Lecture 5 Managing Finance.

Unit Costs & Pricing

Decisions.
Week
- 4 Shah
Lecturer:
Vijay

Unit Costs.

Unit Cost.
Definition:
A cost unit is a unit of product or service
for which the cost is computed.
BPP, Managing Finance, P167

Unit selected has to be appropriate to the business.

Expenditures related to that unit should be readily/easily calculated (1 litre

of paint for a paint manufacturer and cost of car for a car manufacturer
are obvious unit items that costs should be calculated for).

Care has to applied to selecting a unit e.g. A transport company using a

tonne of cargo will be inappropriate, as I tonne moved from Glasgow to
London would cost more than Glasgow to Edinburgh. A better unit might
be Tonne-Mile.
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Unit Cost contd

Floggles & Co. Make plastic food containers of different sizes.

The factory contains 2 departments:

Moulding Dept

Finishing Dept.

Each batch of 100 medium sized boxes uses 40Kg of plastic costing

0.6/kg
Labour time for each batch is 1.5hrs, paid at 8.20/hr
Hinges for boxes cost 15/50pairs. Each box uses 1 pair of hinges
Royalties are payable on the hinges at 0.10/pair used in

manufacture of the containers/boxes.

Each batch takes 20 mins to go through the finishing department

where labour costs are 9.60/hr.

Total factory indirect costs for the next period are 8,500.
200 batches of medium sized boxes will be made in the next

period.
60%

of the indirect costs are attributed to the Moulding

department, and 40% to the Finishing department.

Qu. Calculate the Product cost of a batch of 100 medium

sized boxes.

Fixed and Variable Costs

Definitions:
Variable cost is that part of cost which varies with
the volume of production (or level of activity).
Fixed cost is that part of cost which does not vary
with the level of activity or volume of production.
Semi-variable (or semi-fixed or mixed) costs are
partly variable and partly fixed.
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Fixed and Variable Costs

contd

Direct costs will rise as more units of product are made,

hence variable costs will depend on how much you make
Sales commission often varies with sales made, so this is
a variable cost with sales but not with production.
Telephone call costs are likely to increase with
increases/expansion o f the business. Hence they are
variable overhead costs, varying with production and
sales.
Rental costs of a business for a given period of time are
constant so these are fixed costs as they do not vary
with level of activity (production or sales) for that period.

Fixed and Variable Costs

contd

Andrew has a mobile phone where he pays monthly charge of 20.

Calls for the first 500 units are 5p/unit, and thereafter at 4p/unit for any
one month.
Work out the annual cost for Andrew for:
1. 250 units of calls per month
2. 600 units of calls per month

Cost Benefit Analysis

This is a method we all use all the time

E.g. If you were offered to work outside

normal hours for an extra 1/hr and this
meant coming in to work.

Then if your train ticket was 2 then it would

only be worth it if you were to work more
than 2 hrs.

Say you worked 3 hrs then:

Cost of ticket 2
Benefit of 3hrs of work 3
Net benefit of extra pay 1
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Cost Benefit Analysis contd.

There are problems with this:
Difficulty in identifying costs that are relevant to a
decision.
Some costs cannot be expressed in money terms. If
you were asked to do overtime at the week-end but
you had a sick parent that you needed to look after at
that week-end , how much would you value this at (if
not a dear relative then one might say at the cost of
getting some-one else to look after the parent).
Sometimes the Benefits can be hard to quantify i.e.
Benefit of working overtime might be the satisfaction
of finishing the job, how does one value this?

Relevant Costs- Definitions

The costs which should be used for decision
making are often referred to as relevant costs.
a. Relevant cost is a future costs
i.

ii.

A decision is made about the future; it cannot alter what

has been done already. A cost that has already been
incurred in the past is totally irrelevant to any decision
that is being made now.
Cost that have been incurred include not only costs that
have already been paid, but also costs that are subject to
legal binding contracts, even if payments due under
contract have not been incurred (these are known as
committed costs).

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Relevant Costs- Definitions

b.

c.

Relevant costs are cash flows. Usually related to depreciation.

