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53. How Many Kinds of Overhead Variance Analysis!
How many finance people jump on board of a company with a standard cost accounting system well-established and never looked closely!?
The result is the analyses come out automatically without knowing how they are achieved.
That is the case of the Overhead Variance Analysis, one of the most complex issues to explain to a future smart management accountant.
Thestrategiccontroller.com will make an overview to make the mechanisms clear to anyone who may be interested.
Let's start out from the main formula of the Overhead Variance Analysis.
Total Overhead Cost Variance = Actual Overheads - Budgeted Overheads
You know that the Overheads are both variable and fixed, so the companies that have in place a cost system able to distinguish these two categories may carry out the variances in a separate way that spot 3 or 4 of them.
The business not able to make this distinction can use a two-variance model.
At this point you will have understood one of the factors that makes this topic not so easy to be absorbed.
Here is the first and most detaile model.
Four-Variance Model
Total Overhead Cost Variance = (Actual Variable Overheads + Actual Fixed Overheads) - (Total Overhead Application Rate x Standard Driver Quantity)
Please note that the driver chosen as a basis for the overhead allocation to the products may be different and vary according also to the Volume-Based or Activity-Based Approach.
That is not the article for disserting about that and we prefer going on by a simple example.
That difference (Total Overhead Cost Variance) shows how far the related expenses went compared to the amount estimated in the Budget but what matters most is to evaluate the business performance considering the output achieved at the end of the period analysed in the best possible way and costing the products to the same degree and that's why we make use of the concept of Fllexible Budget by appling the unit cost of the driver chosen and the overhead rate (standard and actual) to the period's production.
We can see much better by starting from the following formula.
Total Overhead Cost Variance = Actual Overheads - Applied Overheads
At this point the previous formula becomes:
Overhead Cost Variance = Actual Overhead - Applied Overhead = (Variable Overhead + Fixed Overhead) - (Total Overhead application rate x Standard driver allowed for the production of the period).
Let's assume that the driver chosen for the imputation of the overheads to the products consists of the labour hour.
As a result the Standard driver allowed for the production of the period becomes Standard labour hours allowed for the production of the period.
As we are about to see the formulas for the Variable Overheads may look the same as those of the Direct Cost Variances but the interprepretation is different due to the subjective relationship between the driver chosen (in our case the Labour Hours) and tha varible overheads.
However this issues would require another article and that's why you can get in touch on page Contacts if you want dig deep
Let's turn to our topic and a table showing some numbers for an imaginary Manufacturing company with one product and with Labour Hours as the driver chosen will be very useful to understand that formula.
Table 1 - Standard Cost Sheet (Manufacturing Company A)
Cost Category | Quantity per unit |
Unit Cost or Standard Overhead rate (for Overhead) |
Cost Category Amount |
Total |
Direct Materials | 6 | $ 25 | $ 150 | |
Direct Labour | 5 | 50 | 250 | |
Variable Factory Overhead | 5 hours | 14 | 70 | |
Variable Manufacturing Cost | 470 | |||
Fixed Manufactiring Cost | 5 hours | 26 | 130 | 130 |
Standard Cost per Unit | $ 600 |
After adding these further data:
Actual Output: 1,000 Units
Budget Output:1,200 Units
Actual Variable Overhead Costs: $ 56,000
Actual Fixed Overhead Costs: $ 150,000
We turn that formula into numbers.
Total Overhead Cost Variance = Actual Overheads - Applied Overheads = (Variable Overheads + Fixed Overheads) - (Standard Total Overhead application rate x Standard driver allowed for the production of the period).
Total Overhead Cost Variance = (56,000 + 150,000) - ((Standard Variable Overh. Application Rate + Standard Fixed Overh. Application Rate) x (Standard Labor Hours per Unit x Actual Output)
Total Overhead Cost Variance = (56,000 + 150,000) - ((14+ 26) x (5 x 1000)) = (206,000 -200,000) = $ 6,000
In this case the actual is higher than the second member of the equation by $ 6,000 and that means that the overheads were underapplied to the production because each output unit has absorbed a higher overhead share than the expeced one.
In order to understand the causes we are going on to breakdown this Total Overhead Cost Variance.
