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By this method 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 on the cost. 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: 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 (cost-plus contracts) and has been criticized as promoting wasteful expenditure 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 (T.V.C) or Average Variable Cost (A.V.C) b) Total Fixed Cost (T.F.C) or Average Fixed Cost (A.F.C)
In either case, costs are computed on an average basis. That is, the average cost is:
(A.C) Average Cost = (A.V.C) Average Variable Cost + Average Fixed Cost (A.F.C)
- AC = average cost average cost
- (A.V.C) = (T.V.C) / Q
- (A.F.C) = (T.F.C) / Q
- (A.V.C) = average variable cost
- (A.F.C) = average fixed cost
- (T.V.C) = total variable cost
- (T.F.C) = total fixed cost
- Q = quantity (the number of units produced)
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 a 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 (Rs.= Ratio of the respective share) of total profit, then the mark-up over costs on each unit of output will be X/Q: then the price will be:
P = A.V.C + A.F.C + 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/unexpected later costs
- Perceived ethical advantages
- Ready availability
- Price increases can be justified in terms of cost increases
Cost-plus pricing is especially useful in the following cases:
- Public-utility pricing
- Pre-determined 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 supply chain 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.
- 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.