Say you buy a car for 10,000 and you depreciate this over 4 yrs i.e.
2,500/yr.
This means you deduct 2,500/yr from your annual profits, this is
only a cost on paper. The real cost is 10,000 that got deducted from
your account when you bought the car.
Relevant cost is one which arises as a direct consequence of a
decision. Hence only costs which will differ under some or all of the
available opportunities should be considered; relevant costs are
therefore sometimes referred to as incremental costs or differential
costs.
E.g. If an employee will attend next week with no work to do at a
wage of 300. Then his supervisor might give him a job that will earn
a 40 profit. The 300 cost is irrelevant to the decision as this is a
future cash-flow cost that will be incurred irrespective of decision to
give him work or not.

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Non-Relevant Costs
These irrelevant costs for decision-making because they do not affect future
cash-flows or costs that will be incurred anyway regardless of decisions
made.
Sunk costs are assets already acquired but has no realisable value (i.e.
has not resale value or income value from any other alternative purpose).
Example: A company purchases a machine for 20,000 some time ago, it
has already been depreciated down to 7,000, but it has no resale value
due to newer better machines being available for that purpose.
The company is considering purchasing a new machine and scrapping the
existing one.
The current book value of 7,000 is sunk cost. The writing-off the machine
and incurring a paper loss of 7,000 is irrelevant to the decision-making
process.
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Non-Relevant Costs
Committed Cost

This is a future cash outflow that will be incurred anyway, no matter what decision is made
regarding alternative opportunities.
These may exist because contracts have already been entered to which there is a
commitment.
Notional Cost
Hypothetical accounting cost to reflect something for which no actual cash expense is
incurred, e.g.:
Notional rent which is charge to a business unit treated as profit centre but the building
is owned by the company
Notional interest charged to a business unit treated as profit centre but capital is made
available by the company head-office.
Note:

Variable costs are relevant costs.

Fixed costs are irrelevant costs.

Direct and Indirect costs may be relevant or irrelevant. E.g. Labour if paid irrespective
of work done or not is irrelevant cost, adding another person to the job would incur
costs hence this is a relevant cost.
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Pricing Decisions

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Price Leadership
Large corporations tend to be price leaders. Other smaller companies tend to follow the
leaders price setting. Leader often being the brand or quality leader.
E.g.
If a follower tried to raise the price above the price-leader and the leader did not follow
then the price increases would be halted.
Have you noticed that when 1 supermarket petrol station increases price the others
follow.

Market Penetration Pricing

This is charging low prices when a new product enters the market or is launched. This
is done to obtain sales or market share in order to penetrate the market. May be
appropriate in circumstances:
Existing firm wishes to discourage new firms entering the market
Firm wishes to shorten initial period of Products Life Cycle to enter Growth or Maturity stages
sooner.
To obtain economies of scale through high sales volumes
If demand is likely to increase due to fall in prices
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Market Skimming Pricing

This involves charging high prices when a new product is first launched, and
spending heavily on advertising and sales promotion to obtain sales.
As the product moves into growth, maturity and decline lower prices will be
charged.
Student exercise:
Can you name a product that incurred a higher price at launch, why do you
think the firm was able to charge the higher price?

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Price Leadership
This is where a large corporation with large market share emerge as price
leaders.
Price leader indicate to the price and competitors set their price with reference
to leaders price.
If lower level competitors raise prices above the leader and the leader does not
follow then its likely that competitor will eventually bring his/her price down.
Brand leaders are often cost leaders due to economies of scale etc. A market
with many similar suppliers to the market the weaker is the role of the price
leader.

Market Penetration Pricing

This is where company charges low prices in order to break into the market and
take customers from existing competitors in the market.

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Mark-Up Pricing
This where the company adds profit on top of the full product cost.
Student Exercise
Company budgets to make 10,000 units/yr with variable cost of 3/unit and
fixed cost of 60,000/yr. It decides to fix a profit margin of 33 .33333% .
Calculate the full cost and then the price of one product.

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References
Prepared by: John Owen & Vijay
Shah Essentials Supporting HND?HNC and Foundation Degrees.
Business
Managing Finance. BPP Learning Media.

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