Theoretical Concept of Cost Price Calculation

This article introduces and discusses a range of theoretical concepts on cost-price calculation. Here we will discuss the concept of indirect cost allocation and the allocation of specific indirect costs in the pharmaceutical industry. Also discusses different methods of cost calculation and some applications for the pharmaceutical industry.

The allocation of indirect costs

As with any other industry, the pharmaceutical industry has to deal with the allocation of indirect costs. In the below table, an overview of the most important costs in the industry is given, and whether or not they are usually mentioned in financial statements. The figure highlights the difficulty in analyzing the financial statements of pharmaceutical companies.

Large indirect cost pools like sales, administration, and marketing costs are usually grouped together under the header ‘selling, general and administrative expenses' or ‘marketing and administrative expenses.

This makes the financial statements very non-transparent and one can only estimate the actual costs involved in, for example, marketing. But also the other costs named in the below table under the heading ‘selling, general and administrative expenses are non-traceable and one can only estimate them.

Cost of Product	Mentioned in FS *
Sales / Turnover	X
Direct Costs:
Cost of material	X
Cost of direct labor	X
Indirect Costs:
Distribution costs
Marketing and administration expenses/Selling, general and administrative expenses:	X
Management costs
Costs of local agents
Registration costs
Sponsoring of (educational) projects
Legal costs
Supporting staff (ex. Administration)
R & D	X

Overview of typical direct and indirect costs for the pharmaceutical industry.

* The last column mentions whether or not they are named in the regular financial statements of the industry

What can be said about the costs of the pharmaceutical industry is that they are for a major part indirect. The two major indirect cost pools are R&D and marketing expenses. The innovative pharmaceutical industry is spending much of its resources, both absolute and relative to other industries, on the R&D of new pharmaceutical products. Recent studies indicate spending 15 % of global sales on R&D, amounting up to $30 billion, compared to $26 billion in the public sector (universities and government projects).

They also indicate a still rising trend in R&D spending of approximately 10 % (of R&D spending) a year. As said before, it is hard to estimate the exact expenditures on marketing, but the figures clearly indicate massive expenditures.

At first sight, the costs mentioned above appear to be indirect and cannot be allocated to a specific product. They are made for the benefit of the complete product range. When one, however, takes a closer look at these costs it is possible to further specify them, giving them a more direct instead of indirect character. R&D-related costs can be often allocated to the drug that comes out of the research pipeline and makes it to the market. Marketing costs are made for a specific product or brand, or for a certain region.

In the context of this research, it is important to understand this principle since it might explain why drugs should be sold at a lower cost price level in the developing world. To be more precise: it seems that, when the industry strives for accurate and just cost prices of their products, R&D-related costs and marketing costs are but a small part of the cost price of drugs in developing countries. Most marketing costs are made for the developed countries since they have the purchasing power and liberty to choose between brands and most R&D is done after Western diseases.

Cost Calculation Methods

Standard Costing

Standard costing is a relatively simple method for calculating the cost price of products. It is most suitable in organizations whose activities are very standardized. Most manufacturing companies with repetitive production processes find this method adequate. It is a lot harder to apply this method to organizations with a non-repetitive production process. The basic principle of this method is to set a standard cost for direct costs (materials and labor) and a standard for indirect costs (overhead).

There are basically two approaches to setting standards for direct costs. One is to look at historical figures; the other is to perform so-called engineering studies. The first approach traces historical records to set material and labor standards based on historical averages. The problem with this approach is that historical figures include historical inefficiencies. When done properly this method should eliminate inefficiencies in labor and material usage by tightening the budgets by incorporating a percentage deficiency.

The second approach uses specific studies of the operation processes to gain insight in the actual labor and material usage of different processes. The process is also closely observed and controlled. The downside of this approach is that it is costly and takes a lot of time.

For indirect costs, other approaches are needed. Indirect costs can be split into variable overhead, costs that are not directly related to the cost object, but which do vary with activity (e.g. electricity use), and fixed overhead, which do not vary with activity (e.g. rent). Usually, variable overhead rates are estimated based on historical relationships between changes in overhead costs and activity. These rates usually are linked to machine hours or labor hours.

Fixed overhead rates are usually budgeted for a certain period, charged to a certain cost center and then divided over all cost objects or products. The basic standard cost system appears in the figure.

Life-cycle costing

The life-cycle costing method focuses on the importance of the initial phases of the production process. Life cycle costing (LCC) establishes all costs that will be made in the life cycle of the product. This method focuses on future cost control.

