Cost Plus Pricing
Cost plus pricing is the most common method for pricing. Under this method, the price is determined to cover all the cost and a predetermined percentage of profit. It takes full costs into consideration. Thus, it is also called as full cost pricing and cost based pricing.
Let us assume that a new company Feel Good Ltd., has been floated. It is planning to start a talcum powder unit. To illustrate how the company sets the price of its product, let us assume that the company has budgeted production of 50,000 units requiring the following costs. If the management desires to have a mark-up of 25% on cost to make and sell, calculation of the target price, that is the price the management will seek in the market place, would be as follows:
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Particulars
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Total
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Per Unit
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Rs.
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Rs.
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Direct Materials
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5,00,000
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10.00
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Direct Labor
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2,00,000
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4.00
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Variable Overhead
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1,50,000
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3.00
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Fixed Overhead
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2,50,000
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5.00
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Fixed Selling and Administrative Overhead
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1,00,000
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2.00
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Cost to Make and Sell
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12,00,000
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24.00
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Desired Net Income
(25% x 12,00,000)
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3,00,000
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6.00
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Target Revenue (Price)
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15,00,000
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30.00
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In the above illustration, the target price was based upon the total cost of the firm. This approach of full-cost based pricing is based upon the fact that in the long run the firm must recover all of its costs plus a normal profit margin, if it is likely to remain in business. So now, in the illustration above, if the market place accepts the price of Rs.30, the firm will recover all of its costs and then earn the desired amount of profit at a volume of 50,000 units. If the price is too high, compared to the competitors' price, then the actual sales volume would be less than the budgeted volume and the company would fail in achieving its goals. On the other hand, if the price is too low, relative to the competition, the actual sales would exceed the planned volume of sales and because of its low pricing, the company will become a price leader. Of course, this low pricing will have an impact on the profitability of the company. In a competitive market place, the company would be foregoing available profits. In this way, target price represents the first step, trial and error (heuristic) approach to pricing.
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Box 2: Value of Value Pricing
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It was pointed out as a symbol of what was wrong with General Motors Corporation - an ageing undistinguished car that could not compete with imports or domestics, when it showed languishing sales of the Chevrelot Cavalier in 1992. But in the first six months of 1993, sales of the 11-year old Cavalier soared 25.9 percent and the car became the seventh best selling vehicle in the US outselling the Ford Explorer and Honda Accord.
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What is the magic behind it?
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It is a secret called 'Value Pricing', a phenomenon fast becoming a major factor in automatic marketing. It is a marketing tactic that involves setting a fixed, lowered price on a car that is packaged with attractive options.
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With the success of the Cavalier, General Motors is preparing to accelerate its use of pricing tactic when 1994 models arrive. The success of Cavalier shows a lot of people are just looking for a good value.
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However, value pricing is often applied to models that were selling slowly, so an increase in volume may make-up for the lower margins.
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The full cost approach to pricing tends to follow a modification of nineteenth century classical economic theory, which demanded the long run recovery of costs by firms wishing to perpetuate their existence. Most present-day economists maintain that the full cost approach misapplies long run analysis to short-run problems. Nevertheless, "some economists would assign to full cost a definite role in economic doctrine". Moreover, various investigations and statistics say that, "a majority of businessmen set prices on the basis of cost plus a fair percentage of profit". This position can be explained partly by the fact that some concerns, purporting to use the full cost method, actually calculate proposed prices that are subjected to adjustment for demand consideration, competition and market conditions.
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