Cost-plus pricing is a pricing strategy that is used to maximize the rates of return of
companies.
Firms may achieve profit maximization by increasing their production until their marginal revenue
equals their marginal cost, then charging a price determined by the demand curve.
In practice, most firms use either value-based pricing or cost-plus pricing.
Cost-plus pricing is also known as mark-up pricing where cost + mark-up = selling price.
There are several variations of cost-plus pricing, but the most common method is to
calculate the cost of the product, then add a percentage of the cost as markup.
This approach sets prices that cover the cost of production and provide sufficient profit
margin for the firm to reach its target rate of return.
It also provides a way for companies to calculate how much profit they will make.
Cost-plus pricing is often used on government contracts and has been criticized as promoting
wasteful expenditures in the form of direct costs, indirect costs, and fixed costs whether
related to the production and sale of the product or service or not.
These costs are converted to per-unit costs for the product; then a predetermined percentage
of these costs is added to provide a profit margin.
Information regarding demand and costs is not easily available, so managers have limited
knowledge in these areas.
This information is necessary to generate accurate estimates of marginal costs and revenues.
The process of obtaining this additional information is expensive.
Therefore, cost-plus pricing is often considered the most rational approach to maximizing profits
due to the ease of its calculation and lack of any additional information.
However, the cost-plus approach relies on arbitrary costs and markups.
The Mechanics of Cost-Plus Pricing There are two steps for this approach:
1.
Calculation of cost of production; the total cost has two components:
a) Total variable cost b) Total fixed cost
In either case, costs are computed on an average basis.
That is, the average cost is: AC = AVC + AFC
where AVC = TVC / Q
AFC = TFC / Q AC = average cost
AVC = average variable cost AFC = average fixed cost
TVC = total variable cost TFC = total fixed cost
Q = quantity In cost-plus pricing we use quantity to calculate
price and price determines quantity.
To avoid this problem, a quantity is assumed.
This rate of output is based on some percentage of the firm's capacity.
2.
Determining the mark-up over costs: The objective of this approach is to set prices
such that a firm earns its targeted rate of return.
If that return is Rs.X of total profit, then the mark-up over costs on each unit of output
will be X/Q: then the price will be: P = AVC + AFC + X/Q
Reasons for wide use Firms vary greatly in size, product range,
product characteristics, and so on.
Firms also face different degrees of competition in markets for their products.
Therefore, a clear explanation cannot be given for the widespread use of cost-plus pricing.
However the following points explain why this approach is widely used:
Even if a firm handles many products, this approach provides the means by which fair
prices can be easily found.
This approach involves calculation of full cost.
Prices based on full cost look factual and precise and may be more defensible on moral
grounds than prices established by other means.
This approach reduces the cost of decision-making.
Firms preferring stability use cost-plus pricing as a guide for pricing products in an uncertain
market where knowledge is incomplete.
Firms are never too sure about the shape of their demand curve, nor are they very sure
about the probable response to any price change.
It becomes risky for a firm to move away from cost-plus pricing.
Unknown reaction of rivals to the set price is a major uncertainty.
When product and production process are similar, competitive stability is achieved by using
cost-plus pricing.
This competitive stability is achieved by setting a price likely to yield acceptable
returns to other members of the industry.
Management tends to know more about product costs than any other sources that can be used
for pricing a product.
Insures seller against unpredictable, or unexpected, later costs
Perceived ethical advantages Simplicity
Ready availability Price increases can be justified in terms
of cost increases Usefulness
Cost-plus pricing is especially useful in the following cases:
Public-utility pricing Predetermined selling price: finding out the
design of the product when the selling price is predetermined, i.e. product tailoring.
By working back from this price, the product and permissible cost are decided upon.
This means that market realities are taken into account as this approach considers the
viewpoint of the buyer in terms of what they want and what they will pay.
Single-buyer product: pricing products that are designed to the specification of a single
buyer; the basis of pricing is the estimated cost plus gross margin that the firm could
have received by using facilities otherwise.
One buyer, many sellers: cost-plus pricing is useful in cases like monopsony buying.
In this situation, the buyers have enough knowledge about suppliers' costs.
Thus, they may make the product themselves if they do not agree with the offered prices.
The relevant cost would be the cost which a buying company would incur if it made the
product itself.
Disadvantages Provides an incentive for inefficiency to
companies with a monopoly, encouraging them to raise costs
Calculation of costs is complex and depends on asset valuation, thus offering scope for
disguising what may essentially be value-based pricing as cost-plus pricing
Tends to ignore the role of consumers Tends to ignore the role of competitors
Uses historical rather than replacement value Uses “normal” or “standard” output
level to allocate fixed costs Includes sunk costs rather than just using
incremental costs Ignores opportunity cost
Cost-plus pricing and economic theory Cost-plus pricing might appear to be inconsistent
with the economic theory of profit maximization.
Analysis based on the "marginal cost equals marginal revenue" decision rule may appear
irrelevant due to the wide use of cost-plus pricing.
However, this conflict is more apparent than real.
A comparison of the two approaches to pricing starts with a consideration of costs.
Cost-plus pricing is based on average costs and not marginal costs.
However, in economic theory, long-run marginal and average costs are not very different.
Thus, it can be safely said that using average costs for pricing is a reasonable approximation
of marginal cost decision making.
The second step in comparison involves the target rate of return and the resulting mark-up.
Determination of the target rate of return depends on certain factors including management's
perception of demand elasticity and competitive conditions.
This can be explained with a look at how grocery stores operate.
Grocery profits are held down due to the intense competition that exists, with the average
mark-up for most food items averaging 12 percent over cost.
If the mark-up over cost is based on demand, cost-plus pricing may not be inconsistent
with profit maximization.