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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 (cost-plus 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.
Two steps form 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
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 (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 = AVC + AFC + X/Q
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:
Cost-plus pricing is especially useful in the following cases:
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.