Let's go on with the Total Variable Overhead Variance and see that it is equal to:
Total Variable Overhad Cost Variance = Actual Variable Overheads - Standard Variable Overheads Applied to Production = $ 56,000 (Standard Variable Overh. Application Rate X Standard Labor Hours per Unit x Actual Output) = 56,000 - (14 x 5 x 1000) = 56,000 - 70,000 = -14,000
That means that these Oveheads have been overapplied because each output unit has absorbed a lower variable overhead share than the expeced one
On the opposite side the Fixed Overhead Costs have been underapplied by 20,000 as a result of this equation:
Total Fixed Overhead Cost Variance = Actual Fixed Overheads - Standard Fixed Overheads Applied to Production = $ 150,000 - (Standard Fixed Overh. Application Rate X Standard Labor Hours per Unit x Actual Output) = 150,000 - (26 x 5 x 1000) = 150,000 - 130,000 = 20,000
Variable Overhead Cost Variance
When talking about a four variance model, we are going to see the first two variances that are those related to the Variable Overhead Costs.
First of all, let's show the full data table that will help us to break them down.
Actual Labour Hours per Unit = 5.6
Standard Labour Hours per Unit = 5
LA = Labour Hours applied to production: 5,000
AW = Actual Labour Hours worked: 5,600
APv = Actual Variable Overhead Application rate: $ 10
SPv = Standard Variable Overhead Application Rate: $ 14
Now we can analyse the first variance, the Spending one, that is the difference between the Actual Overhead Costs and the socalled Flexible Budget of the Variable Overheads based on period's inputs.
Variable Overhead Spending Variance = Actual Variable Overhead Costs - Flexible Budget of the Variable Overheads based on the period's inputs = (AW X APv) - (AW x SPv) = (5,600 X 10) - (5,600 X 14) = 56,000 - 78,400 = -22,400
In other terms: (APv - SPv) X AW = (10 - 14) X 5,600 = $ -22,400
It is Favourable since the company should have spent more by applying the Standard Variable Overhead Rate (14) at the Actual Labour Hours worked (5,600 Direct Labour Hours).
In some cases, for some cost categories, this variance could be further decomposed in Price and Efficiency variances needed to dig deep into the causes of it, but that will be explained on request (if interested) on page Contacts.
As to the Efficiency Variance we'll calculate the difference between the Flexible Budget of the Variable Overheads based on period's inputs and Flexible Budget of the Variable Overheads based on the period's outputs.
Variable Overhead Efficiency Variance = Flexible Budget of the Variable Overheads based on period's inputs - Flexible Budget of the Variable Overheads based on period's outputs = (AW x SPv) - (LA X SPv) = (5,600 X 14) - (5.000 X 14) = 8,400
In other terms: (AW - LA) X SPv = (5,600 - 5,000) X 14 = $ 8,400
Please note that in this Variance for Variable Overheads the Flexible Budget of the Variable Overheads based on period's outputs is equal to Standard Variable Overheads Applied to production ($ 70,000).
It is Unfavourable since the company should have spent less by working at the Standard Labour Hours per Unit for the period's output, 1,000, and applying the Standard Variable Overhead Application Rate.
What I feel like specifying about this Variance is that the inefficiency or efficiency one can derive from its analysis follows the same direction of the inefficiency or efficiency of the driver chosen (in our case the Direct Labour Hours) as a basis for the allocation of the Overheads to products/services to the extent of the validity of the relationship between Variable Overheads and the driver.
As a result the person in charge of the subject driver, taken for good that relationship, is also responsible the efficiency of Variable Overheads,
Furthermore, the correct relationship between the driver used to allocate this kind of Overheads makes the manager in charge of the driver (machine hours, labour hours,...) responsible for the same overheads.
As a result, if you make the wrong choice, that will cause problems of fairness and motivation that will translate into a bad effectiveness of the actions taken to decrease the same Overheads.
Fairness because a manager could be held responsible for something that is out of his control and remunerated, in case of compensation partially linked to the financial results of his Business Unit, less than deserved when the Variable Overheads increase.
Motivation because other managers, whose behaviour really impact the amount of the Variable Overheads, won't be pushed to act in the same interest of the Business as a whole and in the end they will make decisions that will cause that expenses to grow and grow.
