, manufacturers no longer have to necessarily choose one methodology at the expense of another.

Experienced software companies should be offering a myriad of functionality that crosses traditional costing methodology lines. First and foremost, they must support the predominant costing methodology required by the nature of the manufacturer. Secondly, they should also have incorporated functionality across other costing disciplines that help them to achieve accurate pricing decisions.

For example, manufacturers that predominantly benefit from job costing functionality can also benefit from features that would normally be associated with standard costing. Likewise, standard costing environments would benefit from functionality that might normally be associated with job costing environments.

Manufacturers must choose a solution that supports their costing philosophy. However, you’ll get more bang for your buck if that choice takes into consideration aspects from other philosophical costing approaches. The bottom line is to choose products that incorporate the necessary range of costing functionality to help you drive more informed pricing decisions.