The first phase in LCC is the product creation process. In the pharmaceutical industry, all innovation expenses (R&D) are made in this phase. In this phase, a customer requirement specification is to be created in order to be able to optimally serve the needs of the market.

This specification indicates the needs and wishes of customers and strives to create a product that will optimally serve the customer. Once the technical specifications of a product are defined a target costing method (see: paragraph 4.2.4) can be used to establish a cost price.

The second phase in LCC is the actual product life cycle. Here the classical phases ‘introduction’, ‘expansion’, ‘satisfaction’, and ‘retrieval’ are taken into account. In the introduction phase, the product is introduced to the market. This phase is associated with low volume, innovative customers, little competition, and little growth. The product will show fast growth in the expansion phase. Furthermore, this phase is associated with higher volume, ‘early adopting’ customers, and increasing competition. The satisfaction phase is characterized by little growth, high volume, solid customer base, and full competition. The retrieval phase finally indicates the downfall of the product. It shows decreasing volume, decreasing customer base and decreasing competition.

Two important factors in this LCC phase are ‘time to market’ (TTM) and ‘time to volume’ (TTV). TTM attends to the question of when to approach the market with a new product (introduction phase). There are four determinants to answer this question namely:

1. Product Performance;
2. Cost per Product;
3. Costs of Development;
4. Introduction date.

These determinants interact with each other to determine the optimal release date. TTV tends to the question of how long it will take to get production to the required level (expansion phase). If the product is successful, the logistics and production must keep up with the increasing demand for the product.

Activity-based Costing

Activity-based cost (ABC) systems emerged in the mid-1980s to meet the need for more accurate cost information on specific products, customers, and services. The system approaches the organization as a bulk of activities that produce goods or services for specific customers. These activities can be distinguished and costs can be applied to these activities.

Kaplan and Cooper (1998), who first developed the ABC method, use a four-stage model to describe different levels of accuracy of cost calculation systems. They test systems for the ability to provide accurate financial data, external financial reports, product/customer costs, and ability to provide data for organizational and strategic control (see the below image).

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Table 2: Four-stage model of cost systems

Stage I systems are highly inadequate as they do not provide accurate information on any data. Small companies and newly emerging companies still often use these systems, but actually, they are not suitable even for financial purposes and should therefore not be used.

Stage II systems are used by most companies. They meet the financial requirements and collect costs through responsibility centers. They, however, according to Kaplan and Cooper (1998), do not report accurate product costs and do not provide adequate, timely feedback to managers and employees. The standard cost system described above is marked as a stage II system.

Stage III systems do provide more accurate information. They use ABC systems to collect data from the regular financial system and in combination with other information use that data to provide more accurate information on the costs of activities, processes, and products. They furthermore provide timely and accurate, both financial and non-financial information to managers and employees.

Stage IV systems combine ABC systems and operational feedback thus forming an enterprise-wide system, which distributes the right information at the right time to the right people.

This study focuses on the differences between stage II systems (standard costs) and stage III systems (ABC-systems) and will furthermore concentrate on the third line from Table 2, the costs of products and the costs and profits of customers, since these aspects are most interesting for the subject.

For direct, variable costs the ABC systems use the same methods as the standard cost systems. They set standards and directly allocate these costs to cost objects. The main difference is the allocation of indirect, overhead costs. The ABC systems do, as pointed out above, apply costs to activities. To do this an organization should first determine activities that take place in the organization and create an activity dictionary in which all the activities are listed. These activities can vary from scheduling production orders to introducing new products. When the organization has composed a set of activities, which define every major activity in the organization, it must determine how much the organization is spending on each of these activities. To do this resource cost drivers must be selected to link expenses to activities. The next step is to determine the organization’s products, services, and customers.

This might seem simple, but this step determines why the organization is performing the determined activities and for what purpose the organization is working. The last step is to select activity cost drivers that link activity cost to the selected products, services, and customers. To perform this last step a choice must be made between transaction drivers, which are the least expensive drivers but also the least accurate, duration drivers, which calculate the time used to perform an activity, and intensity drivers, which charge the resources to each time an activity is performed.

In the below figure, an overview of the activity-based costing system is shown. However seeming identical to the standard cost schedule, the above has shown that it uses a very different approach to allocate indirect costs to products.

