Traditional accounting pricing tools are not fit for the 21st century - Essay Example

? TRADITIONAL ACCOUNTING PRICING TOOLS ARE NOT FIT FOR THE 21ST CENTURY of School INTRODUCTION Since the production of the goods had started the price has been a great matter of concern for both the sellers and buyers. The producers and sellers have been coming up with different pricing techniques and strategies that they found perfect in the scenario they are working. With the change in time and modernization of the society, it has become evident for the sellers to adopt new and better pricing strategies to compete well in market and keep up with the expected prices of consumers as the consumers are always having a wider choice of companies to buy the product that they want in most of the cases. Basically the accounting functions may help in price determination in this modern market place because the accounting functions allow record keeping of all business transactions making it possible to easily estimate the costs and then calculating the prices to be charged accordingly. Several pricing tools have been introduced for sellers and producers in order to the prices for their products effectively. Accurate pricing is very important for each company in order to attain the long term profitability for the company. It is necessary that the objective of the pricing strategies adopted by a company should be a sign of the complete marketing plan of the company. A pricing strategy adopted by the company should be chosen in a way that it helps in maximizing the profits for the company by stabilizing the sales and attracting the potential customers in market (Gitman 2003, 57). To determine the price of a product, it is greatly necessary for the company to take in account all the expenses made in the production of the good and that add up to the cost of production. The proper and complete consideration of the all the variable and fixed costs would allow the producer to decide over the right pricing strategy to be adopted also taking in consideration the market trends (Glueck 1980, 153). The producers then utilize the pricing tools in order to determine the right price for their product. The key feature of any business is to determine efficient pricing strategy, which plays a vital role in order to make the customer perception about the business or product. There was an era when manufactures used to determine the price of the items and retailers simply had to follow it, differentiation would be dependent upon shopping experience, convenience, product range, ambience and quality of service of the retailers (Mankiw 2009, 69). The current market of today globally experiences several fluctuations due to which traditional financial models that used to develop keeping in mind specific variables which were not specifically viable. Hence in order to cope up with the modern requirements of the market and in order to cope up with the fluctuations and randomness of the market new concepts needs to emerge. It is often observed from the past that the changing requirements have forced experts to come up with the amendment in the existing models for financial calculation so that the environmental variables that are more significant would be included in the calculations and the variables that are not relevant or are not highly significant would be eliminated from the model. In order to study the effectiveness of the traditional accounting methods and the need of modern accounting method, it is important to analyze the environmental variables of the current market so that the current pricing strategy is appropriate (Ross, Westerfield, and Jordan 2009, 183). The traditional pricing methods are more focused on customers that are time oriented or money oriented where for some customer’s convenience is the most important factor and for others, price is the most important factor. Apart from these two customers there are some proportion of quality conscious customers as well who seek quality at any cost. The correct pricing strategy actually depends upon the nature of the product as well and the supply and demand state of the product (Leamer 2009, 210). This concept of traditional pricing strategy is called loyalty-based pricing technique. This technique allows the providers to categorize customers into two different segments which are regular customers and occasional customers. The pricing strategy utilized in the past can be studied through four key strategies which are Hi-Lo Pricing, Every Day Low Price, Profit Up Front and Access Pricing. 1. Hi- Lo Pricing In order to make differentiation some retailers start reducing the prices of the key products which attracts more customers into their stores, which instinct them to buy other products too. This pricing strategy born and quickly become norm, it brings excitement into the shopping which leads the customer to go again for shopping due to exceptional bargain. The retailers earn little profit, or even sometime book losses but only increases the revenue in term of increase the sales of other product lines. 2. Every Day Low Pricing Every Day Low Pricing or EDLP is another approach that is focused on shoppers who are indecisive when they see lots of options available to them. This approach simplifies the shopping of too many products where the retailers offer the lowest possible price for each product in a specific category and as a result to this, the low price seekers get the best value out of their shopping. This eventually saves a lot of time of such shoppers that compare products with another in terms of price and quantity. Although for some shoppers this pricing technique seems boring where options are minimal, however the amount of time which the people are able to allocate in their busy schedule this approach is highly popular and successful especially in modern trade retailers where shoppers are able to get all in one roof. 3. Profit Up Front Profit Up Front or PUF is another pricing technique that incorporates two of the above discussed techniques which include Hi-Lo pricing and Profit Up Front Pricing, in this concept the profit margin within the value chain is low and the end consumers are able to buy products at almost wholesale. However the profits to the producers are generated through monthly or annual membership that every consumer who purchases has to pay. This from the providers’ end may not look much profitable and would seem profitable to shoppers but realistically it is profitable for the providers since the technique provides upfront profit to the providers prior to any purchase. 