Proper cost allocation and pricing decisions are instrumental in determining profitability level of corporation’s product. Whenever discussing cost allocation, it is vital to understand how costs such as sunk cost, opportunity costs, and joint products costs are incurred, measured, and related to the sale volume of the product to earn profits from the sales. On the other hand, managers must make proper pricing decisions such as cost-pricing, argent costing, and activity based costing decisions in production and sale. In modern economics various methods can be applied while evaluating the effectiveness of various costing and pricing methods for corporation’s individual items. Cost allocation has been found important in maintaining proper corporate accounting. Although not all costs incurred by corporations are found to be in the fore front to be considered, when reviewed, it is found that some costs are more essential than others in various stages of production.
This paper focuses on a discussion of sunk cost, opportunity costs, and joint costs. It also describes pricing cost that entails activity based pricing, target costing, and cost plus pricing. Moreover, it looks at the benefits and disadvantages of each of them. The paper also tries to study various approaches employed by the managerial staff during the analysis of various cost allocations and pricing structure of the corporation. It is also important to mention that cost allocation and pricing policies of companies differ from one sector to the other. This depends on the nature of costs incurred in each of production stages, industrial differences, and the level of competitiveness of companies.
Cost Allocation of the Companies
According to Jiambalvo (2009), most of the companies practice cost allocation mainly for 4 key reasons. First, companies aim at providing investment decisions to their clients and other managerial staff. Secondly, companies can decide to allocate costs in order to reduce frivolous use of available but scarce resources. Thirdly, it was found that most of the companies practice cost allocations and make careful pricing decisions in order to encourage managers to be efficient while allocating internally available resources (Bruegelmann, 1993). Fourthly, it was found that other companies are currently practicing cost allocation for the purpose of practicing proper accounting of products' full costs and even determine the cost-based price of the product. Three types of costs discussed below are found to be essential in the cost allocation process and thus they must be fully determined.
Joint Product Costs
According to Jiambalvo (2009), a joint cost of a product is a cost, which results from the common manufacturing or processing of goods produced from common raw materials or input. The cost is incurred in the process of producing two goods that are produced from a single input. Good examples of goods that use this cost strategy are sugar and molasses from sugar cane as well as crude oil products such as paraffin, petrol, and diesel. Usually, in managerial accounting production processes of joint goods enjoy a merit of reduced cost of production. However, the production sector faces a challenge in measuring individual good's cost of production. Given this nature of cost, managers choose to estimate each of the product's costs through the amount of output units produced. Up to the spill-off point, joint products incur the same cost, but later each product may incur additional cost depending on further processing. However, managers must be careful when calculating the cost and make sure that does not interfere with profitability.
Most managerial accountants find it difficult to differentiate between sunk and fixed costs. In business and economics, sunk cost are those costs already incurred in the past. They are not recoverable and hence are irreversible. Usually they are the opposite of retrospective or future cost. Sunk costs can be both dependent and continuous in the operation of a business. However, most managers and economists disagree whether the costs are fixed or variable. In pricing decisions, sunk costs are vital as they try to enable cost managers to analyze and guess the price of the product .However, in investment decisions, sunk costs are irrelevant. A decision maker may make his decision depending on the sunk cost of a product. In pricing decision, sunk costs do influence future prices of products as most of managers are risk averse. This means that they must put previous cost consideration in the price tag of the product. However, according to two psychologists, Hal Arkes and Catherine Blumer, who conducted a research on sunk costs, the sunk cost should be avoided when making rational decision about products' pricing. The greatest disadvantage of sunk cost in the production sector and in pricing decisions is that these costs lead to overrun, which leads to irrational decision making. Examples of sunk costs include investment cost of the factory and are irrelevant in company's decision-making process.
Opportunity cost is a cost of the best alternative sacrificed in order for a corporation to choose the other. It is important to note that the benefits are also sacrificed with the opportunity that is given up. For example, where the difference between the chosen investment opportunity and the sacrificed one is $15000 over a given year, and the risk free government bond yields at $20000, then the opportunity cost incurred will be 20000-15000=$5000.
Pricing Decisions of Corporations
Cost plus approach is highly inherently circular among most manufacturing firms. Cost allocation process of a company greatly influences pricing decisions related to the product manufactured or processed. These include cost plus pricing, activity-based, and target costing. Cost plus pricing is a pricing decision based on associating variable costs and some fixed costs of a product before marking up the total cost of the product by a certain percentage, for example 20 percent, to arrive at the cost plus price. The cost is marked up because this pricing decision aims at maximizing profits of the business until marginal revenue equals marginal cost. This approach is easy to calculate. Furthermore, it requires little information on costs and demand of the product, about which managers have little or no information. Secondly, the process of obtaining this additional cost information is costly hence highly preferred. Therefore, the cost plus pricing approach is the most rational method of determining and maximizing profits. It requires only two steps: calculation of production cost and then marking up the prices. Most companies prefer this approach because of its simplicity and its ability to earn them reasonable profit (Vance, 2003)
Secondly, the Activity Based Costing (ABC) is a pricing decision approach used for developing various cost estimates by first subdividing the project into different and discrete quantifiable activities and various jobs or work units. This concept was developed in manufacturing sector in USA around 1970s and 80s. The main step in calculating the cost of the product involves calculating the cost of each activity the product is engaged in before assigning costs to various products or services produced based on direct labor hours, machine hours, or even direct labor dollars used. Note that due to competitiveness and changes in technology, the ABC approach has been found suitable in allocation of overhead costs of a product to various jobs or functions.