At this point the debate could be shift to the most suitable approach to allocate the Overheads we are dealing with but this is not the article dedicated to this topic and let's go on to the other variance left.
Fixed Overhead Cost Variance
As we have seen above the Total Fixed Overhead Cost Variance adds up to $ 20,000 and that means that for product-costing purposes they were underapplied in the meaning we repeated many times in the previous lines.
Yet prior to starting the dissertation over these variances, I want to remember some basic concepts in the end that will help the reader to better interprete them.
The Application rate for the Fixed Overheads is not like that for the Variable ones an immutable amount per unit of the driver chosen (in our example the Direct Labour Hours) that makes the related Overhead Costs increase in direct proportion to the increase in the driver quantity (taken for granted the validity of the relantioship).
It is an amount per unit of driver that increases or decreases following the opposite direction of the increase in the driver quantity because the Fixed Overheads don't vary within a large interval of the driver quantity.
In other terms we are recalling the concept of the variable and fixed costs and their different impact on the product cost.
That said, let's go in-depth with the breakdown of the Fixed Overhead Cost Variance by saying that just like the Variable Overhead Variance it can be broken down into two categories.
They are called Production Volume Variance (PVV) and the Spending Variance.
PVV = Budgeted Fixed Overhead Costs - Standard Fixed Overhead Costs Applied to Production
In our example:
SPf: Standard Fixed Overhead Application Rate
LS: Standard Labour Hours
LA: Labours Hours Applied To Production
52. Project Control and some Risk Assessment Methodologies
This article wants to pay homage to the Project Control and the role the Risk assessment plays therein.
The uncertainty is a typical issue of any business decision to be made but it takes even more importance when the projects take time and the technical steps as well as the related resources may be impacted by the occurence of some events, both positive and negative ones.
That's why any firm operating on project must be well-shelled against the Risk of these events and its operating "way" is so peculiar.
The steps a company makes in analysing the risks related to a potential project are 4:
1. Risk Identification.
2. Assessment
3. Planning
4. Monitoring
We are going to deal with the Assessment step, focusing on two ways that can be followed in order to weigh the consequences of some events if and when they occur.
The existing approches are generally categorized into qualitative and quantitative ones, each of them is broken down in different methodologies.
We want to pay attention to one method per approach.
Prior to getting started let's give a short definition of the quantitative and qualitative techniques.
The quantitative method weighs the risks by means of given measurement units and it is used for different purposes ranging from the financial consequence assessment to the determination of the success probability of the project without forgetting the determination of the effects of potential forced changes in the work schedule.
The qualitative approach is intended to rank the total risk of the project without resorting to any unit of measurement, by defining the criteria enabling the assessment of the consequences resulting from the occurrence of the risky events.
That said, let's start with a methodology of the qualitative approach.
Let's guess a matrix where the projects are classified and ranked according to their positioning with reference to the extent (the higher, the greater extent) of the consequencies of a particular event and the occurence probability of the same event (the more on the right, the less probable the risky event).
Matrix 1 - Risk Exposure Matrix
Occurrence Probability | ||||
Extent | a | |||
b | ||||
c | ||||
d | e | f | ||
The projects d, e and f are positioned beyond an Attention Threshold that causes the project manager to pay more attention to these than to a, b and c.
The size of this Matrix depends on the levels (number of columns and rows) spotted as the appropriate in order to assess the projects according to the usual features of the company projects with reference to some criteria such as:
1. Internal features of the project: skills requested and available, technologies requested, characteristichs of the materials and timing of the supply,....).
2. Financial dimension of the project: presence of subcontracts and/or partners, entity of the investments to be made...).
3. Category of the project: importance of the client, impact on the whole business, contract clauses,...).
As you can notice the ranking of the project under the qualitative approach is subjective since it depends on the judjment of the project manager that relies on his ability and the experience of the business about similar projects that are never the same with reference to the features above exemplified.
On the opposite side the ranking is rather fast and easily comprehensible through that matrix.
If you want to be more detailed and professionally appropriate about the definition of the level of the risk, Exposure, for that event you are looking over, you have to spot some categories the risk level falls in and that depend on the combination of the degrees of each variable.