4. Access Pricing Access Pricing is a modern method which has been developed keeping in mind the requirement of the modern shoppers. Access pricing works on customer-loyalty where the shopping is based upon points that are gained by the shoppers through purchasing regularly or occasionally. Huge discounts are offered to the customers when they earn specific points. This technique has bilateral benefits where the customer gets the benefit of discounts on their selected products whereas for the providers loyal-customers are gained who return frequently and ensure profits in the long run. 5. Cost Plus Pricing Cost Plus Pricing is one of the traditional methods of pricing where the costs incurred in manufacturing the product such as direct material cost, direct labor cost, factory overheads and other overheads are calculated for a unit price of a product and then a profit margin is added to the cost where the actual retail price is generated. This is one of the simplest methods used by traditional price setters to set the price. This pricing technique although assured profits on the sales however many variables that influence the product market position and competition among the competitors are neglected due to which this pricing technique is unable to compete with the modern results. Marginal Costing: On the other hand marginal pricing approach focuses on the variable cost of production and does not take into account the fixed cost of production. Variable cost of production is defined as those cost of production which vary with the level of production and therefore are directly proportional to the level of products manufactured. These include direct material, direct labor and direct overheads. Each extra unit of product is therefore only likely to incur additional direct cost with no impact on the fixed cost of production. Fixed cost of production is therefore considered as period cost and is not allocated to the product on any basis. They are rather written off in profit and loss account after the calculation of gross profit to arrive at the net profit figure. A margin or a markup is added to the direct cost of production to determine the marginal cost for products that are used to price using marginal costing. The basic impact of using marginal form of pricing is that inventory is valued at a lower level and the profit figure is different from that under absorption costing due to difference in opening and closing inventory. Although the pricing method is feasible in the short run as additional units of product have no impact on the fixed cost of production they are not suitable in the long run where firms have to cover both the fixed and the variable cost of production. This form of pricing is only suitable where there is additional or extra capacity and the product’s production does not result in any additional fixed cost. Furthermore, the complexity in costing means that it is very difficult to draw a line between fixed and variable cost and this could distort results under marginal costing. Decisions based on marginal costing tend to be short time whereas the pricing strategy adopted by a company is usually based on long term and therefore marginal costing may prove to be unsuitable. Although marginal costing or sometimes known as relevant costing plays an important role in decisions concerned with outsourcing or producing in-house it fails to consider qualitative factors such as customer goodwill and the level of quality. Thus pricing decisions under marginal costing are only relevant where the pricing strategy aims to undercut competition given excess capacity is present in an organization. Absorption Costing: Conversely, absorption costing is based on allocating all overheads to product cost irrespective of their nature that is whether they are fixed or variable. Initially all direct cost associated with the manufacturing or selling of a product are attributed to it while the indirect cost are apportioned based on either the production or the sales figure (Arens, Beasley, and Elder 2009, 131). Overheads may also be apportioned on the basis of direct labor hours or a factory-wide absorption unit. This method aims to calculate the total cost incurred in the production and thus the selling price is likely to cover all fixed and variable cost while also making a contribution towards the profit. Despite the fact that price based on absorption costing results in a selling price above the cost figure the allocation of indirect overheads is arbitrary and sometimes might lead to distortion of cost figures. The overheads allocated are not correlated to their cost drivers and this might result in selling price that do not in reality cover the cost of producing and selling a product. Under absorption costing, the marketing strategy might be heavily impacted as decisions of expansion or reduction of product line would be made on misleading information provided by the costing system. Moreover, as with other traditional methods customer’s perception demand elasticity and competition is not taken into account. Transfer price: Given the era of globalization and the spread of organizations across the borders the method of transfer pricing has gained increased importance. Transfer pricing is essentially used within multinational companies where there are several transactions between related entities in respect to goods, services, rents, loans and property transfers. Traditional methods of cost accounting resulted in an improper calculation of selling price between entities which enabled them to transfer profits and thereby save tax. In order to save tax MNCs would calculate the selling price and transfer profits from high tax countries to low tax countries. This method enabled them to save on consolidated tax and thereby present a better financial picture to the shareholders. Under the transfer pricing approach related entities must transfer goods to each other at a selling price that is defined under an “arms-length “standard. Under this condition