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Cost price value estimate & the part played by Fixed Cost in the fixation of price

P.R. Sethuraman 
on 01 March 2018

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Cost is a fact incurred in producing and maintaining; and determined from the producer's perspective to find out the cost of production in monetary terms so as to plan his business prospects.

On the other hand, price is normally determined on monetary terms by the seller considering the market conditions for the product and cost incurred in acquiring the products and associated manufacturing costs or rendering services. Price is ascertained from the consumers' perspective Prices of products increase or decrease in line with market conditions and time influence.

But, what's about value? It is based on perception and ascertained from the user's perspective through proper estimates based on the details provided and gathered.

Estimates, on the other hand, are interregnum for proper projection.

The breakup of cost classification:

Cost incurred is a fact and cannot either vary or change as to what is incurred but that cost has two dimensions- measurements - the first and foremost is 'Fixed Cost' and the other is 'Variable Cost'. The role played by 'fixed cost' in the fixation of price is paramount and supreme especially in depressed and highly competitive market. In this kind of situation, the part played by 'fixed cost is a game changer and a guide to fix a price in a volatile situation.

Price and the role of Fixed Cost in the fixation of price:

As spelt out earlier, price is a policy that strategizes the fixation of price properly stitching to a particular environment. That policy is the 'key for the success of any business. How to go about is the real time test for the success of any management in running a business. This is equally valid for administering a profession especially when it is confronted with any legal modification that unsettles an established situation disturbing traditional clientele.

Price, therefore, includes fixed cost, variable cost and profit margin and hence, has necessarily to be fixed covering all the cost and the profit margin expected on them. As has been highlighted earlier, it is 'easier said than done' in all the circumstances for reason environments change on 'the dictates of time' and the policy of price is to be tailored   to the changing environment. That is where the effective role of management is tested.

Big ticket contracts/ professions:

Again, pricing of capital goods and even big ticket professions with full-size bills like auditing profession is a different cup of tea even when the role of fixed cost is a major player. Here, apart from the above, 'strategy' and business contacts are the prime motivators in securing orders - emanates from the proper confidence level of the clients in the secured execution of the order of the contractors/ professionals based on market standing.  

Whether advisable to sell at less than the Cost of production and is when?

There may be situations unleashed whence it would be difficult to recover the entire cost, not to speak of any profit. In such circumstances, what should be the management policy?  That's a thousand dollar question to be addressed! Would it be advisable to shut the business or postpone the production?

If the intention of the management is not to quit the business/profession altogether, will it not inflict additional cost of bearing the entire fixed cost if there is no production to absorb at least a portion in a disturbed situation to slice/ limit the loss ? That is where 'fixed cost' will play a key role in shaping the fixation of the prices in different situations to tide over the difficult positions.

Unique Character of Fixed Cost:

For that, we should know first what are 'fixed expenses'? The nature of 'fixed expenditure' is such that, it  is significantly fixed in amount up to a particular level of production and hence, the incidence per unit varies inversely with the volume of production. If we think in leisure as well in resolute, the name crowned to 'fixed cost' appears to be a 'misnomer'  for reason the incidence of fixed cost varies in proportion to the volume of production---cost per unit will vary with the level of production; and this inbuilt character gives resolutions and direction in fixation of prices indifferent circumstances.

Price Structure of A commodity:

Let us go by an illustration. Mr 'A' produces commodity 'C' for sale.  'A' fixes the selling price based on the present level of sale of 40,000 units per annum against production capacity of 50,000 units with the present installed capacity and other associated fixed cost.

Fixed cost                            Rs. 6 (based on the current sale- level as indicated above)
Variable -Cost                     Rs. 12.
Profit margin, say                 Rs.  2              
Selling Price                         Rs.  20            

Where Discriminatory price is Possible?

Let us assume Mr 'B' a new client agrees to buy further 10,000 units provided it is sold to him at Rs.16 per unit.  Now, what will be the decision of 'A'? On a plain look, it is not a profitable deal while a deep study will unfurl a different story/ judgement. Since MR. 'A' has an unutilised capacity of 10,000 units, there is an ample scope to further profit if he is able to sell at any price more than RS.12 per unit.  That is where pricing policy should play its role. Isn't?

Where discriminatory price is not possible?

Let us examine another circumstance where it would be extremely difficult to have discriminatory prices among customers without disturbing the existing patrons- then what should be approach for level playing.

The following table will highlight the problem in fixation of price.


