Product Pricing Based on Burdened Cost
The classic method for developing a product price is to combine the direct cost of a product with a robust overhead allocation, and then add a profit margin to derive the price. This approach is based on the belief that only by covering all costs can a company set prices that will yield supportable profits over the long term. This full absorption method does not sit well with the sales department, which is continually being hounded by customers to offer lower prices in exchange for large-volume orders.
Product Pricing Based on Throughput Analysis
When reviewing pricing from the perspective of throughput analysis, a different pricing model presents itself. The theory behind throughput is that any price that exceeds the totally variable cost of a product should be considered, since it will generate some profit for the business. In essence, the customer order that offers the highest throughput and uses the company's bottleneck operation the least is to be favored the most, while offers resulting in less throughput and more bottleneck usage receive a lower priority.
Thus, throughput-based pricing offers the sales department a much broader range of possible pricing options, which will constantly vary depending on which products are being sold and the prices being offered. Further, no approval is required by a cost accountant, nor is there a complicated formula to complete. Instead, the process is:
- Subtract the totally variable cost of a product from the proposed price to determine the total amount of throughput.
- Discuss the proposed order with the production manager to see if the order can be processed in a timely manner without impacting any other orders that produce more throughput.
Example of Throughput Pricing
Ambivalence Corporation has received an order for some bat-wing potion, at a price of $5.00 per ounce. Ambivalence applies an overhead charge of $2.00 to every ounce of potion produced; when this amount is added to the $3.25 variable cost of the potion, the cost accountant recommends rejecting the order. However, the financial analyst applies throughput analysis to the concept, and realizes that the order will generate $1.75 of throughput per ounce sold, since the overhead charge is not included in the calculation. In short, as long as there is production capacity available, the sales manager should accept the order for the bat-wing potion.
Problems with Throughput Pricing
Some objections have been raised to the use of throughput analysis in the derivation of prices. These objections are:
- If many orders are accepted at low price points, not all expenses will be covered, resulting in losses over the long term. This is true, if a large proportion of orders are sold at low price points. However, if price points are higher for most orders, and throughput analysis is only used to fill any remaining unused production capacity, it can incrementally increase profits.
- The cost of equipment setup is not included in the derivation of throughput prices, because these costs are not totally variable. The result could be the waste of a large amount of production time doing equipment changeovers for small orders. This assertion is not true, as long as the changeovers involve equipment for which there is excess production capacity. It is only an issue if the changeovers involve the bottleneck operation, in which case there would indeed be a negative impact on throughput. The result should be a willingness to accept a broader range of order sizes and product mixes, up to the point where the extra changeovers begin to create additional bottlenecks within the production process.
- If a company has entered into any contracts with the government that require it to offer the government the lowest price offered to any customer, then the sales staff should be mindful of the issue when offering prices to other customers when trying to take orders to fill up remaining production capacity.
Thus, there are some valid concerns involving the use of throughput-based pricing, which can be dealt with as long as the sales and production staffs are cognizant of how the method should be used.