the seller must charge a price that it would have charged to an independent buyer without the existence of a relation between entities. In other words transactions within a group must be made at a selling price that would have been charged under third party transactions (Kumar, & Sharma 2005, 77-78). Under the transfer pricing approach MNCs would not be able to manipulate their financial statements in respect of sales and tax figures. In order to ensure that the price charges by subsidiaries are in line with the principles enshrined under transfer pricing various testing methods are adopted. These include the Comparable Uncontrolled Price (CUP) whereby a third party is consulted to identify the price charged for goods and services given the same market and contract conditions. Mark up percentages may also be compared in order to ensure the correct selling price. Resale Price Method may also be adopted whereby discount percentages are compared in order to determine the appropriate transfer price (Wessels 2000, 163). Transfer pricing may also be adopted within an organization where there are various departments and the output of one department may be the input of another department. In such cases where products are transferred from one department to another the company might adopt a transfer pricing approach. The transfer price would be based on the excess capacity and the opportunity cost of the given product. Where there is excess capacity the transfer price would be based on relevant costing whereas full capacity would result in market price to be adopted. If there is another opportunity present for selling the product the transfer price would be based on the opportunity cost of transferring the product in-house as opposed to selling it in the market. Modern Pricing: The limitations of traditional costing and pricing methods within the accounting system have now been widely criticized and modern pricing methods have now been implemented in order to overcome the limitations present within the cost plus, absorption and marginal pricing approach (Arnold 2008, 53). Target costing, Activity Based Costing and Value Based pricing methods are now recommended so that an organization is able to formulate a pricing strategy based on the conditions of the modern market. Target costing: The modern market conditions mean that the organizations must continually redesign their products if they wish to compete effectively. The products nowadays have much shorter life cycles than those previously launched and therefore the planning, designing and development stage have become crucial within all organizations. The most important issue faced by the management today is to implement cost reduction techniques during the initial stages of the product life cycle as opposed to cost reductions during the production process. A solution to this management problem is the implementation of target costing. Target costing is an accounting technique that is in contrast to the cost-plus pricing approach adopted by the organizations under the traditional accounting methods. The cost plus pricing approach starts with a calculation of the cost incurred in the manufacturing and selling of a product. Conversely target costing is based on the market price. Initially the organization would need to estimate the target market share that it wants to achieve for a given product. Once this is determined the organization would calculate an appropriate market price that would enable the product to achieve the desired market share. From this selling price, which is essentially based on modern market conditions the organization would deduct the estimated profit margin that it expects to make from the product. This would lead to the estimated cost that the product should incur in the manufacturing and selling process. The organization thus aims to achieve this cost figure by cutting cost during various stages in the product life cycle. Target costing approach intends to focus on the customers along with their willingness to pay the price as opposed to the traditional accounting approach where the primary area of focus is the suppliers. Under the target costing approach the customers demand for quality, reliability and price are incorporated in the production process beforehand that is during the research and development stage. Maximization of sales and profit can be readily achieved due to greater focus on providing maximum satisfaction to the customers. Target costing is stated to be much more flexible than the traditional accounting approach previously adopted by the organizations. The focus on cost reduction from the very start ensures continuous improvements within the process. Although initially the organization may not be able to achieve the desired cost, the target costing technique would enable the organization to set bench marks that would help the achievement of the target cost. Furthermore, these bench marks could be incorporated in the company’s balance scorecard which could ultimately help the organization to adopt a continuous improvement approach based on cost reduction. Under the target costing technique the organization would also be able to achieve cost reductions with the help of learning effect. The target costing technique is much more suitable for the modern day market place as opposed to cost plus pricing approach. The shorter life cycles, high research and development expense and intense competition requires organizations to adopt accounting approach that focuses on continuous improvement. However, the organization must ensure that the targets set for cost are not unrealistic else the workforce might be de-motivated. Furthermore, the data required for the calculation of target costing might be difficult to generate given the complexity of the market place. Despite its limitations, an implementation of target costing approach would enable the organization to incorporate cost cutting from the early stage of product life cycle. Activity Based Costing: Activity Based Costing (ABC) is an alternative approach to allocating overheads that essentially aims to identify a causal link between cost, product and activities. This approach tries to overcome the limitations present within the absorption costing method of allocating overheads. ABC method of allocating