ENTRE 4 PRICING AND COSTING MODULE 1

Cost vs. Price: What's the Difference?

Cost and price are often used interchangeably; however, the two words

mean something different when it comes to accounting and financial

statements. When conducting financial analysis or making investment

decisions, it’s important to understand the difference between cost and

price and how they impact a company's financial profile.

KEY TAKEAWAYS

 Cost is typically the expense incurred for making a product or service that is sold

by a company.

 Price is the amount a customer is willing to pay for a product or service.

 The cost of producing a product has a direct impact on both the price of the

product and the profit earned from its sale.

Cost vs. Price

Cost is typically the expense incurred for creating a product or service a company sells.

The cost to manufacture a product might include the cost of raw materials used. The amount of

cost that goes into producing a product can directly impact its price and profit earned from each

sale. Price is the amount a customer is willing to pay for a product or service. The

difference between price paid and costs incurred is profit. If a customer pays P10 for

a product that costs P6 to make and sell, the company earns P4 in profit.
Cost

Some companies will list the total cost to make a product under cost of goods sold

(COGS) on their financial statements. COGS is the total of direct costs involved in production.

These costs might include direct materials, such as raw materials, and direct labor for the

manufacturing plant. On the other hand, a retail store might include a portion of the

building's operating expenses and salaries for sales associates in their costs. For items sold

through a website rather than physical store, the expense of operating the website might be

included in costs.

Price

The appropriate price of a product or service is based on supply and demand. The

two opposing forces are always trying to achieve equilibrium, whereby the quantity of goods or

services provided matches the market demand and its ability to acquire the goods or service.

The concept allows for price adjustments as market conditions change. Every company must

determine the price customers will be willing to pay for their product or service, while also

being mindful of the cost of bringing that product or service to market.

For example, suppose that market forces determine a widget costs $5. A widget buyer is,

therefore, willing to forgo the utility in $5 to possess the widget, and the widget seller perceives

$5 as a fair price for the widget. This simple theory of determining prices is one of the core

principles underlying economic theory. Supply is the number of products or services the market

can provide, including tangible goods (such as automobiles) or intangible goods (such as the
ability to make an appointment with a skilled service provider). In each example, supply is finite

—there are only a certain number of automobiles and appointments available at any given

time. Demand is the market's desire for the item, tangible or intangible. The number of

potential consumers available is always finite as well. Demand may fluctuate depending on a

variety of factors, such as an item's perceived value, or affordability, by the consumer market.

The Bottom Line Though similar in everyday language, cost and price are two different but

related terms. The cost of a product or service is the monetary outlay incurred to create a

product or service. Whereas the price, determined by supply and demand in a free market, is

what an individual is willing to pay and a seller is willing to sell for a product or service.

DEFINITION OF TERMS

1. Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) refers to the direct expenses incurred in producing goods or services

that a company sells during a specific period. It includes costs like raw materials, direct labor,

and allocated overhead directly associated with production. For manufacturing companies,

these costs represent the monetary outlay required to transform raw materials into finished

goods. For retail businesses, COGS includes the purchase price of goods resold to customers.

COGS plays a critical role in financial analysis because it directly impacts a company’s gross

profit. Gross profit is calculated by subtracting COGS from total revenue, making it a vital

indicator of operational efficiency. A lower COGS relative to revenue implies better cost

management and higher profitability. Companies often analyze COGS trends over time to

identify inefficiencies or cost-saving opportunities in their production processes.

Accurately calculating and reporting COGS is essential for compliance with accounting standards

and for making informed strategic decisions. For example, an increase in COGS without a

corresponding rise in sales price may signal declining profitability. Hence, businesses must

monitor their COGS to ensure sustainable operations and competitiveness in the market.

2. Operating Expense (OPEX)

Operating Expenses (OPEX) are the day-to-day costs of running a business that are not directly

tied to producing goods or services. Examples include rent, utilities, office supplies, employee

salaries, and marketing expenses. These costs are essential for maintaining the overall

functionality of a business and are separate from the cost of goods sold.

Effective management of OPEX is crucial for a company’s financial health. While some operating

expenses, like rent and utilities, are fixed, others, such as advertising or travel, are variable and

can fluctuate based on business needs. By analyzing and optimizing these expenses, companies

can increase their net income without necessarily boosting revenue. This process often involves

identifying non-essential expenditures and reallocating resources to high-impact areas.

