In business, whether we are preparing an insurance quote, producing a product, or delivering a service, the ability to accurately assign costs is critical. In this post, we’ll explore the foundational elements of costing and dive into some popular pricing strategies that businesses use to remain competitive and profitable.

When it comes to costing a product or service, there are three major components that must be considered: materials , direct labor , and overhead . These elements are vital regardless of the type of product or service being produced, whether it's assembling bicycles, baking cookies, or manufacturing electronics.

A key challenge in costing is determining how to apply these components accurately to each product. For instance, if we are assembling a product and using minor supplies like wire or glue, are these supplies considered direct costs, or should they fall under overhead? The classification depends on how the costs relate to production.

Another question arises when allocating overhead: should it be assigned based on labor hours, the number of units produced, or machine hours? Each approach offers different insights, but the correct method depends on the nature of the business and its production process.

While a detailed discussion of each method could fill an entire college course on managerial accounting, some essential concepts include:

For example, a sunk cost represents an investment that has already been made and cannot be recovered, like purchasing machinery.

It's important to remember that product costing —the process of determining how much it costs to produce a product—differs from product pricing —how much you sell the product for. There are three common approaches to pricing:

In target costing , the market determines the price. From this market price, the business subtracts the profit it desires, leaving the target cost. The challenge is then to work with engineers and production teams to design and manufacture a product that can be produced within this cost structure.

For example, if market research shows that a product can only sell for $500, and the company needs a profit of $100, the target cost would be $400. Adjustments, such as reducing features or improving production efficiency, may be necessary to meet this target.

Cost-plus pricing is a straightforward approach where the price is determined by adding a markup to the product's cost. For example, if the cost to produce a product is $600 and the desired markup is 25%, the price would be calculated as follows:

[ \text{Price} = 600 + (600 \times 0.25) = 750 ]

This method is commonly used in government contracts and businesses where cost transparency is vital.

With variable cost pricing , the markup is calculated based on the desired profit and fixed costs, spread across the number of units produced. For instance, if the desired profit is $400,000, fixed costs are $200,000, and the company plans to produce 2,000 units, the markup per unit would be $300.

If the variable cost to produce each unit is $250, the final price would be:

[ \text{Price} = 250 + 300 = 550 ]

This method ensures that both fixed and variable costs are accounted for in the pricing model, helping businesses achieve their financial goals.

Costing and pricing are critical activities for any business, as they directly influence profitability. From determining direct costs to choosing a pricing strategy, businesses must carefully analyze their processes to remain competitive. Whether through target costing, cost-plus pricing, or variable cost pricing, the approach chosen should align with both market expectations and the company’s financial objectives.