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Cost analysis and price analysis are two important procedures that are used by businesses to calculate the true cost of a product or service and determine the best sales price. By understanding and correctly utilizing these processes, businesses can make informed decisions on pricing their offerings. They can also discover ways to streamline their operations, increase prices, or reduce expenses to maximize profitability.
Cost analysis may also be used to determine the full cost of a proposed project or operational change, to help company executives determine whether the contemplated action is worth pursuing.
Proper management of costs and prices is essential to business cash flow and profitability.
What Is Cost Analysis?
Cost analysis is the process of analyzing the total cost of a product, project, or service. Financial professionals use cost analysis to compare the total cost of a product or service with the revenue it has the potential to generate. By analyzing costs, businesses can optimize their efficiency and ensure continued profitability.
Often there are hidden costs that companies fail to recognize without a thorough analysis. Some important considerations in analyzing costs are whether expenses are one-time or recurring, whether they are controllable or non-controllable, and whether they are fixed or variable.
What Is Price Analysis?
Price analysis is different than cost analysis and is the process of analyzing the pricing of a product or service to determine whether it is reasonable, competitive, and profit-making. This is typically done by comparing the price of a product or service against similar products or services in the market.
In any business, getting prices right is essential to success. Price analysis is important because it helps businesses to set prices that customers are willing to pay, while providing sufficient income to earn an adequate profit margin.
How to Perform Cost Analysis:
Below are the steps for performing a cost analysis.
1. Gathering Cost Data
The first step in cost analysis is to collect relevant information. This can be done by analyzing financial statements, conducting surveys, or analyzing production data.
2. Determining Total Costs
Depending on the product or service being analyzed, there may be several factors involved in calculating the total cost. Some of these are:
- Direct Costs. Direct costs may include raw materials, manufacturing expenses, storage cost, labor, fulfilment costs, shipping, credit card fees, sales commissions and more depending upon the industry
- Indirect Costs. Indirect costs may include electricity and other utilities, management overhead, selling costs, rent, and delivery expenses.
- Intangible Costs. In some cases, there are intangible costs such as regulatory compliance, dealing with competition, or the impact of processes on employees, customers, and delivery schedules.
- Opportunity Costs. There are times when it is necessary to evaluate the costs involved in a decision such as whether to rent or purchase equipment or whether to buy, rent, or build a manufacturing facility. A related concept is the differential cost, meaning costs that exist in one proposed scenario but not in another.
3. Performing the Cost Analysis
Once cost data has been collected, it is important to analyze it to identify problem areas, potential opportunities, trends, and patterns. Depending on the circumstances, one or more of the following methods may be incorporated in the analysis:
Activity-Based Costing
One method of cost analysis is the activity-based costing (ABC) method, which involves identifying the activities involved in producing a product or service and assigning a cost to each activity. This method is useful for identifying areas where costs can be reduced by eliminating non-essential activities, enhancing efficiency, or seeking less-expensive suppliers.
Marginal Analysis
Another method of cost analysis is the marginal analysis method, which involves analyzing the cost of producing additional units of an existing product or service or adding a new one. This method is useful for identifying the minimum revenue that a product or service needs to generate to be profitable.
Contribution Margin Analysis
Contribution Margin is the incremental income received for each unit sold after deducting the variable costs of selling the unit. This method reveals the “contribution” of each unit to covering fixed costs and is useful in calculating the company’s breakeven sales point.
Feasibility and Cost-Effectiveness Analysis
Additional methods include feasibility analysis, which helps determine whether an opportunity is worth pursuing, and cost-effectiveness analysis, which can help a business decide which of several potential options is best.
How to Perform a Price Analysis
The steps of price analysis are similar to those of cost analysis but focus on the revenue a product or service provides.
1. Gathering Pricing Data
As with cost analysis, the first step in price analysis is to collect pricing data. This can be done by looking at the prices of similar products or services in the market, conducting surveys, or analyzing sales data. Once pricing data has been collected, it is important to analyze it to identify issues, opportunities, trends, and patterns.
2. Evaluating the Competition
To succeed in the market, a company must provide exceptional value at a reasonable cost to the buyer. If a competitor offers a product or service similar to yours, you must be able to convince potential customers that your offering is better, cheaper, or both. Otherwise, your competitor will probably get the sale. It is essential, therefore, to monitor the market and keep track of who your competitors are, what they have to offer, and what their prices are.
A competitive edge does not have to be solely price-based. In fact, many companies succeed by charging premium prices and catering to a higher level of clientele. A price analysis can help determine the best strategy for your business.
3. Conducting the Price Analysis
As with cost analysis, there are multiple methods for conducting price analysis:
Cost-Plus Pricing
The simplest method of price analysis is the cost-plus pricing method, which involves adding a markup to the cost of a product or service to calculate the selling price. This method is commonly used in companies that face little or no competition, or in industries where the cost of producing a product is relatively similar across different manufacturers.
Value-Based Pricing
Another method of price analysis is value-based pricing, which involves setting the price of a product or service based on the perceived value that it offers to customers. This method is commonly used in industries such as software and technology, where the value of a product can be difficult to quantify.
Demand-Based Pricing
Some companies such as airlines and hotels use demand-based pricing, where prices fluctuate seasonally or in periods of high and low customer demand. Generally, the price rises to maximize profits when demand is high and goes down during slow periods to attract more customers.
Going Rate & Target Return Pricing
Other price analysis methods include going rate pricing, where companies such as gas stations offer nearly identical products and try to match each other’s prices; and target return pricing, where a company sets a goal for a specific rate of return on an investment and sets its pricing at the level necessary to achieve that target.
Benefits of Cost Analysis Combined with Price Analysis
Price analysis and cost analysis are important tools for businesses because they provide valuable insights into the true costs of products and services and the selling prices needed to offset those costs and make a profit.
By conducting both cost and price analyses, companies can make prudent decisions on pricing their products or services as well as identify areas where costs can be reduced or prices set for optimal profit.
For example, a manufacturing business can use cost analysis to identify areas where expenses can be reduced, such as using cheaper raw materials or streamlining the production process. The business can then use this information to do a price analysis and determine how to maximize sales revenue in a competitive marketplace.
Conclusion
Price analysis and cost analysis are important tools for businesses because they provide the information necessary to keep costs low and sales high. Ultimately, the goal of cost and price analyses is to help businesses differentiate their offerings, maximize their profitability, and maintain a competitive edge in the market.
To learn more, we encourage you to browse more articles on our blog, or for personalized information and analysis, schedule a free consultation with our expert CFOs.
About the Author
CARLOS BOWDEN
CFO
Carlos Bowden is a financial leader with experience in multiple industries and global locations, with proven expertise in driving measurable growth, visibility and accountability.