The Absorption Costing Approach to Cost-Plus Pricing

The Absorption existing mount to Cost-Plus PricingAllocating a fair and proper expense to a harvest-time or service may be a tricky balancing act for a participation. Many unattackables have an ongoing struggle with placedting their pricing strategies. It is a well known fact that the success of any yield or service relies straight on the ability to sell them which anon directly depends on the correct pricing strategy (Bosse, 2009). The pricing can non be just randomly guessed by the company. There are several measures that ought to be considered while forming the pricing strategy. By implementing creative judgments and intensifying the awareness of consumer motivation, a company can seize the commercialize. Pricing is not merely a marketing, financial or operational last instead it influences all aspects of the firm (Petersn, 2008).Preliminary Situation for PricingErner (2010) mentions two possible situations to consider for pricing The first one declares that the product in doubt has several competitors who offer products with less differentiation. Hence a market price already exists. In this case customers leave behind not purchase products with high market prices. Therefore the company does not have to conduct extensive research about the pricing strategy as they already have a rule of thumb present.The second situation indicates that the market price does not exist. Herein the product does not have any direct competitors and no pricing standards are available. The company has to decide how to price its products or services. In such a position the company must(prenominal) emphasize more on market research, customer perception, embodying, price testing etc. (Hilton, 2009).The Absorption Cost Approach to Cost-Plus PricingFor pricing decisions accounting information can be used especially if the firm is a leader in the market or a price-maker. As there is hardly time for analyzing demand and marginal salute for each product or service thoroughl y, managers have to depend on a swift and unsophisticated mode for determining prices. Therefore companies apply the Cost-Plus Pricing (CPP) method in which the total cost of the product or service adds a margin to ascertain the selling price (Hilton, 2009). However nearly companies are price-takers as they set their prices tally to the market leaders and have to follow the market, adjusting their prices due to competition. Even in such cases understanding be supports making managerial decisions e.g. which and how many products or services should be produced (Pietersz, n.g.). To give a considerable return on the stockholders investment the determined price in pricing standard products must cover all costs such as production, administrative, fixed and variable sales cost (Erner, 2010). As this should not be the case the business will bear losses and may not even be extant. Comprehending the companys marketing strategy is required for applying cost information in pricing decision s (Collier, 2009).COST + accent UP = SELLING PRICE(Ingram, Albright, Hill, 2003)Determine the Cost CoverageBefore adding a desired profit margin the full costs1for each product or service has to be calculated (Ingram, Albright, Hill, 2003). Flowingly the company has to underline the cost coverage that can be done by the Absorption Cost Approach (ACA) or the Contri hardlyion Approach (CA) (Erner, 2010).In the pricing decision the unit cost of a completed product is a key measure. The so called unit Product Cost (UPC) stipulates the value of goods inventory completed and the cost of sold goods (Tatum, n.g.). On the one side variable costing classes costs according to their doings into variable or fixed. For determining the UPC variable costing only includes costs directly varied to production i.e. direct material and direct labor cost as also the variable manufacturing overhead. The fixed manufacturing overhead costs are dealt like period expenses i.e. expense them like selling and administration cost in the period in which they incur. Fixed costs are not regarded in variable UPC. On the other side absorption costing classes the costs according to their function either into manufacturing or non-manufacturing costs. For calculating the UPC by applying the ACA all manufacturing costs, variable or fixed, are included (Ingram, Albright, Hill, 2003).Contribution ApproachIn the CA the cost base consists of the variable expenses associated with a product. The mark-up used must include the fixed costs considering the desired profit per unit. The cost base must be unplowed free of any element of fixed costs facilitating the pricing in special situations (Guilding, Drury, Tayles, 2005).In this paper the CA is not considered in detail.Absorption Cost ApproachIn the ACA the cost base is defined as the cost to manufacture a single unit. The selling and administration costs which are not included in the cost base are considered in the mark-up stage that is added on to the target selling price (Guilding, Drury, Tayles, 2005).The ACA illustrates the pricing decision as deceitfully easy. It seems that a company only has to calculate its UPC, determine the profit level they want and set the price.It appears that a company can contract demand and nonplus at a price that will safely yield whatever profit it wants (Garrison, Noreen, Brewer, 2010, p. 760).The ACA depends on unit sales predictions and nor the UPC nor the mark-up can be determined without them. In this approach it is anticipated that customers need the predicted unit sales and are willing to pay any price the firm stipulates. But customers have a election as they can either purchase from a competitor or decide not to buy the product at all if the price is set too high (Garrison, Noreen, Brewer, 2010).Determine Mark-up for Absorption Cost ApproachA mark-up is the percentage added to cost for profit, whereas the margin is the percentage of the selling price that is represented by p rofit (Collier, 2009, p. 173).The ACA and CA both bury some cost elements in the mark-up. The mark up percentage has not only to cover the buried costs but also has to generate a satisfying return on assets employed (Erner, 2010). The mark-up over cost ought to be set according to the market conditions, but many firms rest their mark-up upon desired profit and cost (Garrison, Noreen, Brewer, 2010).The formula for determining the right mark-up percentage by applying the ACA is as follows (Garrison, Noreen, Brewer, 2010, p. 759)Mark-up % = (required RoI x investment)+ selling and administrative expenses/ (UPC x unit sales)Adjust Price to Market ConditionsThe final stage considers adjusting the prices pursuant to the market conditions. The CPP usually tends to ignore the relationship between the price and the volume to be produced which in turn can result in lower profits, insufficient demand etc. Thus the sales forecasts need to be met in rule for the pricing to be reliable. The fi nal selling price may be much higher than the figure received due to the mark-up stage as companies (can) ignore the competitive positioning, promotional strategy, product differentiation, packaging etc. (Erner, 2010).Practical ExampleTo illustrate an example2of CPP using ACA it is assumed that Company X just underwent some design modifications for their product Y and wants to set a selling price accordingly. The cost estimates are as followsThe first step in ACA is to calculate the UPC which is illustrated in the following calculation. Here it adds up to 23.50 per unit as a volume of 10 000 units is assumed for Company XSeveral companies set their profit on costs and desired profits. This can be illustrated by using the given formula for mark-up percentage for ACA (see 2.2 Determine Mark-up).To illustrate how the formula is applied, assume Company X invests 100 000 in operating assets like e.g. equipment to produce and market 10 000 units of the product each year. Further suppose Company X needs 20% RoI. So the mark-up calculations are as followsMark-up % = (20% x 100 000)+ ( 2 per unit x 10 000 units + 60 000)/ ( 23.50 per unit x 10 000 units) 42.55%The Mark-up of 42.55% resulted to a tail Selling Price of 33.50. Only if Company X really sells its 10 000 units at this price the products ROI will be 20%. Logically the ROI will step-down if fewer products are sold. The betoken volume of sales is achieved only when the required ROI will be reached.