pricing - full cost plus pricing
Full cost plus pricing seeks to set a price that takes into account all relevant costs of production.� This could be calculated as follows:
Total budgeted factory cost + selling / distribution costs + other overheads + MARK UP ON COST
Budgeted sales volumes
An illustration of applying this method is set out below:
Consider a business with the following costs and volumes for a single product:
Fixed costs:
Factory production costs
�750,000
Research and development
�250,000
Fixed selling costs
�550,000
Administration and other overheads
�325,000
Total fixed costs
�1,625,000
Variable costs
Variable cost per unit
�8.00
Mark-Up
Mark-up % required
35%
Budgeted sale volumes (units)
500,000
What should the selling price be on a full cost plus basis?
The total costs of production can be calculated as follows:
Total fixed costs
�1,625,000
Total variable costs (�8.00 x 500,000 units)
�4,000,000
Total costs
�5,625,000
Mark up required on cost (�5,625,000 x 35%)
�1,968,750
Total costs (including mark up)
�7,593,750
Divided by budgeted production (500,000 units)
= Selling price per unit
�15.19
The advantages of using cost plus pricing are:
- Easy to calculate
- Price increases can be justified when costs rise
- Price stability may arise if competitors take the same approach (and if they have similar costs)
- Pricing decisions can be made at a relatively junior level in a business based on formulas
The main disadvantages of cost plus pricing are often considered to be:
- This method ignores the concept of price elasticity of demand - it may be possible for the business to charge a higher (or lower) price to maximise profits depending on the responsiveness of customers to a change in price
- The business has less incentive to cut or control costs - if costs increase, then selling prices increase.� However, this might be making an "inefficient" business uncompetitive relative to competitor pricing;
- It requires an estimate and apportionment of business overheads.� For example, total factory overheads need to be calculated and then allocated in some way against individual products.� This allocation is always arbitrary.
- If applied strictly, a full cost plus pricing method may leave a business in a vicious circle.� For example, if budgeted costs are over-estimated, selling prices may be set too high.� This in turn may lead to lower demand (if the price is set above the level that customers will accept), higher costs (e.g. surplus stock) and lower profits.� When the pricing decision is made for the next year, the problem may be exacerbated and repeated.
Amongst the factors that influence the choice of the mark-up percentage are as follows:
� Nature of the market - a mark-up should reflect the degree of competition in the market (what do the close competitors do?)
- Bulk discounts - should volume orders attract a lower mark-up than a single order?
- Pricing strategy - e.g. skimming, penetration (see more on pricing strategies further below)
- Stage of the product in its life cycle; products at the earlier stages of the life cycle may need a lower mark-up percentage to help establish demand.