Cost Plus Pricing

Surveys of business pricing practices indicate that most firms use cost plus pricing or full cost pricing or average cost pricing technique'. This can be an optimal pricing policy where prices are set to cover all direct costs plus a percentage mark-up for profit contribution. It applies only for market structures where companies have some market power and are, therefore, able to set prices for their products. There are various forms of cost plus pricing, the typical form involves following two steps.

1.       The firm estimates the cost per unit of output of the product. The cost per unit is the variable production and marketing cost per unit of output plus the average overhead cost.

AC = AVC +AFC

AVC=TVC/Q

AFC = TFC/Q

Since this cost generally varies with output, the firm must base this computation on some assumed level. Usually, firms use for this purpose some percentage of capacity, generally between two-thirds and three-quarters.

2.       A mark-up or profit margin is added to the estimated average cost.

This markup is generally in form of a percentage and includes certain costs that provide a return to firm's investment. It is determined by demand elasticities and competition. Mark-ups are lower where demand is more elastic and competition intense. The mark-up can be expressed as follows:

Mark-up = price-cost/cost

Where price - cost is profit margin. Suppose the cost of a paperback book is Rs 4 and its price is Rs 6.

Markup = 6-4/4 = 0.5

or 50 per cent. If we solve the equation of mark-up for price we get,

Price = AC (1 + mark-up)

Thus the price of the paperback book is,

Price = 4 (1 + .50) = Rs 6

Some firms set a target - return figure, that they hope to earn, which determines the mark-up. If Rs X is the total profit, the mark-up over cost on each unit of output will be X/Q. Thus under target rate of return pricing, price is set equal to

P = AVC + AFC +X/Q 

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