What Is The Primary Reason To Understand Your Product Cost?

Dec 16, 2013

I can answer that with one succinct statement: knowing your product cost is not so important for setting a price as it is to manage your costs for operational purposes.

Cost based pricing has many advantages (assuming you know your costs), it’s flexible, easy to calculate and change, and its very transparent. It also has many disadvantages, it ignores competition and to a large part product demand, it forces price increases and decreases if your costs change, and most importantly, it doesn’t provide any incentive to improve your cost efficiency.

In my opinion, the disadvantages far outweigh the advantages. The most important factor in setting the sales price is the sales demand as a function of your price. This demand is influenced by competitor’s prices, customer preferences, and the availability of an equivalent product from another supplier.

understandingWhat does all this mean? For most of my clients, the price they can charge is dictated by the market. So, knowing product cost is crucial to their success because they have to manage their costs to be profitable.

So many sales decisions have to be made based on COST. Occasionally you are faced with a sales opportunity for which only incremental costs and revenues for that one transaction are relevant. Then there are intermediate or long-term decisions which include more than incremental costs such as fixed costs the company is incurring.

In the long run,  it’s pretty simple! The revenues of the company must exceed its costs to survive. If your cost is set by the market, then there is only one variable you can change: YOUR COST! The management accounting system needs to provide information to the managers about whether sales prices for products are in excess of their FULL cost of production to provide the company with a sufficient rate of return. If we are not covering the full product cost, then managers need to be equipped to make those hard decisions such as dropping products that are unable to cover their full costs.

Experience has shown that if you go to the operations team and are precise about what the problem is then they can fix it. “Precise” meaning they need to take three cents out of material cost for every unit produced, not we need to reduce the product cost.

If the team is not able to deliver the required reductions in cost and our system supports that, it is time to re-evaluate this sale. There may be extenuating circumstances that would lead you NOT to eliminate this product, but you will not be able to make that decision without sufficient costing information!

Categories: Cost Accounting