The realm of price setting is an arcane one for the accountant, who is frequently asked for advice regarding the best price at which a product or service should be set. The pricing decisions just outlined for short-range situations are ones that will bring a company to the brink of bankruptcy if it uses them at all times, for they do not allow for a sufficient profit margin to pay for a company’s overhead, not to mention the profit it needs in order to provide some return to investors on their capital.
Proper long-range and life cycle pricing requires more than just variable costs of production, plus a small profit. It needs the consideration of several additional costs, which will be discussed in this post. Follow on…
As I just mentioned; proper long-range pricing requires the consideration of several additional costs which are as follows:
- Product-specific overhead costs. This is the overhead associated with the production of a single unit of production. This tends to be a very small cost category, for if a cost can be accurately identified down to this level, it is considered to be a variable cost instead of a fixed one.
- Batch-specific overhead costs. A number of overhead costs are accumulated at this level, such as the cost of labor required to set up or break down a machine for a batch of production, the utility cost required to run machines for the duration of the batch, the cost of materials handlers needed to move components to the production area as well as remove finished products from it, and an allocation of the depreciation on all machinery used in the process.
- Product line–specific overhead costs. A product line may have associated with it the salary of a product manager, a design team, a production supervisor, and quality control personnel, customer service, distribution, advertising costs, and an ongoing investment in inventory. All of these overhead costs can be allocated to the products that are the end result of the overhead costs incurred.
- Facility-specific overhead costs. Production must take place somewhere, and the cost of that ‘‘somewhere’’ should be allocated to the production lines housed within it, usually based on the square footage taken up by the machines used in each production process. The costs of overhead in this category can include building depreciation, taxes, insurance, maintenance, and the cost of any maintenance staff.
The costs described here can greatly exceed the total variable cost of a product. When fully applied to all products manufactured, the marketing staff will commonly find that the resulting product costs are several times higher than is the case when only variable costs are considered. This is a particular concern for companies that require a large (and expensive) base of automated machinery to manufacture their products, for they have such a large investment in overhead that they must add on a very large additional cost to their variable costs, as well as a reasonable profit, before arriving at a long-range price that will adequately cover all costs.
The size of the markup added to the variable and fixed costs of a product should at least equal the target rate of return. This rate is founded on a firm’s cost of capital, which is the blended cost of all debt and equity currently held. If the markup margin used is lower than this amount, then a company will not be able to pay off debt or equity holders over the long term, thereby reducing the value of the company and driving it toward bankruptcy. It may also be necessary to increase the target rate of return by several additional percentage points, in case managers feel that the product in question may have a high risk of not selling over a prolonged period of time at adequate levels; by increasing the markup, the price is driven higher, and the company earns back its investment sooner than would otherwise be the case (assuming that customers are still willing to buy the product at the higher price).
If a company wants to determine its long-range bicycle price, it should include the additional factors noted in the following table, which covers all possible fixed costs plus a markup to cover its cost of capital:
Cost Per Unit
Total variable cost $ 116.06
Product-specific overhead costs $ 0.00
Batch-specific overhead costs $ 41.32
Product line–specific overhead costs $ 5.32
Facility-specific overhead costs $ 1.48
Markup of 12% $ 19.70
Total long-range price $ 183.88
Setting Prices Over The Life Of A Product
It may not be sufficient to think of long-range pricing as just the addition of all fixed costs to a product’s variable costs. Such thinking does not factor in all changes in a product’s costs and expected margins that can reasonably be expected over the course of its market life.
If one were to compile the full cost of a product at the point when it has just been developed, the cost per unit will be very high, for sales levels will be quite small; this means that production runs will also be short, so that overhead costs per unit will be very high. Also, it is common for a company with the first new product in a market to add a high margin onto this already high unit cost, resulting in a very high initial price. Later in the product’s life, it will gain greater market share, so that more products are manufactured, resulting in lower overhead costs per unit.
However, competing products will also appear on the market, which will force the company to reduce its margins in order to offer competitive pricing. Thus, the full cost of a product will vary depending on the point at which it is currently residing in its life cycle.
The best way to deal with long-range pricing over the course of a product’s entire life cycle is to use a company’s previous history with variations in cost, margin, and sales volume for similar products to estimate likely cost changes in a new product during its life cycle.
An example of this is shown below:
The above table shows that a company will have a considerable amount of overhead costs to recoup during the startup phase of a new product life cycle, which will require a high price per unit, given the low expected sales volume at this point. However, setting a very high initial price for a product leaves a great deal of pricing room for competitors to enter the market; accordingly, many companies are now choosing to initially lose money on new product introductions by setting their prices at the long-range price rather than at the short-range price that is needed to recoup startup costs. By doing so, they send a signal to potential market entrants that they are willing to compete at low initial price points that will leave little room for outsized profits by new market entrants. This strategy forgoes large initial profits, but may reduce the number of competitors, thereby reducing the level of competition in the long run.
The above table also shows that sales volumes will gradually decline as a product enters the maturity phase of its life cycle. At this point, price competition becomes fierce, as competitors strive to fill their production capacity by undercutting competitors.
The company must make a decision at this point to either compete with low prices, terminate a product, or replace it with an improved one that is just starting a new product life cycle.
Based on a table similar to the above, a company can determine the most appropriate pricing strategy to adopt over a product’s entire life cycle, so that the company is appropriately positioned in the marketplace and can earn the greatest possible profit over the entire period during which a product is sold.