Costing

I have been reading Cosentino's 'Case in Point' lately and yesterday I came upon this observation by the author - Cosentino presented an excerpt from an article that talked about pricing methods. Two main methods were enlisted - cost based pricing, and price based costing. In the former method, the company calculates all costs incurred in developing the particular product or service, and attaches its profit margin to that before selling it at the new price. In the latter, a company first calculates how much would a consumer be willing to pay for the particular product or service, and fixes that price while judiciously allocating resources to keep the costs in check below the price. He talked about why you see so many Japanese companies leading the Consumer electronics industry today as compared to American companies, which are quite few, as many of us would know. The reason presented in his analysis is that the Japanese companies practised price based costing while their American counterparts concentrated on cost based pricing.

Isn't it remarkable that such a seemingly trivial business strategy can either spell out to be a triumph or a catastrophe? Most of us are comfortable with the notion of cost based pricing. So let me focus on a pricing method called 'Activity based costing' for now, based on what I learn from Wikipedia. This method arose and became popular in the 1980s, primarily in the manufacturing sector in USA. The traditional cost accounting methods were designed somewhere around the 1870s and in those days the industry was labor intensive, devoid of automation, with a limited product variety and the overhead costs in companies were generally very low. Such costing methods began spelling trouble for companies in the 80s owing to their irrelevance to that time. Activity based costing came to the rescue of many companies during those times.

The main differentiating aspect about Activity based costing is that this method assumes that costs do not consume resources, but activities. Besides, this is a process oriented method, as against the traditional methods of pricing which were structure oriented. In the traditional methods, cost allocation held more importance. In the activity based costing scheme, it is assumed that costs cannot be managed; one can manage the processes and the costs will respond automatically. This affords a greater scope to companies to increase productivity, by proper supervision of production capacity in each process. Besides, traditional costing methods were labour intensive. Now-a-days in countries like USA and other European countries where labour is expensive, such costing schemes are inefficient for this reason too. In the new scheme, drivers are used to assign costs (Drivers are cost estimates at each process level - unit level, batch level, product level and facility level). There are two main types of drivers - activity drivers (which track how cost object behaviour effects activity levels) and resource drivers (which track how the activity levels influence resource consumption). the notion of fixed and variable costs is different too - a fixed activity cost is something that exists because of the sheer existence of an activity, and a variable activity cost is something that varies with the output of the activity. These notions of the costs make more sense than the traditional ones in modern day business.

Thus, account based costing can point towards the causes of costs by focusing on processes, which are critical success factors for any company. This makes the costing scheme a powerful tool towards a company's growth and success. Rather, it is a must-have these days.