Shadow Pricing

It is an approach that is relevant to companies that are trying to price their products and services when their value estimations are unclear, or there is no market benchmark. 

 

Pricing is one of the most crucial activities conducted by businesses. It involves assigning value to a commodity, product, or service. In simple terms, pricing is putting a price tag on your products and services to be sold in the targeted markets. 

In today's markets, we have different types of companies and start-ups. Hence, markets provide users, customers, and clients with different products, services, and commodities.

These varying offerings require different approaches to pricing and promotions. 

Pricing can be done through different techniques, and it could be as simple as adding a markup on your products and services or as complex as competitive pricing.

Nonetheless, pricing has to be conducted regardless of its complexity for companies to provide their products and services to their customer base. 

Now, pricing, whether simple or complex, can always be conducted when firms know the value and costs of their provided products and services.

However, a question prompts about the products and services that are not usually sold or priced in markets. 

What approach can be taken for such products or commodities? In such scenarios, we could apply shadow pricing. This approach is relevant to companies that are trying to price their products and services when their value estimations are unclear or there is no market benchmark

Simple pricing estimation can be of great value to companies planning on creating new types of commodities or providing commodities that are not usually brought to certain markets, but what is shadow pricing in essence, and how does it work?

What is shadow pricing?

The pricing of intangible goods or services cannot be quantified through a reference price. Hence, the pricing of such products will rely on estimations rather than having a benchmark price set by the market.

Usually, tangible items provided to customers and market users have a relative price rate. This is because a benchmark price exists; hence any new provider entering the specific market of a certain item will have a strong idea about the current price accepted by customers. 

Assume a situation in which the true value of an item is unknown and can only be inferred. This is because the market itself cannot give a price.

However, the greatest price a company is willing to pay to buy the item is frequently assumed as the basis for the estimation. 

Since a shadow price is determined using assumptions and best guesses, its accuracy may or may not correspond to the item's actual value.

Financial analysts frequently use this in cost-benefit analyses to give intangible assets a monetary value.

This term also translates to the maximum cost a company would be willing to pay to produce one additional unit of a specific item.

In such a scenario, this term is related to the perceived benefit a company can obtain from producing this one additional unit and/or utilizing resources for this activity. 

A clear example of this term definition is when a company pays overtime to employees to remain for extra hours to perform more tasks related to a specific product, service, or production line. In this situation, the shadow price would be the contribution margin a company will lose if it doesn't conduct this specific activity. 

How does it work?

In this section, we will go through the functions of this term when applied, but we need to understand that the term has different meanings when applied in different fields or markets, in addition to those previously mentioned.

This approach has different points of view or purposes when applied, for instance, in money market funds compared to the pricing of products and services.

Both, however, will be based on value estimations made without a reference to the price from the market. 

Shadow pricing, as it correlates to the money market, signals the activity of accounting and the pricing of securities based on amortization costs rather than on their given market value

Money market fund shares are usually valued at a nominal net asset value (NAV) of $1 while, in reality, the actual NAV is slightly above or below this figure.

Typical funds are legally obligated to display the actual NAV-the shadow share price-to show the fund's performance to investors more precisely. Nonetheless, the use of this term in relation to money market funds is uncommon usage of the phrase.

Instead, it is more regularly used in the stages of cost-benefit analysis in business decision-making.

A shadow price is a "virtual" price given to a non-priced commodity, asset, or accounting entry in its regular and typical usage. Specific assumptions regarding costs or value regularly drive it. It is overall a subjective and inexact, or imprecise, endeavor. 

To decide on the execution of an initiative or investment, businesses usually conduct a comparative analysis of the investment cost against the projected potential values.

In conducting a cost-benefit analysis, a company often must consider the costs or benefits of intangible assets that are complex to value. 

Advantages and disadvantages

A business can better comprehend the true worth of a project by using shadow pricing.

It is an essential component of conducting a cost-benefit analysis and can support management's choices about many facets of a project's strategy and scope.

It is a crucial instrument in fairly evaluating a project and requires morally upright conduct.

However, there are certain restrictions on this. The fact that the assets this method attempts to value are ethereal makes shadow pricing particularly subjective and proofless.