Here are the levels of the risk (Exposure) that we suppose are four:
1. Absent
2. Moderate
3. Outstanding
4. Alarming
At the same time, turning back to our example of the Matrix 1, the variables, whose classification convergengy determine the level of the risk (Absent, Moderate, High, Alarming) are weighed this way:
Extent:
1. Irrelevant
2. Reasonable
3. Strong
4. Disastrous
Occurrence Probability:
1. Low
2. Average
3. High
4. Very High
After that here is the Risk Exposure Matrix in its detailed configuration.
Matrix 2- Risk Exposure Matrix (Full Version)
PROBABILITY
EXTENT |
Very High | High | Average | Low |
Disastrous | Alarming | Alarming | Outstanding | Moderate |
Strong | Alarming | Outstanding | Outstanding | Moderate |
Reasonable |
Outstanding | Moderate | Moderate | Absent |
Irrelevant | Moderate | Moderate | Absent | Absent |
Once you place your project into one of the Matrix cells its exposure will be immediately ranked and if it lies in the Alarming/Outstanding cells (above an imaginary Attention Threshold Line), it will need all the precautions and consideration of the project manager and his team with reference to that given event under "investigation".
If many risky event might occur, as many Risky Exposure Matrixes should be drawn and the classifification of the business projects with reference to the whole exposure comes out as a anatural consequence according to the number of the most risky placements of each project.
There is the chance of getting a most accurate classification but that means passing to an intermediate form between quantitative and qualitative approach; nonetheless that isn't the goal of this article and if you want to know more, you can reach out to thestrategiccontroller.com on page Contacts.
Having dealt with that specific qualitative technique, let's move on to one of the quantitative ones.
The Earnings Matrix is one of the application of the Decision Theory and is particularly useful when assigning a percent probability to a very unusual or even Unprecedented event to assess the Risk Exposure of a project/decision is hard.
As a matter of fact this is a very current recurring issue and it turns out to be a very useful way to estimate according to your strategy and your risk aversion.
When it comes to attributing a percentage to a given scenario/event the Bayes' Theory shows up as the best technique we know.
It has previously been "dealt with" in the article n. 18 of this page, "How to deal with the uncertainty in the estimation process", under the paragraph Scenario Analysis.
Now let's turn our attention to the Earnings Matrix and draw a matrix where Dx is a specific decision (comparable to a project) and Sy is the state (comparable to an event).
The combinations of Dx and Sy result in an amount that can be either a gain or a loss and we indicate as P (when negative - P)
An example will make the concept more clear.
D1 = Launch of a busines product into a single new country
D2 = Launch of a business product into two new countries
D3 = Increasing the sales of the existing products through a larger commercial network in the usual market.
S1 = Scenario with some Entry barriers into one country.
S2 = Scenario with some Entry barriers into two countries.
S3 = No Entry Barriers into the countries involved.
Matrix 3 - The Earnings Matrix
State Decision |
S1 | S2 | S3 |
D1 | 140,000 | 140,000 | 200,000 |
D2 | 220,000 | 155,000 | 280,000 |
D3 | 200,000 | 200,000 | 200,000 |
At this point you can apply your personal Risk Aversion by adopting one of these criteria:
Optimistic Criterion: you will choose the decision that realizes the highest potential earnings (in our case D2 with P (profit) of 280,000 under the Column "S3").
Minimax Criterion: you will choose the decision when the lowest earnigs are the highest possible (in our case D3).
Halfway Criterion: you will choose the decision when the average earnings are the highest possible (in our case D2 with the average that is worth 218,000).
See you on the n. 53.
51. When the Operating Leverage is used as an excuse
We all know the considerations the managers should make when planning their costs based on the concept of the Operating Leverage.
Operating Leverage: Fixed costs/Total Costs
Once we have recalled that it is the ratio between Fixed Costs and Total Costs of a business the practical result from this magical formula is that
the higher it is the higher the potential Operating Profit, the higher the potential Loss (if the Sales Units are lower than the Break Even Point).
Another ratio we are used to taking into account is the Degree of the Operating Leverage.
