COST-BASED PRICING

It is a pricing method that is based on the costs of a product or service.

To assign a price, following this pricing method, a fixed sum or a percentage of the total cost is added to
the cost of a product. This sum results in the sales price.

Cost + Fixed Sum or Percentage of Total Cost = Sales Price

This term implies the understanding of the value that consumers give to the benefits they acquire from a
product or service, it is important to consider it, since it also influences the setting of an appropriate cost
for the good.

To determine the cost price of a product, two general ways can be established:

a) Full cost or full cost

b) Partial cost or proportional cost

Full cost or full cost

This method consists of imputing not only the variable costs to the product, but also a proportion of fixed
costs under some distribution variable or variable convenient proxy. Here two scenarios can be
considered: cost of manufacturing single product and multiple product manufacturing.

Scenario 1: Manufacturing of a single product

Product cost = cost of raw materials

+ labor cost

+ indirect manufacturing costs

+ marketing cost

+ financial cost

+ administrative cost

= Total production cost

We will break down each of the concepts:

Cost of raw materials (MP): determined with the purchase cost (the price paid to the supplier) plus the
supply cost (transportation costs both internal and external, insurance, etc.)

Labor cost (MO): consists of the following costs:

direct costs: salaries paid to workers

indirect costs: social insurance, paid vacations, etc.

Indirect manufacturing costs (CIF): these are all expenses related to the production process (amortization,
maintenance and conservation expenses, among others) that cannot be objectively attributed to
particular operations, products or profit segments.
Consider a product whose costs are as follows:

Concept Cost
Raw materials (MP) $450
Direct labor (MOD) $200
Indirect manufacturing costs (CIF) $300
Administration, marketing, financial and $50
administrative costs
10% profit

In this case, the total production cost is mainly composed of costs variables:

Total production cost = MOD + MP + CIF

Total production cost (variable costs) = 450 + 200 + 300 = 950

Fixed costs are administration, marketing, financial costs, etc.:

Marketing, financial, administrative costs (fixed costs) = 50

Therefore, applying the product cost formula we have:

Product cost = CV + CF

CP = 950 + 50 = 1,000

According to the full cost process, our selling price is determined by the cost of the product and the desired
profit.

Selling price = product cost + profit

Selling price = 1,000 + (10%) 1,000 = 1,100

The selling price of the product will be $1,100, according to the cost method complete.

Scenario 2: Manufacturing of multiple products

When multiple products are involved, it is necessary to distinguish between those direct costs, which can
be easily attributed to a given product (raw material costs and direct labor costs), and indirect costs, which
cannot be easily attributed. Direct costs immediately affect the cost price and indirect costs are distributed
according to some imputation method so that a fair distribution is achieved, which is carried out based
on some proxy variable; It is always better that said variable be related to the value of the product and
not set arbitrarily. There are the following methods of assigning these costs:

a) Indirect costs based on direct labor It consists of assigning indirect manufacturing costs based
on direct labor costs.

It consists of allocating indirect manufacturing costs based on direct labor costs.

Rate = Indirect manufacturing costs (CIF) / Direct Labor (DL)

Establishes a relationship between direct labor and overall manufacturing costs. It does not take into
account that normally lower direct labor costs They entail higher indirect manufacturing costs. We
will illustrate this concept with the following example:

Let's assume the following data for the development of our example:

Concept Cost
Raw material for product A (52,350 units) $314,100
Raw material for product B (90,000 units) $540,000
MOD A $157,050
MOD B $405,000
CIF $750,000
Hours/machine A $26,175
Hours/machine B $135,000

The direct labor rate is calculated to allocate manufacturing indirect costs:

Rate = 750,000 / 157,050 + 405,000 = 1.33 = 133%

Therefore,

Costs Product A Product B

RM $314,100 $540,000
DL $157,050 $405,000
CIF $157,050 × 1.33 $405,000 × 1.33
Total cost $680,026.50 $1,483,650

b) Indirect costs based on the cost of materials and direct labor

Another method of allocating indirect costs occurs based on costs direct, such as direct labor and
raw materials.

Rate = Manufacturing indirect costs / Direct labor costs (MOD) + Costs of raw materials (RM)

Assume direct costs are $1,416,150 (MP A + MP B + MOD A + MOD B).

Rate = 750,000 /1,416,150 Rate = 0.5296 = 52.96%

Costs Product A Product B

RM $314,100 $540,000
DL $157,050 $405,000
Total $471,150 $945,00
CIF $471 150 × 0.5296 $945 000 × 0.5296
Total cost $720 671.04 $1 445 472
c) Allocation of indirect costs based on raw material costs

Due to the characteristics of our production system, a method of assigning Indirect costs may be based
simply on material costs. It is mainly used in companies where said materials have a relevant role
regarding production costs.

Rate = Manufacturing indirect costs (CIF)/Raw Material Costs (MP)

Raw materials = 854 100 (MP product A + MP product B) Rate = 0.8781 = 87.81%

Costs Product A Product B

RM $314,100 $540,000
DL $157,050 $405,000
CIF $314 100 × 0.8781 $540 000 × 0.8781
Total cost $746 966.64 $1 419 174

d) Product unit

In this case we will assign the indirect costs based on the total expected production.

CIF per product unit = CIF / Expected total production

Expected production of A = 52,350 units

Expected production of B = 90,000

General expenses per unit of product = 5.26 CIF per expected unit

Costs Product A Product B

RM $314,100 $540,000
DL $157,050 $405,000
CIF $52,350 × 5.26 $90,000 × 5.26
Total cost $746 966.64 $1,418,400

e) Machine-hour rate

A machine hour is the cost of processing a product or order in an hour. It is not an easy method to apply,
since it is only applicable when machinery operations represent an important part of the product cost.

CIF per machine-hour = CIF / Machine-hours

The total machinery hours planned for the period are 161,175.

Costs Product A Product B

RM $314,100 $540,000
DL $157,050 $405,000
CIF $26 175 × 4.65 $135 000 × 4.65
Total cost $592 863.75 $1 572 750
Partial cost or proportional cost

When only the direct or proportional cost is imputed to the price, the fixed costs or indirect are
considered as load or expenses of the period, derived from the existence of the company and
attributable to its production only indirectly (through the account result).

There are several types of partial cost:

a) Cost price = variable cost: Costs are divided into fixed and variable. The cost price is equal to the
variable costs, while the fixed costs are taken directly to the income statement as bills.

b) Cost price = direct cost: The cost price is calculated by dividing the costs into direct and indirect.
The direct ones are divided into variable and fixed ones. Variables are directly imputed at cost price
and the fixed costs are distributed among the different products. The costs Indirect expenses are
taken directly to the income statement as expenses.

c) Cost plus: Cost plus is a technique for setting the sales price, not the cost price. of the product. Said
price is obtained by adding the unit variable cost.

d) Sales price = variable cost + margin (fixed costs + profit) It is a method widely used in retail trade,
where the sales price of a product is calculated from the acquisition cost of the merchandise with the
sum of a fixed margin.