Furthermore, there is a high possibility of biases because analysts must make a lot of assumptions. Accordingly, there is a strong likelihood that the shadow price is inaccurate. 

If the process used to calculate the shadow price is faulty, the firm may be undergoing activities that are counterproductive and could damage its reputation.

Finally, some detractors contend that shadow pricing overemphasizes the short-term societal opportunity cost while neglecting the company's long-term goals.

This pricing aids businesses in fully grasping the true value of a project; it also:

  • Promotes frugally sound business decisions 
  • An essential tool for conducting a cost-benefit analysis 
  • Aids businesses by being more proactive 

However, it is always subjective, making it such that:

  • The valuation is often unreliable
  • The methodology used for shadow pricing leaves a possibility of prejudice 
  • The valuation is possibly overly rigid

Example

This is a practical example of shadow pricing in the trading context. It will cover the core function of the concept and how a company can use it to estimate the potential value of a specific action, product, or service. 

XYZ Company is a retailer that sells most of its products online. The current shipping method uses UPS Ground Shipping to ship the items that have already been sold. This usually takes 4-5 days. 
 
The company believes that providing a two-day delivery service for all orders can significantly increase sales.

The company can't assign a specific value to the potential increase in sales that could be achieved by changing shipping policies. Therefore, it allocates a shadow price of $ 50,000. This is the best estimate of their monetary benefit from the modified shipping policy.  
 
The company then performs a cost-benefit analysis to compare the shadow price of the profit from the additional revenue with the shipping cost required for the two-day delivery service.  
 
If the total additional shipping costs are well below $ 50,000, the company determines that the change in shipping policy benefits revenue and vice versa.

The above is an example of how a company uses it and cost-benefit analysis in decision-making. Of course, it's important to note that the company's cost-benefit analysis can be inaccurate if the shadow price estimates of using the two-day delivery service are incorrect.

Shadow pricing in accounting 

It is practiced by companies and organizations to conduct reasonable pricing activities and to evaluate their products and services.

This is one of the approaches companies can apply or utilize to achieve this goal.

Before reasonable market prices and regulations apply to some products, independent third parties and other companies provide input on what they believe is an accurate reflection of the value of the offerings. 

Most businesses that have significant carbon or water footprints do this. For instance, Microsoft Corporation has established a price for CO2 emissions at $27 per ton.

Each business unit's P&L (Profit and Loss account) was then charged for this. The money was then used to fund the company's renewable energy and efficiency programs. 

In an article published in "Climate Money Policy-Carbon Shadow Pricing," Brian Reynolds wrote: 

"118: There are 118 buildings on the Microsoft campus (15 million square feet), each with different heating, cooling, lighting, and energy requirements. Each has different potential requirements and strategies to increase efficiency. And each has different capital needs."

"30,000: These 118 buildings contain 30,000 different machinery and seven different unique building management systems. None of them are designed to talk to each other."

"$1.5 million: First-Year Savings: This is the amount Microsoft realized after adopting carbon shadow pricing."

Final take

In the trading context is a method to assign an estimated value to a service or product with no relevant market pricing.

It is an estimated value of how much the company would be willing to pay to purchase a specific product or service.

This approach can be used not only to estimate the value of a product or a service but also to estimate a change in an activity conducted by the company, as in the example mentioned above, or in a behavior that will increase the efficiency of an operation. 

Cost-benefit analysis is usually associated with this approach to determine a more realistic valuation or expected value gained from a product, service, or a change in an activity conducted by the company. 

It gives administrators a better understanding of the costs and benefits associated with a project.

In the world of public policy, this pricing helps determine if a public project is worth pursuing. It can save you money by showing the right course of action.

In the face of difficult business decisions, cost-benefit analysis, which uses shadow pricing to determine production costs and the monetary value of intangible assets, makes it clearer which course of action is most economically impactful.

Shadow prices quantify measurements of production and abstract commodities that are not normally assigned numbers. A common example of abstract goods is a public park. The shadow pricing process can help assign a monetary value to the park to help determine how and whether or not to proceed with the project.

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Researched and authored by Ahmed Fagiry | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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