From the course: Accounting Foundations: Cost-Based Pricing Strategies

The Stice custom-made oak table

From the course: Accounting Foundations: Cost-Based Pricing Strategies

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The Stice custom-made oak table

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- Okay, imagine a big beautiful oak dinning room table. - Okay, I have it in my mind. - Big enough to fit your entire family you, your wife, all your children, all your grandchildren. - Wow, now that would be a big table because there are about 40 of us. - Perfect, now if you went into a custom bought furniture making company. How will they determine what price to charge you for such a table with personalized oak chairs for each person. - That would be difficult, that would be difficult because the wood furniture company almost certainly, would have never before made such a table. They would be priceless, they would say oak table with chairs sitting for 40 people. - Obviously, this is not a simple supply and demand market price situation. This is a unique customized product for which there is no clearly defined market price. - This is where Cost-Based Pricing comes into play. The starting point and setting the price for such a customized product is the production cost of making the product. - First, making the oak table will require some oak in a management accounting setting we call this cost direct materials. - This is the actual stuff that the item is made out of and this case is the wood. If we were making automobiles the direct cost would be metal and other things that go in the making automobiles. - The direct materials cost is pretty easy to estimate you describe the size the table and the design and the type of wood, oak in this case, and the experience wood furniture makers can figure out how much wood will be required. - But the wood doesn't form itself into a table. How many hours will it take the workers the skilled craft people to construct this table. - Again the company can estimate this labor cost pretty well because of its long experience making wood furniture of all types. - In management accounting we call these skilled craft people the direct labor people. They are the skilled people who actually do the work. - Direct materials cost that's the wood, direct labor cost that's the cost of the skilled labor. Now these two numbers are easy. Anybody who makes wood furniture can easily estimate the amount of direct materials. The amount of oak in this case that's required to make this table. - The number of hours required for the direct labor people to complete the table that's also easily estimated. - Okay are we done. If I go out in the desert somewhere with a pile of wood and some workers, do I have myself a nice oak custom made dinning room table. - Nop, you need some infrastructure, you need a building and some machines an electricity and some supervisors and some maintenance people. These costs are called Overhead costs. - And it's a bit more difficult to figure out how much of say the supervisors cost should be assigned to this table and that book case in the corner on the far side of the room and that desk. Overhead cost is difficult to trace to individual projects or processes or customers. - The three categories of product costs are; direct material, direct labor and overhead. The cost of direct materials and direct labor is easily traceable to individual products. Overhead is more difficult and so, merits careful consideration. - Until the wood furniture company knows the cost to make this oak table. The total cost it is not possible to generate a reasonable and justifiable selling price.

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