AN INTRODUCTION TO

COSTING & PRICING

PRIMER ON COSTING

AGENDA

CLASSIFICATION OF COSTS

BREAK EVEN ANALYSIS

MARGINAL COSTING

CONTRIBUTION

LEVERAGE

PRICING CONCEPTS

PRICING APPROACHES

PRICING STRATEGIES

PRIMER ON COSTING

CLASSIFICATION OF COSTS

BASED ON BEHAVIOR

BASED ON FUNCTIONALITY

BASED ON RELEVANCE TO PROJECT

PRIMER ON COSTING

BASED ON BEHAVIOR

FIXED COSTDo not vary with units producedInsurance of factory, MD fee

VARIABLE COSTVary directly with number of units producedRaw Materials

SEMI-VARIABLE COSTPartly Fixed and Partly VariableTelephone Bills

PRIMER ON COSTING

FIXED COST IS VARIABLE

VARIABLE COST IS FIXED

COMMENT!!!!!

PRIMER ON COSTING

BREAK-EVEN ANALYSIS

FC

TC

VC

BEPMS

CO

STS

/ R

EV

EN

UE

S

NO. OF UNITS PRODUCED / SOLD

X

Y

REV

PRIMER ON COSTING

BREAK-EVEN ANALYSIS

BREAK EVEN POINT

NO PROFIT NO LOSS

ALL FIXED COSTS ABSORBED

FURTHER PRODUCTION INCURS ONLY VARIABLE COST COMPONENT

MARGINAL COSTING

PRIMER ON COSTING

BREAK-EVEN ANALYSIS

BREAK EVEN = FIXED COSTSSELLING PRICE - VARIABLE COST

PRIMER ON COSTING

MARGINAL : UNIT INCREASE ; ONE MORE UNIT PRODUCED

WHAT IS THE COST INCURRED

IN THE PRODUCTION OF ONE MORE UNIT OF THE SAME ITEM ?

KEEP BREAK EVEN CAPACITY AS LOW AS POSSIBLE

OFFERS PRICING FLEXIBILITY

MARGINAL COSTING

PRIMER ON COSTING

FAIRLY NEW CONCEPT

GIVES GREATER CONTROL TO DECISION MAKING

SELLING PRICE - VARIABLE COST PER UNIT

FIXED COMPONENT HAS BEEN ABSORBED

CONTRIBUTION

PRIMER ON COSTING

CONTRIBUTION

SELLING PRICE

- VARIABLE COST/ UNIT

CONTRIBUTION

- FIXED COST/ UNIT

PROFIT/ UNIT

PRIMER ON COSTING

The following information is available about ABC International

Selling price per Unit = Rs.20/-Variable cost per Unit= Rs.12/-Total Fixed Costs = Rs. 560,000/-

a) What is the Break Even output ? b) What is the Profit earned when the output is 100,000 units ?

c) What is the break even sales in rupees ?

BREAK EVEN ANALYSIS

EXAMPLE

PRIMER ON COSTING

BREAK EVEN ANALYSIS

SOLUTION

BREAK EVEN OUTPUT = FC / (SP - VC) = 560,000 / (20-12) = 70,000 UNITS

PROFIT AT 100,000 = Q (P - V) - F = (100,000 (20-12)) - 560,000 = Rs.240,000/-

BREAK EVN SALES = BEQ * P = 70,000 * 20 = Rs.1,400,000

PRIMER ON COSTING

BREAK EVEN ANALYSIS

MARGIN OF SAFETY

SAFETY MEASURE

LEVEL OF SALES ABOVE BREAK EVEN SALES VALUE

PREFERABLE TO BE MAINTAINED HIGH

PRIMER ON COSTING

BREAK EVEN ANALYSIS

P / V RATIO

PROFIT / VOLUME RATIO

SENSITIVITY OF SYSTEM TO CHANGES IN VARIABLES

P / V RATIO = (CONTRIBUTION MARGIN / VALUE OF SALES)

HIGHER THE BETTER

PRIMER ON COSTING

BREAK EVEN ANALYSIS

MARGIN OF SAFETY AND P / V RATIO

HOW MUCH PROFIT DOES EACH UNIT ABOVE BEP CONTRIBUTE ?