OPEX also plays a role in pricing strategies and budget planning. High operating expenses may

necessitate higher product or service prices to maintain profitability. Conversely, companies

with lean OPEX structures can offer competitive pricing, potentially gaining a market edge. OPEX

is typically reported in financial statements under operating activities, and reducing it

strategically can directly improve a company’s operating margin.

Supply refers to the total quantity of a product or service available for purchase in the market at

various price levels. It is a fundamental economic concept that directly impacts pricing

strategies and market dynamics. Supply can range from tangible goods, like cars or groceries, to

intangible services, such as consulting or education.

The concept of supply is governed by the Law of Supply, which states that as the price of a good

increases, suppliers are willing to produce and sell more of it. This is because higher prices often

result in higher profits, incentivizing businesses to increase production. However, supply is also

limited by factors such as production capacity, availability of raw materials, and labor

constraints.

Supply fluctuations significantly affect market equilibrium. For instance, a sudden shortage of

raw materials can reduce supply, leading to increased prices. Conversely, oversupply often

results in price reductions as businesses compete to clear inventory. Understanding supply

dynamics allows companies to anticipate market changes and adjust their production or

inventory strategies accordingly.

4. Demand

Demand represents a consumer’s desire to purchase goods or services and their willingness to

pay a specific price for them. It is a cornerstone of economic theory and plays a pivotal role in

determining market prices. Demand can vary based on factors such as consumer preferences,

income levels, and the availability of substitutes.

for it typically increases, and vice versa. This inverse relationship highlights the sensitivity of

demand to price changes, known as price elasticity. For instance, luxury items may experience

significant demand fluctuations with small price changes, whereas necessities often have

inelastic demand.

Demand is also influenced by external factors like economic conditions, seasonal trends, and

technological advancements. Companies monitor demand patterns to tailor their product

offerings and pricing strategies. For example, increased demand during festive seasons may

allow businesses to raise prices without losing customers, maximizing profits.

5. Equilibrium

Equilibrium is the state where supply and demand in a market are perfectly balanced, resulting

in stable prices. At this point, the quantity of goods supplied matches the quantity demanded,

ensuring that there is neither surplus nor shortage in the market.

Achieving equilibrium is essential for market efficiency. If supply exceeds demand, surplus goods

may lead to price reductions to encourage sales. Conversely, if demand exceeds supply, prices

may rise as consumers compete for limited resources. This balancing act ensures that resources

are allocated efficiently, benefiting both producers and consumers.

Equilibrium is dynamic and influenced by factors such as changes in consumer preferences,

technological advancements, and external economic shocks. Businesses must adapt to shifts in

equilibrium to maintain competitiveness. For example, during an economic downturn, demand

inventory.

6. Free Market

A Free Market is an economic system where prices are determined by supply and demand with

minimal government intervention. In this system, voluntary exchanges and competition drive

economic activity, promoting efficiency and innovation.

The free market allows businesses to operate independently, setting prices based on market

conditions and consumer behavior. This autonomy fosters competition, which often leads to

better products, services, and pricing for consumers. However, it also requires businesses to be

highly adaptive and responsive to market changes to remain viable.

Despite its benefits, the free market is not without challenges. Market failures, monopolies, and

externalities may require regulatory intervention to ensure fairness and prevent exploitation.

Nevertheless, free-market principles remain a cornerstone of modern economies, promoting

growth and individual choice.

7. Manufacturing Costs

Manufacturing costs are the expenses a business incurs during the production process to create

a finished product. These costs include three main components: direct materials, direct labor,

and manufacturing overhead. Direct materials are the raw inputs used in creating the product,

while direct labor involves the wages paid to workers who physically produce the goods.
Manufacturing overhead encompasses indirect costs such as utilities, equipment depreciation,

and factory maintenance.

Accurate identification and allocation of manufacturing costs are essential for pricing,

budgeting, and financial reporting. Companies typically track these costs on their income

statements, categorizing them as part of the cost of goods sold (COGS). This data helps

businesses determine gross profit, as it reflects the direct expenses associated with generating

revenue. Managing manufacturing costs efficiently can lead to increased profitability and

competitive pricing in the market.

Additionally, analyzing manufacturing costs can reveal areas for improvement within production

processes. For instance, reducing waste, improving labor efficiency, or negotiating better prices

for raw materials can help lower overall production costs. This ensures that businesses maintain

profitability while offering competitive prices, which is crucial in dynamic markets with

fluctuating demand.

