Influence of Costs as a Pricing Tool
The cost factors play an important role in pricing and their influence in pricing varies with the circumstances. In some pricing decisions, costs play only a secondary or tertiary role. For instance, in a liquidation sale, costs are relatively unimportant. On the other hand, the impact of cost factors is great in some pricing decisions. For example, in a cost-plus contract, they become the primary determinant of price. Actually, these are two extremes. Ordinarily, the influence of costs in pricing falls somewhere between these two extremes. But within these limits, costs assume distinct gradations of importance in pricing decisions, since they play different roles in determining proposed prices. For example, costs may play a significant role in pricing a new product, a differential product, or products produced to customer order.
On the other hand, in some situations of pricing, cost acts like an indication of profitability rather than a pricing tool. Whenever a standardized product competes in an established market with other products serving the same purpose, price is established by the competitive market through the law of supply and demand and is relatively unaffected by the costs of individual supplier. Instead of providing a pricing tool, costs in this case serve primarily to indicate the profitability with which a product might participate in an established market at the current or predicted future price. Or, if the costs of a product prohibit it from being sold in the competitive market at a satisfactory profit, management is asked to discontinue the production of the product or discover ways to produce and market it less expensively.
In addition to cost as a pricing tool, management needs cost calculations for aiding in determining the profitability of the proposed prices or for testing the desirability of established market prices. Questions arise concerning which cost data are useful and how they should be employed. The answers to these questions are complicated because management may need more than one type of cost to consider different aspects of a given problem as Howard C Green, in the 1952 Dickinson Lectures, stated: "The cost of a product is not some single precisely calculable figure. Cost-finding for pricing purposes is necessarily the assemblage of variety of cost factors, which can be combined in a variety of ways to produce a variety of answers".
Nature of Costs used in Pricing
Pricing decisions depend also on the nature of costs on which these prices are based. The proposed selling price, which is the price applicable to sales made at some future date, raises a question about the nature of costs used in pricing. In accounting theory, matching of costs and revenues is done to accurately determine income. Accounting theorists maintain that, when accountants compare acquisition with disposition prices, their principal concern is the matching concept, i.e., the periodic matching of costs and revenues. Though the periodic matching is preferred to determine accurate income, in practice, they recommend different procedures for different costs based upon the time elapsed between cost incurrence and cost disposition. The elapsed time factor becomes even more crucial when using costs for pricing, since the major issue then becomes the cost of replacing the products being priced. This issue must be solved by projecting, as accurately as possible, the costs of the products when sold. Future costs thus become relevant costs for pricing.
It is likely that the importance of application of current and historical costs decreases as the time interval between pricing and sales lengthens. So the greater the period of time lag between pricing and anticipated sales dates, the greater the chance that important changes will develop between current and replacement costs. In such situations, the principal contribution of current and historical costs to pricing resides in their ability to guide the forecasting of future costs.
Since future products will be produced with the infrastructure and the product designs currently being used, both current and historical costs represent excellent starting points for forecasting anticipated costs. Under these conditions, current or historical costs with required adjustments made for forecasted changes in current price levels, will ordinarily provide usable costs to aid many pricing decisions. However, additional adjustments for changes in material requirements, labor needs, and manufacturing overhead composition, may be necessary.
Marginal Analysis and Pricing
Many companies want to set a price that will maximize current profits. They estimate the demand and costs associated with alternative prices and choose the price that will produce the maximum current profit. The current profit-maximizing price for a particular product is that price which produces the largest difference between total revenues and total costs. Here, the company is emphasizing current financial performance rather than long run performance.
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