As investors or business owners, certain financial analysis scenarios may require you to make careful assumptions to estimate the price of a product. These situations arise when there isn’t a ready consumer base for the product or the price depends on various unique and intangible factors that make cost determination difficult. In such situations, shadow pricing techniques are used to price the items.
What is shadow price?
The shadow price is an approximate cost of a product not usually sold in the market. Since there is no base price to help determine the product’s cost, several assumptions are made, and estimates are drawn to arrive at the shadow price.
Additionally, assigning a shadow price helps conduct a cost-benefit analysis of an abstract commodity that is not usually traded as an individual asset in the market.
These assets or commodities include intangible assets and production costs. Intangible assets are mainly evaluated using shadow pricing for cost-benefit accounting.
Shadow price may also refer to the true price of a money market fund share, even if its value is negligible. Also, economists use this concept to evaluate public infrastructure projects.
How do shadow pricing techniques work?
Shadow price commonly refers to the assumed price of an accounting entry or an asset that usually doesn’t carry a price. This price is based on cost and value estimates and is not precise. The absence of data to back the shadow price always poses the risk of inaccuracy.
Despite its approximate value, it helps with critical decision-making.
Shadow pricing techniques, as mentioned above, are used in money market funds and involve accounting for the securities’ price based on amortised costs and not the market value assigned to them.
This is because the nominal Net Asset Value (NAV) of money market fund shares is always $1, even with slight deviations. The law mandates such money market funds to reveal the real NAV, i.e., the shadow price. This helps portray the fund’s performance more accurately to the investors.
However, this application of shadow price is less common when compared to its use in cost-benefit analysis.
Common applications of the shadow pricing concept:
- Evaluation of public infrastructure projects: Shadow pricing techniques are vital in public infrastructure projects. Public sector plans rely heavily on approximate capital prices, foreign exchange, and other aspects that do not have a fixed cost. Thus, public parks, transportation, and other public infrastructure projects can be evaluated using shadow pricing.
- Decision-making in business: Businesses can assess the sustainability of new ideas by conducting a cost-benefit analysis based on shadow price. This helps them make essential business decisions.
The significance of shadow pricing:
While not the most accurate, the shadow pricing technique has several significant advantages. Many important decisions of a business depend on qualitative aspects. Shadow pricing helps assign a numerical value to these aspects so that the decision-making process is simplified.
Once a quantified value is assigned to a commodity under consideration, it is easier to calculate opportunity cost, further improving the decision-making process. It also becomes easier to assign a monetary value to individual tasks associated with a project. Using shadow pricing, businesses can avoid pricing their items lower than the deserved price.
Irrespective of the size of the business, economic calculations across the board can be simplified with the shadow pricing technique.
Bottom Line
Shadow pricing is an important concept that helps ascertain the economic viability of a project by assigning quantitative values to qualitative aspects. Shadow pricing technique is valuable for businesses as it helps assess a project’s feasibility based on its costs and advantages. While it has some limitations, it helps with business-related decision-making and evaluating financial projects.