HND –Business Management

Managing Financial Resources

Analysis of Cost

There are many types of business costs involved in starting or running a business.
This article looks in detail different types of business costs.

Fixed costs:
Costs that don't change over a period of time and don't vary with output. E.g. salaries,
rent, tax, insurance, heating and lighting. Fixed costs can also be called indirect costs
as they are not directly associated with the final product. Fixed costs have to be paid
even if the company is not producing any goods.

Variable costs:
Costs that vary directly with output so when output increases, variable costs also
increase. E.g. raw materials, electricity. Variable costs can also be called direct costs
as they are directly associated with production.

Semi-variable costs:
These costs have fixed and variable elements. E.g. a person working for the company
may have a fixed salary but may also earn commission on sales.
Total costs are calculated by adding together fixed, variable and semi-variable costs.

Economic Cost: Also known as the "opportunity cost" is a payment made to obtain
the services of a resource which is at least equal to what that resource can earn
elsewhere.

Opportunity cost: It is the net return that could be realized if a resource were put to
its next best use. It is "what we give up" from "the road not taken."

Implicit costs: The monetary income that a firm gives up when it uses a resource that
it owns rather than buying it from the market. In other words implicit costs are
opportunity costs of owner owned resources including the services of the
entrepreneur-costs that are not paid but must be taken into account to estimate the
total cost

Explicit costs: The monetary payment a firm must make to an outsider to obtain a
resource.

Total costs: The costs of all resources paid (explicit) and not paid (implicit)

Accounting profit: Is the difference between total cost explicit costs

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Normal profit: Is the opportunity cost of the entrepreneur (owner) - the minimum
income that the entrepreneur must receive to perform the entrepreneurial functions for
the firm.

Economic profit: The total revenue of a firm less all its economic costs; also called
"pure profit" and "above normal profit."

Short run: A period of time so short that quantity of all inputs cannot be changed
and at least one input (usually the plant) remains fixed or unchanged. New firms do
not enter the industry, and existing firms do not exit.

Long run: A period of time long enough in which the quantity of all inputs can be
changed-increased or decreases. New firms can enter and exit the market place

Fixed costs: Costs of inputs that do not change in a given period known as the short
run.

Variable costs: Cost of inputs that can change even in the short run.

Relevant costs: These are costs that are relevant with respect to a particular decision.
A relevant cost for a particular decision is one that changes if an alternative course of
action is taken. Relevant costs are also called differential costs. Relevant costs are
decision specific, meaning that a relevant cost may be important in one situation but
irrelevant in another. They are also called incremental costs by accountants.

Sunk costs: These are costs that were incurred in the past. Sunk costs are irrelevant
for decisions, because they cannot be changed. Sunk costs are unrecoverable past
expenditures. These should not normally be taken into account when determining
whether to continue a project or abandon it, because they cannot be recovered either
way.

A summary of costs, revenues, and profits

Total costs = Rents + Wages + Interest + Normal profit

= Explicit costs + Implicit costs
= Fixed costs + Variable costs

Accounting profit = Total revenue (income) - Explicit costs

Economic profit = Accounting profit - Implicit costs

= Total revenue - (Explicit costs + Implicit costs)

= Total revenue - Total costs

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Cost plus pricing

One method used by businesses to determine how to price goods and services. This
type of pricing includes the variable costs associated with the goods, as well as a
portion of the fixed costs of operating the business. It is calculated as (average
variable cost + % allocation of fixed costs)*(1+ markup %).

For example, if a business sells a microwave that has a variable cost of $15.00,
a fixed cost allocation of $5, and a desired markup of 30%, the price of the
microwave using this method would be ($15 + $5)*(1+0.30), or $26

Advantages of cost-plus pricing

1. Easy to calculate
2. Minimal information requirements
3. Easy to administer
4. Tends to stabilize markets - insulated from demand variations and
competitive factors
5. Insures seller against unpredictable, or unexpected later costs
6. Ethical advantages (see: just price)

Disadvantages of cost-plus pricing

1. provides no incentive for efficiency

2. tends to ignore the role of consumers
3. tends to ignore the role of competitors
4. use of historical accounting costs rather than replacement value
5. use of “normal” or “standard” output level to allocate fixed costs
6. inclusion of sunk costs rather than just using incremental costs
7. ignores opportunity costs
8. contractors may not focus on performance because the cost is always
covered by the client

Activity Based pricing

A variant of cost-plus pricing that takes into account the specific resources required to
make a product. Instead of charging an arbitrary fee to cover fixed expenses, a
business would calculate the cost of labor, buildings, administration, and other inputs.
This type of pricing is more difficult to calculate than simple cost-plus pricing.

Target profit pricing

A pricing method that involves (1) identifying the price at which a product will be
competitive in the marketplace, (2) defining the desired profit to be made on the
product, and (3) computing the target cost for the product by subtracting the desired
profit from the competitive market price.

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The formula
Target Price - Desired Profit = Target Cost

Target cost is then given to the engineers and product designers, who use it as the
maximum cost to be incurred for the materials and other resources needed to design
and manufacture the product. It is their responsibility to create the product at or below
its target cost.

Value-Based Pricing

Definition: Value-based pricing is a method of pricing products in which companies

first try to determine how much the products are worth to their customers. The goal is
to avoid setting prices that are either too high for customers or lower than they would
be willing to pay if they knew what kind of benefits they could get by using a product.
Data mining software can play an important role in the process by helping users
segment their customers and define the value they receive.

Competition based pricing

Competition based pricing is a price set by a company for a product to compete with
another company's pricing. Production and distribution costs are ignored to drive
demand towards another brand. This method of pricing can cause a long-term
decrease in product perception and decrease a product's value for future profits.

Prepared by
P.Suthaharan