DOL = Contribution Margin/Operating Profit
Let's make an example to explain this concept.
Sales Units: 3,000
Contribution Margin: $ 120,000
Operating Profit: $ 30,000
DOL = 120,000/30,000 = 4
What does it mean?
That means that (when everything else is constant: Fixed Costs, Total Costs) each increase in the Sales of 1% would bring about a 4 % increase in the Operating Profit.
It goes without saying the higher the Fixed Costs portion the higher the potential increase in the Operating Profit.
Why?
Because the denominator will decrease if the fixed costs increase and as a result the DOL will be higher.
If you want to better understand how operating leverage and DOL work, please refer to the rich literature on the subject where you will find comparisons of different reactions to increases in units sold between companies with the same starting operating profit but with a different proportion between fixed costs and variable costs.
The focus of this article is in fact different and aims to highlight behavioral aspects of the managers.
In some cases you come across the strange thing the Fixed Costs planned are higher than the level some could expect based on the prospects of the market demand.
In some other other cases throughout the Budget period you may have witnessed the persistence of some Business Units' managers, justified for instance by a need for a technology upgrade, in asking during the resource negotiation process for a high level of investment in Long-lived assets (as a matter of fact mainly Fixed costs) compared to the level of the Variable costs even if the projections of the Sales Units aren't very good.
Be aware that the Operating Leverage and the related DOL, that when high promise great results if the planned Sales are higher than the Break Even Point, can be a good excuse for this persistence.
Let's make a distinction.
When the company has a great competitive advantage (of any kind) over the competitors, no doubt about that behaviour is needed.
For instance, if your company produces a sort of "unique and advanced" exciter that goes into the airbags of the automobiles, no further "doubt" is needed.
As a matter of fact the safety standards concerning the cars are increasing and increasing over the years and that will make the need for the Airbags constant.
As a result the planned Sales Units of that exciter are not only a plan but an "actual".
Instead the doubt will arise in all the cases the responsibility of the Fixed Costs is held within the sphere of the whole Company and the managers of some Cost Centers will be held accountable only for the Variable Costs that are considered controllable by them.
In this context when the certainty degree of the customer demand for your products is not so optimistic, the persistence of some Managers towards an exagerated amount of Fixer Costs compared to the total costs of the company should be investigated.
What is this case called?
Cost Shifting.
Some remedies are possible and don't consist just in putting the Fixed assets under the responsibility of the Cost Center's Managers.
In fact some nonfinancial indicators to assess the performance of the cost centers involved could be used (I invite you to take a look at the article n. 12, SBU manager evaluation: - Nonfinancial measures and strategic structure, of this webpage).
In case of Share Assets (those used by more than a single cost center) suitable cost drivers for the fair allocation the fixed costs to the differnt centers are very advisable.
In any case an in-depth analysis of the investment requests will be always an appropriate way of proceeding.
50. A Common Manufacturing Accounting "Misundertanding"
At this time I will make just a clarification about a common "operational" misunderstanding just because the strategic side of the controlling dissertations must rely on the correct accounting concepts in order to be fully understood.
Starting from the next article the strategy is going to be predominant again.
When many, even managers, talk about the costs of the manufacturing departments, often two different categories are confused with each other.
The Cost of Goods Manufactured and the Manufacturing Costs.
Then, in order to make the things more clear I want to dedicate this article just to this "clarification", leaving the strategical side of the dissertations on this website aside on this occasion.
As a matter of fact, when the confusion reigns, any kind of debate may be useless and that's why I want to make an example of a Manufacturing Statement.
Prior to dealing with it let's take a step back.
Here is a piece of an Income Statement of a Manufacturing company
Table 1 - Cost of Goods Sold Breakdown
Beginning Finished Goods Inventory | $ 45,000 + |
Cost of Goods Manufactured |
$ 220,000 = |
Cost of Goods Available for Sale | $ 265,000 - |
Ending Finished Goods Inventory |
$ 42,000 = |
Cost of Goods Sold | $ 223,000 |
As you can see from table 1, the category of Cost of Goods Manufactured (COGM) is the total amount of Manufacturing dpt expenses that shows up in an Income Statement and that's why, may be, many confuse it with the Manufacturing Costs.