Figure 5: An overview of an ABC system

Target costing en kaizen costing

Target costing claims to be an integrative mechanism to link the functional areas of a company into a coherent system. In this method, a target cost is determined by indicating a required sales price and deducting the target profit margin. The target cost method is future-orientated, focuses on the costs of design decisions, and determines profitability before the product is produced. The target cost method is an additional method, which can be used to focus the attention of producers on the needs and capacity of their customers.

Kaizen costing focuses on present cost control. Kaizen is the Japanese term for continuous improvement. The method focuses attention on improving the efficiency of the production process, thus decreasing the cost price. The philosophy of the method is to outperform the standards set for the cost components. The application of kaizen costing can take place in many forms, but all have in common the following characteristics.

1. focus on the areas in which the best opportunities exist for cost reduction;
2. continuous updating of standards for production;
3. setting target reduction based on possibilities and market incentives.

The methods described in this section are supporting methods for cost calculation. The reason they were included in this chapter is because of their significance for the pharmaceutical industry and their usability in conjunction with life cycle costing, standard costing, and activity-based costing. The following paragraph will refer to these methods when discussing cost calculation in the pharmaceutical industry.

Application of the Theory to the Pharmaceutical Industry

The standard cost systems are not optimal for dealing with the characteristics of the pharmaceutical industry. They have two major limitations. First, they do not report on the actual costs of processes and products. Second, they do not provide sufficient information to control costs and monitor efficiency. As said before the focus will be on the first limitation and leave the second for further research.

The standard costs system does identify the short-term variable costs. They separate fixed and variable costs and therefore facilitate short-term cost control. They do however not capture other costs related to design and development or marketing and selling accurately. Furthermore, these systems treat many expenses as fixed or periodic expenses, while those expenses, in fact, do vary with volume or other conditions.

For the pharmaceutical industry, this implies that cost prices are not as accurate as they could be. R&D and marketing costs are not allocated optimally. Defining different markets could lead to better allocation of marketing costs and a more accurate cost price. With regards to R&D expenses, such segmentation is harder to implement in these systems.

Life cycle costing can enrich the standard cost systems by adding a focus on the customer and the cost of drug development. Regarding the differences between the market for developing countries and the market for developed countries, LCC can change the way in which pharmaceutical companies approach these markets. Understanding the capacity of customers helps develop solutions for these customers. Low-budget drug packages, e.g. HIV/AIDS cocktails, are suitable for developing countries and in that way, these markets can become profitable.

Target costing methods should be used to determine the target price that can be set for these countries. The philosophy behind this method is extremely suitable for the developing world market. By making an assessment of the buying power and wishes of the consumers in these markets the industry can determine the target price, and target cost and assess the amount of R&D they can use for this market. Both innovative and generic producers could furthermore apply the principle of kaizen costing to reduce the direct cost and indirect cost of producing drugs, thus increasing their profits in both the developing and developed market.

ABC systems focus on activities rather than responsibility centers, trace costs of using resources, rather than supplying resources, and use a richer set of cost drivers to more accurately show the effects of complex production for assigning costs to cost objects. Instead of abandoning the standard cost system, the ABC system enriches the standard cost system to provide a more accurate cost price. The philosophy of the ABC system is very simple. If one deploys activities towards certain products or groups of products, customers, or groups of customers, then charge those products and customers for the costs related to that activity.

For the pharmaceutical industry, this might have some far-reaching consequences. If a certain drug is produced for a certain group of customers, the R&D costs and the selling and marketing costs will not only be charged to the created drug, but to the purposed group of customers. If, for some reason, the drug will also be fit to serve another group of customers, in another region, not only the marketing expenses should not be charged to that group, but one might reason that also the R&D costs should not be charged to these customers, as they were not part of the purposed group. In other words: is it correct that customers in developing countries pay for the R&D costs, or marketing costs for that matter, of a product that was never designed for the market of developing countries?

From an ABC point of view, the answer to this question should be ‘no’, evidently. Developing countries should not be charged with these costs. They should be charged with a cost price that is accurate and just and not the most favorable. ABC provides the tools to construct a more accurate cost price. R&D and marketing costs are charged to the consumers for whom they are made. This would leave the developing world with a situation of ‘natural’ price differentiation, not a political decision but a company decision based on accurate information and accurate allocation of indirect costs. Given the characteristics of the industry (highly innovative and high indirect costs) one should expect ABC to have gained ground on more traditional cost price methods like standard costing. In the next chapter, the use of methods in practice will be investigated.

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