Sr.No

Narration

Based on 50,000 units

Based on 40,000 units

1

Sale Value per Unit

RS. 9,50,000 @RS.19 PU

RS 8,00,000 @ RS.20 PU

2

Less Variable Cost

RS.6,00,000 @RS.12PU

RS.4,80,000 @RS.12 PU

3

Contribution

RS.3,50,000

RS. 3,20,000

4

Less Fixed Cost

RS.90,000

90,000

5

Profit

RS.2.60,000

RS. 2,30,000


A bird's eye view of the above chart will without doubt bring out that the reduction in price contributes in augmenting the profit.

Pricing at extreme moment:

In running a business, there may arise some intimidating situations when a business man may have to take an extreme call to tide over the threat from the competitors to uproot his business if he has to be in the line of business. What is the way out? If he has to survive in the line of business, he may have to take at times an extreme step of 'dumping' in order to drive away the competitors in order to protect his skin. Here also, the part played by fixed expenditure is distinctive. So long as he is able to recover the variable costs and makes some contribution to relieve the burden of fixed cost, he has to manage the pricing to sustain in the business. But, it is a short-term arrangement to turn over the situation.

Whether the philosophy of pricing applicable equally to professional or labour contacts?

The above line is relevant for all lines of business whether of manufacturing, professional income or labour contract etc., but has to be stitched according to the situations to guard against itches developed or confronted. As has been stated earlier, this is equally valid for administering a profession especially when it is confronted with any legal modification that unsettles an established situation disturbing traditional clientele. For brevity, it is not elaborated.

 Can we attempt a formula?


SR.No

PAST

PRESENT

1

 Let Q1 represent  Quantity handled

Q2 represent  Quantity handled

2

Let F1 represent  Fixed Cost- PU based on Q1

F2 represent Fixed Cost- PU based on Q2

3

Let  V1 represent  variable cost PU

V2 represent  variable cost PU

4

Let FA1 Total Fixed Expenditure Q1 handled

Let FA2 Total Fixed Expenditure Q2 handled                                                          


Fr1 = FA1/Q1
Fr2 = FA2/Q2

Vr ---- Change in variable cost PU  = V2-V1

To fix the price change in rate to be considered = (FA1/Q1 -FA2/Q2) - (V2 - V1)

In the above formula, 'adverse' change may be indicated by 'minus' symbol and favourable change may be indicated by 'plus' symbol.  If the above formula is adopted, with adjustments for other factors - internal and external, that will throw light on the extent of price/rate increase or decreased.

Value---Profit or gain:

Value is a perception as dealt with earlier. Let us suppose 'X' buy a land at a remote place with no much of value. All of a sudden, let us assume a popular cine star has purchased near the land. What happens to the value of the land? Undoubtedly, the price shoots up.  What is the contribution of 'X' in the shoot-up except for his original investment? Let us further assume that an airport is coming nearby.  Without any doubt, the price jumps by leaps and bounds. What is 'X' contribution except original investment nothing further. Let us assume further that a big industry is coming nearby. The natural consequence is a quantum jump in price. Here again, 'X' contribution is nothing additional. Here, it is the society that has contributed and hence it is value heap with attended capital gain and not profit that is normally the result of once effort in business or profession.

Mahatma Gandhi is neither conferred Bharat Ratna nor Nobel Prize but he does not lose any value but the decorations lost the lustre. If I recall, that was what I have written in the visitors' book when I visited his birth place in Porbandar.  That speaks of the real value.

In share market, apart from market value, one should strike a balance between risk and return and at times one yells it is a surmise/guess bordering on astrological predictions. 

Value is not price but a 'prize' that it commands whence it is up!

Though valuation is done very often in the business environment, it is on the basis of various   norms and then valuation is struck with proper weight age to various methods like Net worth, market value, weighted average method and so on basically an opinion based on various logical assumptions and presumptions. Let us deal this in an exclusive article.

Estimates:

Assumptions are based on estimates. To estimate one should be well versed in and on the subject. On the top, he is posted of all the information connected with estimates.  Before the dawn of civilization, husbands and wives were sleeping on 'mats' whence they became 'mates' that facilitated to estimate each other since highly inter connected. Mr.Dhoni is known all the team 'mates' in nuts and bolts and hence can decide the rotation of batsmen, bowlers and fielders as warranted by the situations. Class mates know each other and hence decide a particular 'mate' for consulting on a specified subject. What it suggests is to estimate on an assignment, he should be thorough with back ground experience that will only ensure the creditability of the estimation.

Conclusion: 

Cost, price, estimate and value are valuable ingredients in the context of pricing and valuation.  While price is basically based on cost, valuation is based on appraisal, evaluation, estimation and its projected utility. At times, it is a 'prize' rather than a 'price' for the assignments in value. Price arises through and by well defined policy; valuation awakes through insight into dependable appraisal, evaluation, estimation .its projected utility based on proper judgement; and stop not till the goal is achieved (until a more reliable route found to achieve the goal).


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