Wednesday, 12 June 2013

Pricing your products Correctly

If you are a small to medium size business owner or know someone along those lines you might find this useful.

Activity Based costing (ABC) is a costing model that identifies the cost pools, or activity centres, in an organisation and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service.

There are costs that vary with the number of transactions. These are known as activity costs. As the diversity and complexity of the production process increases, additional support services tend to be required thus the greater number of goods and services produced, the greater number of transactions required to support them.

It works like this:
·         Identify a group of cost activities through which a product must pass before it is delivered to the customer
·         The total cost of operating each of the activities for a year must be estimated
·         The total number of hours that will be spent on each of the activities must be estimated
·         Based on this a ‘cost driver’ for each of the activities can be calculated
·         Assign a suitable cost driver to each of the activities and calculate an estimate for each cost driver unit.

Here is an example courtesy of the School of Business New York.
ACME Inc produces two products.
1.        Product A
·         1 hour direct labour ( direct labour cost for I1hour @ $20 / hour = $20)
·         demand = 100

2.        Product B
·         2 hours of direct labour ( direct labour cost for 2 hours  @ $20 / hour = $40)
·         demand = 950
Total overheads: $100,000
Total direct labour: $2,000 hours
$100,000/ 2,000 hours = $50/ hour
Thus Product A is $50 a unit and Product B $100/ unit on Traditional cost accounting (TCA)

Let us now look at what Activity based accounting gives us.

ACME inc

Activities

Cost drivers

Activity cost

Total used

Set-Up

No. of set-ups
$10,000
4
Machining
Machining hours
$40,000
1900
Receiving
No. of Receipts
$10,000
4
Packing
No. of Deliveries
$10,000
4
Engineering
Engineering Hours
$30,000
1000





This then gives us Our Activity Data
Activity
Cost ($)
Product A
$
Product B
$

Set-Up

10,000
1
2,500
3
7,500
Machining
40,000
100
2,000
1900
38,000
Receiving
10,000
1
2,500
3
7,500
Packing
10,000
1
2,500
3
7,500
Engineering
30,000
500
15,000
500
15,000

Total Cost



24,500

75,500


Thus we get Overhead costs:
·         Product A is $24,500/ 100 = $245
·         Product B is $75,500/ 950 = $79.47

Comparison of ABC versus TCA
Cost for Product A:
Overhead         TCA $50                      ABC $245
Direct cost                $20                           $20
Total                         $70                           $265

Cost for Product B:
Overhead         TCA $100                    ABC $79.47
Direct cost                $40                           $40
Total                         $140                         $119.47

Thus not only do we get a more accurate cost of the product we also get to know which customer is your best customer ie contributes more to net profit
By not pricing properly you do a lot of work for seemingly little reward.
As can be seen you need professional advice to do this however it is worth it both for your bank balance and your sanity!