Definition of Shadow Pricing
Shadow pricing has two definitions, which are as follows:
- The assignment of a price to an intangible item for which there is no ready market from which to derive a price. Shadow prices are most commonly used in cost-benefit analyses where some elements of the analyses cannot be quantified by reference to a market price or a cost.
- The maximum price that a business should be willing to pay for one additional unit of some type of resource. This definition relates to the perceived benefit that management believes it can obtain from the additional unit. An example of this definition is the cost of paying overtime to employees to stay on the job and operate a production line for one more hour. Thus, if the result of keeping the production line running longer (the shadow price) exceeds the cost required to run the line, management should do so.
In the latter case, a shadow price can be considered the contribution margin that a business will lose if it does not engage in a specific activity.
Examples of Shadow Pricing
ABC International is considering turning over some of its excess property to the local city government, to be converted into a park. The alternative is selling the property to a developer who will convert it into an office park. ABC can assign a shadow price to the intangible asset that is the utility that city residents will gain from use of the park, and compare it to the proceeds the company could achieve from selling to the developer.
ABC International is considering paying its truck driver to work late in order to deliver a shipment to a customer early. Doing so may qualify the company for more business with the customer. ABC assigns a shadow price of $5,000 as the benefit of this improved relationship with the customer. Therefore, ABC should be willing to pay up to $5,000 to the truck driver to make the delivery.
Advantages of Shadow Pricing
Shadow pricing is useful for incremental decisions, when management needs to know the benefit associated with the cost of extending the usage of a resource.
Disadvantages of Shadow Pricing
A shadow price is frequently a guesstimate for which there is little proof, especially when it is applied to intangible items. In this case, a range of estimates can be used, with probabilities assigned to the most likely outcomes in the range. Even using a range analysis, there is a good chance that any estimates proposed will be incorrect, and possibly by substantial amounts.
Evaluation of Shadow Pricing
Shadow pricing is a limited concept that should only be applied to very specific financial analysis situations.