Study notes

What is 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 volume

An illustration of applying this method is set out in this study note.

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.

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