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Cost and Financial Analysis

Surprisingly, many businesses do not have a good knowledge of what it costs them to provide their goods (products and services).  Even when cost data is available the estimates are often distorted by accounting practices. Costs estimates used for pricing decisions should reflect the change in total cost associated with providing the goods. However, it is common that the cost estimates come from accounting procedures that allocate sunk or fixed overhead to the cost of production. Since fixed and sunk costs do not vary with the level of activity, they should not be included in estimates of unit cost. As a result, allocating fixed overhead results in an overstatement of the true cost of increasing production and may motivate unprofitable shifts in production away from certain factors simply because doing so avoids allocated overhead.

The cost analysis also identifies indirect and intangible costs that may not be directly included in the estimate of the unit cost of a product or service. These costs might include the cost of holding inventory until shipped, customer service, the expected cost of returned merchandise, and marketing expenditures.

Properly accounting for the costs that should be considered in pricing decisions involves forward-looking thinking. For example, the relevant cost for goods in inventory is not what it cost to produce or obtain the inventory. The cost estimate used for pricing these goods should reflect the cost of replacing them less the inventory holding costs that would have been incurred if they would not have been sold. Thus, pricing goods sold out of inventory should be based on replacement costs rather than acquisition costs. If the goods are not going to be replaced in the cost of acquiring them should properly be viewed as sunk and not relevant for pricing decisions.

An effective cost analysis also can be valuable in determining the optimal design of product and service offerings. It is not uncommon for product and service offerings to contain features that are unprofitable in the sense that customers are willing to pay less for them than it costs to provide. A cost analysis makes it possible to identify features, products or services that can be unbundled or omitted.

A cost analysis can be extremely valuable for businesses that utilize cost driven pricing rules due to the necessity of pricing a large number products or extreme difficulty in estimating the willingness to pay of customers. By including indirect and intangible costs and competitive benchmarking, a cost analysis can greatly improve the way markups are set and the pricing processes of firms that use cost as a primary foundation for setting price.
When combined with an estimate of demand and an assessment of competition, it becomes possible to reliably estimate the financial consequences of a new product launch or changes in price and product offerings.

A Case Example
(This case study is based on an actual analysis but names have been changed and details omitted to protect confidentiality)

OMG is a distributor of industrial products. Due to attempts by customers to reduce costs, OMG found its profit margin squeezed by increasing costs due to just-in-time fulfillment of smaller orders and value added services associated with delivery. A cost analysis indicated that a number of these activities cost OMG more than the value that they provided the majority of their customers.

To address this problem OMG decided to raise the markup on the products that it sold to customers who insisted on placing small just-in-time orders with the full complement of value-added services. They then offered discounts based on order size, which encouraged customers to place fewer and larger orders. They also gave discounts to customers who are willing to forgo some of the value added services that OMG found costly to provide. These pricing changes were accompanied by an education campaign on the part of OMG's sales force to demonstrate how customers could save money under the new pricing policy.

These changes allow to OMG to reduce their costs and pass along some of the cost savings to their customers. OMG was able to retain most of their customers. However, they did lose some customers who wanted to have full-service the switch to competitors who provided full-service and lower prices. OMG's profits increased significantly even though was serving a somewhat smaller market, while competitors saw their profits fall as the high cost, high maintenance customers switched to them.

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