Allowable costs

Definition

Allowable costs are expenses that can be included in the calculation of a product's total cost and subsequently used in pricing decisions. These costs are essential in determining the price a company can charge for its products while ensuring profitability. Allowable costs play a significant role in strategies like cost-plus pricing and target costing, where understanding what costs can be factored into pricing is crucial for competitive positioning and market success.

5 Must Know Facts For Your Next Test

1. Allowable costs can include both direct and indirect expenses associated with manufacturing a product, such as materials, labor, and overhead.
2. Understanding allowable costs helps companies set prices that cover their expenses while achieving their desired profit margins.
3. In cost-plus pricing, the selling price is determined by adding a markup to the allowable costs, ensuring that all incurred costs are covered.
4. Target costing focuses on controlling allowable costs by identifying necessary reductions early in the product development process to maintain profitability at market-driven prices.
5. Accurate tracking of allowable costs is crucial for compliance with regulations and contracts, especially in industries that have strict cost accounting requirements.

Review Questions

• How do allowable costs influence pricing strategies like cost-plus pricing?
  • Allowable costs directly impact pricing strategies such as cost-plus pricing because they form the basis for calculating the final selling price. In this approach, businesses first determine all allowable costs related to producing a product and then apply a markup percentage to those costs to set the price. This ensures that all expenses are accounted for and helps maintain profitability while remaining competitive in the market.
• Discuss how target costing utilizes allowable costs to achieve competitive pricing in the market.
  • Target costing leverages allowable costs by determining what price consumers are willing to pay and then subtracting the desired profit margin to find the maximum allowable cost for production. This method encourages companies to innovate and optimize their processes to meet cost targets while still delivering quality products. By focusing on allowable costs from the beginning, businesses can ensure they remain competitive without sacrificing profitability.
• Evaluate the impact of accurately identifying allowable costs on a company's long-term financial performance.
  • Accurately identifying allowable costs has a profound impact on a company's long-term financial performance because it influences pricing decisions, profitability analysis, and strategic planning. By ensuring that all relevant costs are captured, a business can make informed decisions about pricing, budgeting, and investment. Misidentifying or overlooking certain costs can lead to underpricing products or misallocating resources, ultimately jeopardizing financial sustainability and market competitiveness.

Related terms

Cost-Plus Pricing: A pricing strategy where a fixed percentage or amount is added to the total cost of producing a product to determine its selling price.

Target Costing: A pricing strategy that starts with a desired profit margin and subtracts it from the competitive market price to determine the maximum allowable cost for production.

Variable Costs: Costs that change in direct proportion to the level of production, such as materials and labor costs, which are often included in allowable costs.