Question

Pricing is based on a cost-plus formula where costs are estimated then contracts are priced at 50% above cost. What would happen if Maya picked the “wrong” cost driver to set target costs and prices? What other implications may result from choosing the wrong cost driver?

Answer 1

Depending on the cost driver Maya chose--it could end up setting its prices either too high or too low. If it set them too high, it might become uncompetitive and lose business. If she set them too low (even if its competitors were priced equally low), it would make less profit form operations and might even lose money.

If the costs set are less than revenue, there is profit and a probability of expansion. If the costs equal revenue, then the business is at a point of indifference and it can be closed or continued depending on other variables apart from cost or on how costs can possibly be adjusted.

Other implications that may result from choosing the wrong cost driver are-

• Total production costs are used to set the selling prices for particular products. Thus, if the costs are inaccurate, the profit forecasts will not be accurate, and the whole accounting system of the particular organization will be subject to errors.
• A cost driver exists to allocate manufacturing overhead. The correct allocation of manufacturing overhead is important for determining the true cost of a product. For this reason, the selection of accurate cost drivers has a direct impact on the profitability and operations of an entity.
• A cost driver is selected at management's discretion based on the associated variables relating to the expense being incurred. If the right cost driver is not selected it will lead to high expenses and more cost in reversing the effects.
• When the selection is at managements discretion, if the wrong cost driver is selected it will lead to loss of faith in management of the company. worker have to work more and they will begin distrusting management's decisions.