EFFECTIVELY, MARGINAL COSTING !!!

PROFIT = P / V RATIO * MARGIN OF SAFETY

PRIMER ON COSTING

CONCEPT OF LEVERAGE

EFFECT OF THE PRESENCE OF A FIXED COMPONENT

LEVERAGE : GREATER OUTPUT FOR LOWER INPUT !

FINANCIAL LEVERAGE AND OPERATING LEVERAGE

FINANCIAL LEVERAGE - DEBT / EQUITY

HIGHER THE FIXED COMPONENT ; HIGHLY LEVERAGED

PRIMER ON COSTING

OPERATING LEVERAGE

DUE TO PRESENCE OF FIXED COSTS

HIGHER THE FIXED COST, HIGHER THE OPERATING LEVERAGE

HIGHLY LEVERAGED ; BREAK EVEN INCREASES

BEYOND THAT PROFITS ARE HIGH; BELOW THAT LOSSES ARE HIGH

ELSE BREAK EVEN DECREASES

AND PROFITS AND LOSSES ARE NOT SO PRONOUNCED

PRIMER ON COSTING

OPERATING LEVERAGE

FC

TC

VC

CO

STS

/ R

EV

EN

UE

S

NO. OF UNITS

REV

0 100 200 300 400 500

100

200

300

400

500

PRIMER ON COSTING

OPERATING LEVERAGE

FC = 80 (APPROX) ; VC = 4 (APPROX) BREAK EVEN AT 200 UNITS

SALES COST REVENUES PROFIT

100 230 120 (110)

200 250 250 0

300 280 350 130

400 320 470 150

PRIMER ON COSTING

OPERATING LEVERAGE

FC

TC

VC

CO

STS

/ R

EV

EN

UE

S

NO. OF UNITS

REV

0 100 200 300 400 500

100

200

300

400

500

PRIMER ON COSTING

OPERATING LEVERAGE

FC = 100 (APPROX) ; VC = 8 (APPROX) BREAK EVEN AT 120 UNITS

SALES COST REVENUES PROFIT

100 145 135 (10)

120 160 160 0

200 200 250 50

300 250 320 70

PRIMER ON COSTING

DEGREE OF OPERATING LEVERAGE

DEGREE OF SENSITIVITY

CHANGE IN OPERATING INCOME WRT CHANGE IN UNITS SOLD

(% Change in EBIT) / (% Change in Units Sold )

