Product costing and pricing

Knowing the full cost of creating each product that a business sells is vital because it helps a company price its products appropriately and assess the performance of the business.

How it works

Both direct and indirect costs contribute to the production cost of a product, whether it is a manufactured good or a service being provided. In order to calculate the cost of a product, it is treated as one unit of production. The direct and indirect costs involved in creating that single unit are then assessed and added together to create the full cost.

38%
the average total of US business costs that can be accounted for by indirect costs

NEED TO KNOW

• ❯ Absorption costing Allocation of all production costs to product
• ❯ Differential costing Difference between the cost of two options
  ❯ Incremental (marginal) costing The change in total costs incurred when one additional unit is made
  ❯ Throughput costing An analysis of the impact that one extra unit of production will have on sales
• ❯ Cost-plus pricing Product price is based on direct and indirect costs, plus markup percentage

OTHER COSTING METHODS

There are several different approaches to costing and pricing depending on the industry, the type and size of the business, and the method of production.

JOB COSTING Used for a customized order made to a client’s specifications—for example, a printing company that prints brochures for a client

BATCH COSTING Used when a batch of identical products is made—for example, an electrical goods company manufacturing television sets

CONTRACT COSTING Used for a large one-time job, often the result of a tender process (when a company bids for work) and carried out at the client’s site—for example, a construction company building homes in a new residential development

PROCESS COSTING Used for an ongoing job that often involves several manufacturing processes, making it difficult to isolate individual unit costs—for example, an oil refinery which processes crude oil into diesel oil

SERVICE COSTING Used when the product being sold is a standard service offered to customers—for example, a nail salon offering an express manicure and pedicure within a set period of time and for a fixed price

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Full cost pricing

Direct costs can be measured in terms of how materials and labor are used to produce each unit. Indirect costs (overheads) are harder to assess but also need to be factored in so that the full cost of each product can be calculated. Managers and accountants must apportion indirect costs to reflect their contribution to the cost of creating a single product. Once this is ascertained, the full cost of that product can be determined. In general terms, the price is worked out by adding the direct and indirect costs of production with a profit margin that gives an appropriate selling price.

Direct costs

• ❯ Materials
• ❯ Direct labor
• ❯ Direct expenses
• ❯ All used exclusively to create a product or service for sale

Share of indirect costs

• ❯ Production and service overheads❯ Administrative and management overheads
• ❯ Sales and distribution overheads

Profit margin

• ❯ Must be able to generate profit for the company
• ❯ Must be in line with how the
  product has been marketed
• ❯ Must be
• pitched realistically so that customers will buy

Selling price

• ❯ Low: in order to gain market share, or to match competitors
• ❯ Cost-based: recover direct and indirect costs and profit margin that the market will accept
• ❯ Service-based: flexible since no manufacturing or distribution cost