As a matter of fact the COGM includes the Manufacturing Costs and consists also of the Fluctuations concerning the Goods In Process Inventory.
What better example than a Manufacturing Statement to distinguish them!
Table 2 - Manufacturing Statement
Direct Materials | |||||||||||||||||||||||
Beginning Raw Materials |
$ 14,000 + |
||||||||||||||||||||||
Raw Materials Purchases | $ 92,000 = | ||||||||||||||||||||||
Raw Materials available for use | $ 106,000 - | ||||||||||||||||||||||
Ending Finished Inventory |
$ 11,000 = |
||||||||||||||||||||||
Direct Materials Used | $ 95,000 + | ||||||||||||||||||||||
Direct Labor | $ 75,000 + | ||||||||||||||||||||||
|
|||||||||||||||||||||||
Total Factory Overheads | $ 43,800 = | ||||||||||||||||||||||
TOTAL MANUFACTURING COSTS | $ 213,80O | ||||||||||||||||||||||
+ |
Beginning Goods In Process Inventory | $ 14,200 = |
Cost of Goods In Process | $ 228,200 - |
Ending Goods In Process Inventory | $ 8,000 = |
COST OF GOODS MANUFACTURED | $ 220,000 |
The strategical side in the next number, again.....
49. Make the Right Price
One of the most complicated tasks that a business has to carry out is to determine the winning price in order to hit the the desired level of profitability.
Why is it so complicated?
The answer to this question is the great range of factors to be included in this important decision.
I make a try to do a list so that you may understand the reasons why I make this statement.
Here is my attempt:
- Gathering the best product/service cost basis.
- Regrouping and channeling the cost data of the point 1 to the product /service unit to reflect the real consumption of the business resources as best as it can and according to the kind of the internal activities and their level of diversification.
- Taking into account the profitability target set by the business top management.
- Taking into account the strategy "chosen" by the top management to build a competitive advantage in the market, if it is based either on the differentiation or on the Price leadership or on a mix of the previous ones.
- Segmenting the customers according to their respective preferences towards the features/functionalities of the product/service amd their purchasing power.
- Considering the product configuration to see whether differentiating the service level of the product/service and applying the following different prices.
- Being adherent to the stage of the Life Cycle of the product/service (launch, growth, maturity, decline).
- Competitiveness level and price of the competitors.
- Seasonality of the demand.
- Inventory level
-------
This is the list of the main factors that come up to my mind and that one should consider in setting the right price, sometimes simultaneously.
The extent of the dissertation doesn't aim at comprising all of them but is intended to highlight, just as in all the articles posted on page Topics, the strategic side of the pricing that shouldn't be an automatic task to fulfill.
That's why the issues dealt with here will be just some of those concerned and if you want to know more, don't hesitate to get in touch on page Cpontacts of this website.
It goes without saying that the following content doesn't apply to the most part of the businesses making use of the Target Costing (see article n. 47 on page Topics) that are price takers and not price makers.
Let's start with spotting the different situations that a price maker should face with reference to the stage of the product/service Sales Life Cycle.
The first step is the Launch (or Introduction) of the product/service and the cost basis for determining the price has to include the R&D costs, and other marketing costs needed to "introducing" it in addition to the "manufacturing" ones (meaning by these the typical costs incurred to deliver the services if the the industry is the service one) that in their turn, in case of a manufacturing company, consist also of the new production assets to make the new product.
As a result, usually it is the stage when the price the highest of the all Life Cycle.
The second step is the Growth and the price is initially rather stable because the demand is high and that allows the business to realize the largest profits in all the life Cycle. The competion gets stronger and the differentiation feature is not as before so at a some point the price will begin to fall
The third step concerns the Maturity stage when the demand increases a a lowest rate because the product is not longer something new in the market.
The cost basis should be the manufacturing costs plus the usual marketing/sales ones incurred and if the business increases the level and the range of the services (such as the after-sales service) and in some industry tries to enlarge the product functionalities, in order to keep the market share as untouched as possible, the related costs have to be added to the Price basis.
As a result, in consideration of the lowest value acknowledged to the product by the customers, the price falls even more and profit from that product is smaller and smaller.