* EBIT - EARNINGS BEFORE INTEREST AND TAX

PRIMER ON COSTING

TYPES OF BREAK EVEN

1. ACCOUNTING BREAK EVEN

2. CASH BREAK EVENBased on Operating Cash FlowsIs there a cash flow problem every year ?

2. FINANCIAL BREAK EVENBased on Net Present Value CriterionTo undertake the project or not

PRIMER ON COSTING

INTER-RELATIONSHIPS

VARIABLE INC / DEC IMPACT

P/V RATIO MoS BEP

SELLINGPRICE

INC

DEC

INC

DEC

INC

DEC

DEC

INC

VARIABLECOST

INC

DEC

DEC

INC

DEC

INC

INC

DEC

FIXEDCOSTS

INC

DEC

NO CHANGE

NO CHANGE

DEC

INC

INC

DEC

PRIMER ON COSTING

BASED ON FUNCTIONALITY

PRIME COST Related to prime activity of producing goods

Direct Labour, Direct material, Direct Expenditure

PRODUCTION OVERHEADSOverall production relatedElectricity in plant, consumables

ADMINISTRATIVE OVERHEADSManager salaries, Interests

SELLING AND DISTRIBUTION OVERHEADSSalesman Commissions, Ad expenditure

PRIMER ON COSTING

BASED ON FUNCTIONALITY

DIRECT LABOUR DIRECT MATERIALS DIRECT EXPENSES

PRIME COST

PRODUCTION OVERHEADS

WORKS COST

SELLING AND DISTRIBUTION OVERHEADS

ADMINISTRATIVE OVERHEADS

COST OF PRODUCTION

COST OF GOODS SOLD

PROFIT

SELLING PRICE

PRIMER ON COSTING

BASED ON RELEVANCE TO PROJECT

OPPORTUNITY COST Cost forgone in adopting a project in favour of another

Cost forgone by not adopting a projectReturns forgone if the same had been invested elsewhere

SUNK COSTAlready committedCannot be recovered

DIFFERENTIAL COSTSAdditional expense due to some change / additionCaused by specific decisions taken

REPLACEMENT COSTCost of replacing an existing asset

PRIMER ON COSTING

PRICING CONCEPTS

PRICE

AMOUNT OF MONEY CHARGED FOR A PRODUCT / SERVICE

VALUE THAT A CUSTOMER EXCHANGES FOR PERCEIVED BENEFITS

ONLY P TO PROVIDE REVENUES

PRIMER ON COSTING

PRICING CONCEPTS

ART ZONE

COST OF PRODUCTION

CU

ST

OM

ER

S’

LIM

IT

EC

ON

OM

IC C

ON

DIT

ION

SCOMPETITORS’ PRICES

LOSS LEADER

PREMIUM

NE

W S

EG

ME

NT

FO

OL

HA

RD

Y

PRIMER ON COSTING

PRICING CONCEPTS

PE

RC

EIV

ED

VA

LU

E

COST

PREMIUMVALUE FOR MONEY

ECONOMY OVER PRICED

PRIMER ON COSTING

PRICING CONCEPTS

1. COST PLUS PRICING

COST PLUS STANDARD MARK UP

UNIT COST = VC +(FC / UNIT COST)

PRICE = UNIT COST / (1 - DESIRED RETURN)

PRIMER ON COSTING

PRICING CONCEPTS

2. BREAK EVEN / TARGET PROFIT PRICING

PRICE AT WHICH BREAK EVEN IS ACHIEVED

PRICE AT WHICH TARGET PROFIT IS MADE

BEP = FC / CONTRIBUTION

PRIMER ON COSTING

PRICING CONCEPTS

2. BREAK EVEN / TARGET PROFIT PRICINGPRICE

($)DEMAND

TOBREAKEVEN

EXPECTEDDEMANDAT GIVEN

PRICE

REVENUE TOTALCOST

PROFIT

14 75000 71000 994000 1010000 (16000)

16 50000 67000 1072000 970000 102000

18 37500 60000 1080000 900000 180000

20 30000 42000 840000 720000 120000

22 25000 23000 506000 530000 (24000)

PRIMER ON COSTING

PRICING CONCEPTS

3. VALUE BASED PRICING

BASED ON BUYERS’ PERCEPTION OF VALUE

WHAT THEY WOULD PAY NOT WHAT I WOULD OFFER

4. COMPETITOR BASED PRICING

GOING RATE

PRIMER ON COSTING

PRICING STRATEGIES

1. MARKET SKIMMING2. MARKET PENETRATION3. PRODUCT LINE4. OPTIONAL PRODUCT5. CAPTIVE PRODUCT6. BY PRODUCT7. PRODUCT BUNDLING8. DISCOUNT AND ALLOWANCE

cash, quantity, functional, seasonal discountstrade in, promotional allowances

9. SEGMENTEDcustomer, product form, location, time

10. PSYCHOLOGICAL11. PROMOTIONAL12. GEOGRAPHIC

fob, uniform, zone, basing point, freight absorption13. INTERNATIONAL14. BUS STATION

PRIMER ON COSTING

PRIMER ON COSTING