It is important to note that managers must also identify activities under which the costs are going to be a portioned. An activity refers to an event or unit of work with a given purpose, for example designing a product, setting up machines distributing products, or operating machines. The ABC approach must, however, be consistently undertaken because it is different from other pricing decision approaches in that it relies on estimation of the actual cost of a product before apportioning it among various jobs. The approach may sometimes give misleading information due to overestimation of costs.
Secondly, it has been identified to have several advantages over traditional based cost methods of pricing decisions because costs are based on all activities used in the production process. In most cases advocates of this approach have found that ABC helps identify opportunities of ensuring that the business process is efficiently and effectively designed to arrive at an accurate profit level. Thirdly, the approach is more beneficial to distributors of products because it improves solution of various problems related to products' initial costs and curbing high inflationary cost that they may fear. This can help managers track new customers and products in the market.
Third pricing decision approach is the target costing method. It is a process of determining how much allowable cost of a product can be maximally allocated to a new product before developing a prototype that can be constructed for the purpose of cutting down the costs. This is because once the actual product is made, 80% of it cannot be changed, yet costs had been incurred. Numerous companies, especially in Japan, have been using this kind of pricing decision to maximize their costs. These companies include Cummins Engines, Ford, and Isuzu Vehicles manufacturing companies. In making target costing pricing decisions, profits desired by the company are deducted from selling prices of company’s products. Later, the product development team is given a task to design various products, manufacturing costs of which must not exceed set target cost. The first step in targeting costing approach involves determining customers' wants and price-based sensitivity. Later, the planned selling of the product is set before the target cost is determined based on the selling price minus the desired profit that the corporation intends to make from selling manufactured products. Lastly, several teams of employees from different production fields are tasked with duties to design products, determine various manufacturing processes and necessary raw materials. In the production process, costs are assessed through the stages before a trade off to meet the needed target cost is achieved (Fabiani, 2007).
There are several reasons for using target costing approach over other approaches described above in recognition of various characteristic such as costs and markets for the product. The market determines the price of the product based on the demand and supply laws, and any corporation that ignores this costing technique do so to its own peril. Moreover, target costing is often used by managers in setting up cross-functional product development teams, which include engineers and cost accountants. This leads to good communication on how to develop the pricing process. This means that the anticipated market price is taken as products target costing hence the company must consider this approach. The greatest advantage over all other approaches is that the cost is determined before the product is produced. Moreover, the pricing decision is essential because the most proactive approach to cost management breaks down barriers between departments, fosters partnership among the suppliers, and, lastly, reduces the time of delivering the product to the market. It also has a drawback such as lowering the quality of products. Lastly, its implementation requires a lot of willingness to cooperate in the production process.
Implication of Cost Allocation and Pricing Decisions for Firm's Profitability
As competition for the market share in the industry increases, and supply of products exceeds demand, market forces have been found to influence prices of the products significantly. In order to achieve a sufficient margin of costs over prices, companies must select relative costs to market prices in order to help their products penetrate the market. In making daily pricing decisions the success of the company depends on how well the management understands the meaning of cost allocation and pricing tools. Prices should always exceed the cost incurred in the production process and managers should charge reasonable prices that allow to maximize the profit, while at the same time creating competition and market for the product. Avoiding allocation of death spiral in products and services will ultimately render the product uncompetitive and unprofitable. Thus the best choice is to consider the opportunity costs, sunk costs, and lastly joint cost.
It is essential that corporations fully understand cost allocation techniques before adopting any pricing decision approach. Managers must always put into consideration opportunity costs, which refer to all sacrificed costs of an alternative product to that already produced. These ensure that company chooses the most profitable alternative in the production sector. Secondly, sunk costs are also vital being past costs associated with the product. Moreover, the company should understand joint costs of products produced together in order to avoid losses. All these costs must be carefully allocated based on pricing approaches such as target costing, cost plus pricing technique, and activity based costing approach. According to Jiambalvo (2009), companies excelling in pricing decisions manage to ensure that competition against their products in market is curtailed.
Moreover, it has been commonly assumed that the opportunity cost of company’s product should be equal to the allocated cost. As opposed to other costs, the opportunity cost is not actually incurred. It rather shows the cost that could have been incurred if the resources were employed in the production process of another product. However, it is very difficult to actually estimate the cost due to the heavy fluctuations of price and cost, which leave managers with only one option of setting bottom line of the product's cost.