8. Allocated Manufacturing Overhead

Allocated manufacturing overhead refers to the portion of indirect production costs distributed

to each unit produced. Since overhead costs such as electricity, rent, and equipment

maintenance are not directly tied to individual products, they must be allocated using a

systematic approach. This allocation often involves dividing total overhead costs by total

machine hours worked or labor hours spent during production.

reporting. It ensures that each product reflects its fair share of indirect costs, preventing

underpricing or overpricing. For example, if overhead costs are underestimated, products may

be sold at a price that does not fully cover production expenses, leading to financial losses.

Conversely, overestimating these costs could result in inflated product prices, reducing

competitiveness.

Businesses can use various allocation methods, such as activity-based costing (ABC), to improve

the precision of overhead distribution. By analyzing the actual drivers of overhead costs,

companies can identify inefficiencies and streamline their production processes. This

contributes to better decision-making regarding pricing, production planning, and overall cost

management.

9. Raw Materials

Raw materials are the fundamental inputs required to manufacture finished goods. They can be

categorized into two types: direct raw materials, which are integral to the final product (e.g.,

wood for furniture), and indirect raw materials, which support the production process (e.g.,

lubricants for machinery). Examples of raw materials range from steel, oil, and plastic to

agricultural products like corn, grain, and cotton.

The availability and cost of raw materials significantly influence manufacturing operations and

pricing strategies. Fluctuations in raw material prices, often driven by market demand,

geopolitical factors, or supply chain disruptions, can impact a company’s profitability. Businesses
frequently monitor raw material costs to ensure that price adjustments align with production

expenses and market conditions.

Efficient raw material management is vital for minimizing waste and reducing production costs.

This involves maintaining optimal inventory levels, sourcing from reliable suppliers, and

adopting sustainable practices when possible. In industries with volatile raw material markets,

companies may also use forward contracts or hedging strategies to stabilize costs and mitigate

financial risks.

10. Direct Labor

Direct labor refers to the wages paid to employees who are directly involved in the production

of goods or services. These workers perform tasks such as assembling components, operating

machinery, or crafting products by hand. Direct labor costs include not only hourly wages but

also benefits such as health insurance and retirement contributions.

Accurate calculation of direct labor costs is essential for determining the true cost of

production. This information helps businesses set competitive prices while maintaining

profitability. By analyzing direct labor costs, companies can identify areas for improvement, such

as enhancing worker productivity through training programs or investing in more efficient

machinery.

Direct labor costs are also a key factor in financial reporting and cost accounting. Businesses

allocate these costs to specific products or cost centers, ensuring precise tracking of expenses.
In industries with fluctuating production volumes, managing direct labor efficiently—such as

using temporary staff during peak seasons—can help control costs and maintain profitability.

11. Indirect Labor

Indirect labor refers to employees whose work supports production and business operations but

is not directly tied to creating specific products or services. These roles include administrative

staff, accountants, engineers, and IT personnel. Indirect labor costs are categorized as part of

overhead expenses rather than direct labor.

The importance of indirect labor lies in its role in maintaining operational efficiency and

supporting the production process. For example, engineers ensure that machinery operates

smoothly, while accountants handle financial management and compliance. Though not directly

involved in production, these employees are essential for the overall success of the business.

Managing indirect labor costs requires careful planning to strike a balance between operational

needs and financial efficiency. Companies may streamline workflows, automate processes, or

outsource certain tasks to reduce expenses. Proper allocation of indirect labor costs ensures

accurate financial reporting and helps businesses make informed decisions about resource

allocation and budgeting.

12. Cost-Plus Pricing

fixed percentage to its production cost. For example, if a product costs $100 to produce and the

company applies a 20% markup, the selling price would be $120. This method ensures that

production costs are covered while guaranteeing a profit margin.

Cost-plus pricing is straightforward and widely used, especially in industries with predictable

production costs. It provides a clear framework for determining prices and helps businesses

maintain consistent profitability. However, this pricing method does not account for market

demand or competitor pricing, which could lead to products being overpriced or underpriced.

To mitigate these risks, companies often combine cost-plus pricing with market research and

competitive analysis. By considering factors such as consumer preferences, economic

conditions, and competitor strategies, businesses can adjust their markup percentages to align

with market realities while maintaining profitability.