The fourth step is the decline of the sales of the product and of the money the customer are open to spend for it decreases.
The focus of the business shifts to the control and reduction of the macnufacturing and distribution costs. It cannot leverage properly the price to be profitable.
If you have paid attention to what happens throughout the Sales Life Cycle, there is a clear decrease from the highest beginning price related to the differentiation strategy (generally speaking) of the the first two steps to the lowest one related to the cost leadership of the maturity and decline steps.
As a result, this fact changes the cost basis for making the right price that shouldn't be always at the same level for the product/service and the solution is without any doubt a full Life-Cycle Costing method that wouldn't focus only on the Manufacturing dpt but would take into account all the value chain costs attributable to the product/service.
It goes without saying tha in case of a multiproduct business a correct overheads allocation "policy" should be adopted in consideration of the different Sales Life Cycle stage where each of the products is at a given point of the business life.
However this falls beyond the scope of the article and cannot be argued here.
Turning back to my statement about the appropriateness of a Full Life-Cycle Costing method, do you want an example that may include also a Profit target of a company?
Here it is.
Let's suppose that a business estimates for the future period 20,000 Sales unit and want its ROI to add up to 15% of its Assets, being worth $ 5,000,000.
The Unit Full Life-Cycle Cost is $ 200.
First of all, let's calculate the markup needed to hit 15% as the ROI target.
Markup = Assets X 15% / Unit FLCC X Expected Sales =
= 5,000,000 X 15%/ 200 X 20,000 = 18,75%
Then the Sales Price.
Price = Unit FLCC X (1 + markup) = 200 X (1,1875) = $ 237,50
Of course this price target is at a first stage an ideal one since the factors that can modify it are several and of different nature.
One of this elements that is consistent with the goals of the dissertations of thestrategiccontroller.com is first of all the Strategy adopted by the business to achieve a competitive advantage in its industry compared to the other competitors.
This "concept" goes beyond the natural and gradual shifts of strategy we have seen in the previous lines when writing about the Sales Life-Cycle of the product/service and it refers to the "will" of the top management to characterize their company.
As we have seen many times the choice is from a Cost Leadership Strategy and a Differentiation One except for some market segments where a mixed Strategy is the most appropriate.
Let's deal with about the classical two categories.
As to the industries where the Cost Leadership is pursued by their actors the Pricing is characterized by the continuos search of the lowest cost basis to which apply the markup and generally the most efficient business determines the price target of the other competitors.
More complex is the Price issue in the Differentiation industries where the Strategies policies are different.
The companies involved for instance can resort to a value profiling of their customer segments, spotting the features of their products/services preferred by the customers the most and channelling their expenses to those activities and resources needed to meet those preferences.
The amount resulting from this efforts are the cost basis to which applying a markup.
Just as an example of value profiling, here is a table showing the two segments of a pen manufacturer and the value features "weighted" by the customers
Table 1 - Value Profiling of the business customers
Value features |
Writing pen customers |
High-end pen customers |
Weighted Average Value |
Writing Quality |
55% |
30% |
50.2% |
Model Availability |
15% |
10% |
14.0% |
Brand Name |
9% |
20% |
11.1% |
Appearance |
7% |
28% |
11.1% |
Price |
14% |
12% |
13.6% |
Total |
50,000 (100%) |
12,000(100%) |
100% |
Another alternative in the hands of a differentiated firm is the Skimming policy, that is applying (when possible) different prices to the same product/service according to the customer kind; the highest ones to those customer categories open to spend more and the lowest one to those paying much attention to the money spent on the purchase.
How to do it?
One way for instance is the different level of potential additional services related to the product/services that could be high for the "rich" and lower for the others.
Another way is the different timing of the sale: low prices for the first buyers and higher prices for the following.
As you can understand the elements for the best price go beyond the simple cost basis and relate to the factors depending on the will of the top managenet as well as external factors that affect the pricing and cannot be manoeuvred by the managers such as in some industries the oil price, the interest rates, the seasonality of demand...
The purpose of the dissertation was to highlight the strategic side of the pricing and hope to have been successfull.
Of course some further argumentations are possible and that's why the page Contact can't wait for your "initiatives".