overheads is useful in organizations where overheads form a large proportion of the total cost. Under the traditional method the overheads are apportioned on an arbitrary method which usually results in misleading cost and selling calculation. While absorption costing technique uses a factory wide absorption rate, the ABC approach intends to allocate the overhead cost to the products based on their usage of support activities. The support activities that generate overhead cost mostly include cost of setting up production runs, cost of running customer service department, maintenance and warehouse cost. Rather than allocating overheads on an arbitrary basis, the ABC method uses cost drivers to allocate overheads. Cost drivers are defined as those factors that can be directly associated with the cost incurred. For example the set up production run cost is incurred as a result of number of setups and therefore this cost is allocated to the product based on the number of setups incurred in this specific product. For each support activity the ABC method identifies the respective cost driver and then the cost is spread over the cost driver which is then allocated to the product. The ABC system allows the organization to accurately estimate the cost of the product and thereby ascertain the market price. Another advantage of ABC system is that it allows an organization to analyze the different activities that incur cost and therefore implement cost-cutting procedures. For example an organization that has a large customer base is able to generate customer profitability analysis through ABC. Costs that are incurred as a result of after-sales service, delivery and customer service are exposed which could help the organization in identifying profit and loss making products and customers. The intense competition in the market means that organizations need accurate accounting information to make profitable decisions as any cost distortion can give a competitive advantage to the competitors. This aim can be achieved through usage of ABC system. Furthermore, ABC system also helps the organization to set selling price that ensures profitability as opposed to those determined under the absorption costing system. The focus on identifying the cost incidence of the activities also mean that the organization is able to identify those activities that create cost but do not add value. These activities can then be eliminated and quality of the product improved. ABC system also results in an analysis of activities that relate to cost of poor quality such as department of customer complaint, repair and rework department excreta. The information generated through the ABC system can then be used to lower down cost level and improve quality. Thus an organization by using ABC pricing technique is not only able to allocate overheads on a more systematic basis but also improve the quality of the product while also cutting down avoidable cost. Although the ABC system results in the organization to calculate the cost and selling price with a greater level of accuracy it is never the less time consuming and costly. The benefits that arise as a result of accurate cost information might be eroded by the cost incurred in implementing an ABC system. Furthermore, all overheads cannot be traced directly to services and products as some overheads are not incurred as a direct result of a specific activity. The change from a traditional cost accounting system might also not be acceptable by the employees and the organization might face employee resistance. Despite its limitations ABC accounting method is widely suitable for organizations that focus on customer satisfaction and produce both mass-marketed and niche-marketed products. The ABC system does not only provide detailed cost information but also highlights problem areas and therefore help the organization in improving efficiency and cutting overhead cost. Value Based pricing: The simplest and easiest method of pricing is the cost based pricing. However this form of pricing is based on pure accounting and does not take into account the price that consumers are willing to pay for a specific product or service. With the advent of technology and globalization the market place is no longer product based and organizations should price their product in a manner such that value is captured. Traditionally organizations used to launch products in the market based on research and development conducted. The market place was product based whereby customers were encouraged to buy products introduced by the organizations. However, nowadays the market is customer based whereby the organizations need to conduct market research in order to identify the needs of the customers and then produce the product accordingly. The selling price is primarily based on the value perceived by the customers as opposed to the cost incurred. This method of pricing also ignores the market competition and the prevailing market price and instead aims to identify the value that customers would be willing to pay for the product based on its attributes. The conventional method of costing intends to achieve the lowest possible cost for a given product or service. Through the value based pricing method the organization tries to implement the least-cost method of producing a product or a service that also satisfies the customer to the maximum possible extent. The value based approach is primarily based on identifying those activities that add value to the product while eliminating those that add unnecessary cost. An unnecessary cost can be defined as any cost that does not add value to the product or more simply does not make the product more appealing to the consumers. Value based pricing technique focuses on identifying what the customer want that is focusing on those aspects of the product that compel the customers to buy the product. In essence the firm tries to charge a price that correlates to the benefit that the product or service provides. Value based pricing approach tries to manufacture a product or service by creating a balance between three attributes generally valued by the customer. These three factors are namely quality (of the product or the service), price and appearance. For example a customer might value quality in a certain