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Burdened vs. Throughput Pricing

Product Pricing Based on Burdened Cost

Traditional cost accounting methodology holds that pricing should include fully absorbed costs plus an acceptable profit margin.  The reason for this thinking is that all costs must be covered by an adequate level of pricing, or else there will be no profit once all product and operating costs are subtracted from the total of all prices paid by customers.  The sales and marketing staff chafes under this approach, since it is sometimes confronted with offers from customers to buy large quantities of product at reduced prices – but the accountants will not approve the lower prices, even if the proposed price points exceed the variable cost of the products.

Product Pricing Based on Throughput Analysis

However, throughput theory holds that any price point that exceeds the totally variable cost of a product should be considered.  Proposed price points and unit volumes for incremental sales can then be included in a mix of current production activity to determine what the change will do to total throughput and the constrained resource.  If the result improves throughput and there is a way to handle the increased production volume, then the price point is approved.  Consequently, throughput accounting gives the sales staff a much greater degree of flexibility in setting pricing.  The sales staff does not need to wade through a complex absorption costing formula for each product that it needs to price.  Instead, all it needs is the proposed price, the totally variable cost of the product under consideration, and a discussion with the production scheduling staff to see if the proposed job can be scheduled into the constrained resource without hurting other scheduled production.

Example of Throughput Pricing

Tasmanian Chutney Company (TCC) has received a request for a special garlic-flavored chutney, at a price of $1.50 per jar.  TCC applies a standard overhead charge of $0.40 to each jar of chutney produced.  When this overhead cost is added to the $1.25 variable cost of producing a jar of garlic-flavored chutney, TCC’s cost accountant calculates that there will be a loss of $0.15 per jar, and so rejects the proposed order.  However, a throughput analysis of the pricing proposal is included in the following table of TCC’s various products, which shows a positive throughput of $0.25 per jar, because the overhead allocation is ignored for pricing purposes.  Thus, TCC should accept the offer if there is sufficient production capacity to handle the order.

Problems with Throughput Pricing

There are several objections to the exclusion of overhead costs from the pricing formula.  First, it may result in extremely low price points that will not allow a company to cover all of its expenses, which results in a loss.  Over the long term, this is an accurate assessment.  However, in the short term, if a company has excess production capacity available and can use it to sell additional product that generates throughput, then it should do so in order to increase profits.  If its production capacity is already maximized, then proposed sales having lower throughput levels than items already being manufactured should be rejected.

Second, traditional accounting holds that a small proposed order that requires a lengthy machine setup should have the cost of that setup assigned to the product; if the additional cost results in a loss on the proposed transaction, then the sale should be rejected.  However, throughput accounting does not include the cost of setups in the totally variable cost of the product, since it assumes that the company’s existing production capacity can absorb the cost of the incremental setup without incurring any additional cost.  Under this logic, if there is excess production capacity, then setups are free.  This approach tends to result in a company offering a much richer mix of order sizes and products to its customers, which can yield a greater market share.  However, this concept must be used with caution, for at some point the ability of the company to continually set up small production jobs will maximize its capacity, at which point there will be an incremental cost to adding more production jobs.

The third issue arises not from traditional cost accounting, but from federal government pricing rules.  If a company enters into a contract to offer products or services to the federal government at a certain predetermined price, a key provision of the contract will be that the government will automatically receive the lowest price offered by the company to any of its customers.  Consequently, when reviewing new pricing proposals, the sales staff should be mindful of how a new price point will impact any existing sales to and throughput arising from transactions with the federal government.

In short, throughput accounting results in more pricing flexibility for the sales staff, since a product’s totally variable cost represents the lowest possible price point, rather than a fully burdened cost.

Podcast

A discussion of throughput concepts is available on Episodes 43 through 47 of the Accounting Best Practices podcast.

Related Topics

Opportunity cost of operations
Sales department bottleneck
Theory of constraints
Throughput price setting
Types of constraints