Cost-Based Pricing

In a previous post I glossed over the costs of production, taking for granted that they are familiar to most people.  I've since come to realize that production cost is not so obvious a topic, so it merits some delineation.  So be warned that what follows is going to be very tedious and entirely unnecessary to anyone who's taken an accounting course, but possibly enlightening (though no less tedious) to anyone who hasn't.

Cost-Based Pricing Model

When a producer sets a price in the market, he must consider the cost of production in order to remain financially viable, which includes more than the obvious cost of fashioning raw materials into finished goods.   The total cost includes variable costs, overhead, and cost of capital.   A few other items, required return and risk, are also considered - though not strictly necessary for the sustenance of his operation, it is generally necessary for him to sustain his interest in sustaining his operation, and thus merits consideration.

Variable Costs

The variable costs of a product are mostly straightforward, and can largely be derived from considering the components that are assembled to create the final product, as well as to the labor involved in its creation.

A simple example is the bread produced by a baker: each loaf requires a certain amount of flour, yeast, salt, and water an the amount depends on output - you need twice as much material to make two loaves as one, and a thousand times as much material to make a thousand loaves.

Waste and spoilage are costs related to risk, which will be considered later, but they are strongly related to variable cost because waste often occurs per-unit and spoilage results from purchasing more materials than are needed.

Labor is also said to be a variable cost, but it is not as flexible and is more subject to waste: workers generally demand a fixed wage rather than being paid by piece-count and, while it's possible to release a worker on a full-day or half-day basis, maintaining a consistent labor supply often requires paying idle workers.   So while labor can in theory be accounted as a fixed cost, it is usually more in the nature of an overhead cost.

Overhead (fixed costs)

The overhead costs of a product pertain to any cost that does not change regardless of the number of units sold.   This generally involves any expense that involves an item that is not delivered to the customer as part of the product.

Back to the example, the baker's oven and utensils are overhead costs as is the rent of his shop: regardless of whether he bakes one or a thousand loaves, these costs are still accrued.

There is often an attempt to calculate overhead costs as fixed costs - per the previous example, the amount of labor to create a loaf is often considered a fixed cost, but because his employees' wages are based on the number of hours they work rather than the number of loaves they produce, the cost is not truly variable though it can be made to seem so by accounting.

There is likewise an attempt to make the cost of equipment into an fixed cost, figuring that a mixing bowl will wear out and break in a year, during which time a certain number of loaves will be produced, and therefore its cost can be apportioned per loaf.   This, too, is an artificial calculated value that is not strictly accurate in reality.

While overhead costs are not strictly related to the volume of output, volume is a driver.   That is to say that the capacity of an oven is not infinite, and it can produce only so many loaves even if it is operated around the clock, and that if the baker's volume increases beyond that point he will need to purchase a second oven.

There are various ways to flex overhead costs, but for the most part they recommend a long-term commitment: to buy and sell an oven based on whether it is needed on any given day is possible if the equipment can be rented on a per-day basis, but most equipment rental is longer term; and while a purchased item can in theory be sold and repurchased, this is also not a common practice that suppliers will accommodate.

Cost of Capital

Costs of capital pertains to the interest paid on loans, which must be repaid from the profit of any activity that the loan facilitated.  For example, if a baker who needed a second oven took out a loan to obtain it, his cost is not merely the cost of the oven but of the interest owed on the money borrowed to buy it.

It is a common mistake to consider, as a cost of capital, any interest that might have been earned on financial resources that are tied up in the business (such the amount of bank interest that could have been earned on the cash in the register) or the amount of profit that could be made by entering another line of business (a better return on equity by selling off the bakery and operating a butcher shop).

These are both important costs to consider when making an investment decision, such as which kind of business to open or whether to sell off one business and start another, but insofar as the operating costs of a business, they are irrelevant.

Required Return

Required return is the amount of profit that the owner of a business expects to make by operating it.   Strictly speaking, it is also an investment decision that is not germane to the operation of the business, but it does influence the price at which merchandise is sold, and merits consideration.

The required return is the most flexible part of pricing.   The owner must make enough to cover fixed, variable, and capital costs to avoid bankruptcy.  He would very much like to make a profit on his investment, but it is not strictly necessary for him to do so, and a business can run at break-even for an indefinite amount of time, though few would care to invest in such an enterprise.

The opportunity cost of investment elsewhere, as mentioned in the previous section, is generally a driver of required return.   That is to say given an opportunity to buy a second oven out of cash (rather than taking a loan) must consider other uses that could be made of the money.  If it would be more profitable in another investment, the wise decision is not to invest in the business.  Conversely, if the business needs the money to increase its volume, it must offer a return higher than competing alternatives.

Risk Margin

The risks involved in a business also impact the cost of the product, but it's a gangly topic that can make an already tedious meditation completely unbearable, so I will try to keep it short.   However, it's necessary to mention because too many arguments of price and cost suffer from the "perfect world" fallacy in which everything can be known and flawlessly predicted.

Risk in variable cost relates to waste and spoilage: a baker who expects to sell 500 loaves a day purchase enough material to make that many loaves.  If his prediction is too ambitious and he has more flour than he needs, it will eventually rot and his expense will be wasted.  If the baker spills a sack of flour, the cost is likewise wasted in that it will not be recovered by selling bread that might have been made of that loaf.

The risk in overhead costs is twofold: the gross profit (the difference between the revenue and cost of each unit) may be insufficient to cover overhead due to low sales volume, and things that are included in the overhead may have a shorter lifespan than expected.   The owner must also elevate the price to cover this risk.

The risk of cost of capital is generally mitigated by fixed-interest loans, that assure the borrower he will pay a certain amount of interest.  If the financing is not fixed-rate, such as an expense charged to a credit card with a floating rate or credit obtained by a short-term loans that rolls over upon itself, then there is some risk to be borne by the owner, and passed along to the customers in the price.

And while the required return does not entail any risk, all of the above factors constitute a risk that the required return will not be achieved.   And since the desired return is higher when the risk is higher, it will have an impact on cost.

Finally, there is a species of risk wholly unrelated to cost, such as disaster risk: it can be as devastating as the cart being run over by a bus, the vendor being robbed at gunpoint, or as minor as a wind that blows a stack of napkins into a puddle.

None of this changes the fundamental structure of the costs, but it does factor into the calculation of price.

Putting it All Together

I'm going to refrain from posting a spreadsheet that shows a tabular accounting of all of the costs of production - the excursion has been so tedious that I have bored even myself - the point being that in determining the minimum price at which a producer can offer his goods for sale, all of these factors (and possibly others I have  failed to consider) must be tabulated and broken down to the unit level, based on a projected volume of sales.