product and therefore might be willing to pay a high price for that product. Value based approach would then try to eliminate those activities that do not add quality to the product and are considered unnecessary. The analysis would result in various alternative approaches and the organization would select an approach that would not only improve quality but also results in least cost method. However, this technique is usually applied for products that are niche marketed that is where customers are willing to pay more for unique design or style of the product. The approach would largely fail in a market place where the competition is intense or where customers regard price as the deciding factor for buying a product or service. Comparison of traditional and modern methods of pricing: The traditional methods adopted by the organizations resulted in the departments to focus solely on the product cost. However the modern market place means that for any organization to survive the focus needs to extend towards the needs of the customers. The extreme competition means that the organization needs to maximize customer satisfaction and this can only be achieved if the organization switches from traditional accounting approach towards modern pricing approach. Target costing, ABC and value based pricing primarily focus on analyzing activities and eliminating non-value adding activities while improving value added activities. The modern pricing approaches are not only based on customer demands but also allow the organizations to implement cost cutting procedures that ultimately help the firms maximize profit. The traditional accounting approaches are largely criticized due to their ignorance of market condition and arbitrary overhead allocation. Conversely, modern pricing techniques focus on market conditions and allow the organization to reduce cost from the initial stage of product life cycle. Modern pricing methods increase the visibility of the cost associated while also imparting better knowledge of the profitability of various products marketed by the organization. The constant stream of information also allows the organization to implement continuous improvement techniques such as Kaizen, JIT and TQM which are essentially Japanese techniques for product improvement. Despite the fact that modern pricing approaches are more time consuming and complex there is little or no doubt that they are much suitable in the 21st century where product life cycles are much shorter and firms manufacture a diversified product range. CONCLUSION Pricing strategy is the main part of every business. For any business the key factor is to set a differentiating image in the mind of the customer and once that differentiating factor is set in the minds of the customer one can easily play on prices of the product. However for this purpose one needs to have a grip on appropriate pricing strategy to get the best results. Having considered two different kinds of pricing strategies namely traditional and modern pricing strategy it can be identified that there are two kinds of customers. There are few customers that are more interested in saving their time and money and quality for them is of least importance, whereas on the other hand there are few customers who will buy best quality product no matter what the price of the product is. In both scenarios pricing strategies plays a vital role to get hold of the customer and to get optimum profit from the product. In traditional methods of pricing organizations were mainly focused on how to maximize the profit regardless of considering demand of the people, however the arrival of modern pricing strategies has encouraged the organization to look beyond the cost approach and instead drive price based on values and notions conceived by the customers. For any business to survive in this era the key factor is to get into the minds of the consumer and to set their strategies accordingly and this is what modern pricing strategy solely works on. Thus the focus of the organizations should be to maximize the profit tactically keeping in mind the demands of the customers and to set such pricing strategy that is best for both the organization and from the point of view of customers. References Arens, A, Beasley, M, and Elder, R 2009, Auditing and Assurance Services: An Integrated Approach, Prentice Hall: New Jersey. 13 ISBN: 0136084737 Arnold, R (2008), Microeconomics, South-Western Cengage Learning: Mason, Edition:8, OH. Gitman, L 2003, Principles of Managerial Finance, Addison-Wesley Publishing: Boston. Retrieved March 1, 2012 from http://www.unisa.ac.za/contents/studyinfo/prescribed_books_06/undergraduate/business_management_06.pdf Glueck , W. 1980, Business Policy and Strategic Management, McGraw-Hill, New York. Jaffe, J 2007, Corporate Finance, Pashupati Printers Pvt Ltd: Delhi. Johnson, G., & Scholes K 2001, Exploring Corporate Strategy: Text and Cases. 6th edition, Prentice-Hall: London. Retrieved March 1, 2012 from http://www.kevinhinde.com/strategic/EC490%20Corporate%20and%20Strategic%20Management.pdf Kaplan, R, and Atkinson, A 1998, Advanced Management Accounting, 3rd Edition, pp. 128, Prentice-Hall, New Jersey. Kumar, R, & Sharma, V 2005, Auditing: principles and practices, Prentice Hall: New Delhi. Pp. 382, Retrieved March 1, 2012 from http://books.google.com.pk/books?id=3I2yT25BtWEC&dq=Auditing:+principles+and+practices+2005&source=gbs_navlinks_s Leamer, E. 2009, Macroeconomic Patterns and Stories, Springer – Verlag Berlin Heidelberg, Heidelberg. Retrieved March 1, 2012 from http://books.google.com.pk/books?id=XObELQuIWv8C&dq=Macroeconomic+Patterns+and+Stories+Leamer&source=gbs_navlinks_s Mankiw, G 2009, Principles of Economics, South-Western Cengage Learning, , Mason, OH. Retrieved March 1, 2012 from http://books.google.com.pk/books?id=EwhMBt-DvwYC&dq=Principles+of+Economics,+South-Western+Cengage+Learning+Mankiw&source=gbs_navlinks_s Ross, S., Westerfield, R., and Jordan, B 2009, Fundamentals Of Corporate Finance Standard Edition, McGraw-Hill: New York. Sekaran, U 2006, Research Methods for Business. John Wiley & Sons, Inc: New Jersey. Retrieved March 1, 2012 from http://www.seerc.org/docs/phd-resources/rt1-phd-resources.pdf Wessels, W 2000, Economics, Barron’s Educational Series, New York. Pp. 480 Read More