In some previous articles we were talking about competitive pricing as a well known pricing strategy. In this article, we are going to speak about another very popular pricing strategy, known as the cost plus pricing or mark up pricing as it involves calculating the cost of the product and adding a percentage of the cost as mark up.
What is cost plus pricing?
The basics of cost plus pricing strategy is that it sets prices for either products/services, which covers the cost of production and it provides sufficient profit margin for the firm to reach its target rate of return. In other words, the company decides the margins that it wants from the product, and then adds the margin on top of the cost to come to a selling value. Thus, the mark up pricing or cost plus pricing method can provide the company with an overview on how much profit they are going to have.
Calculation of Cost plus pricing
The calculation or computing of the cost up pricing takes into consideration the average variable and average fixed costs as well as the quantity, which is assumed based on an evaluation of the firm’s production capacity.
Therefore, we have the average cost derived from the multiplication of average variable cost and average fixed cost. The average variable cost is calculated by dividing the total variable cost by quantity. This is the initial phase in computing the cost-up pricing.
AVC= TVC/Q
AFC= TFC/QAC= AVC+AFC
Where – AC is Average cost.
AVC is average variable cost
AFC is average fixedcost
TVC is total variable cost
TFC is total fixed cost
Q is total quantity
The following and last step consists in identifying the mark-up over costs. Here we introduce a target rate of return, which is a ratio of the respective share of total profit. If the target rate of return is x, then the equation of the unit of output would be:
Unit of output = X/Q
Where – X is rate of return and Q is total quantity.
The final price through the cost-up pricing strategy will be:
P= AVC+AFC+X/Q.
Cost plus pricing has been considered the most rational approach to maximizing profits due to the ease of its calculation and lack of need to any additional information. Therefore, compared to competitive pricing, the cost up pricing strategy tends to ignore the competitors completely when establishing the price.
At the same time, it also ignores the consumers which is its drawback. In order to determine the profit margin it is essential to take into consideration also the management perception, the demand elasticity as well as the competitive conditions. After all, the main interest of managers is to focus on emphasizing the product’s maximum value.
Application of Cost plus pricing
This strategy can be applied in markets where there is a lack of information in uncertain markets. As it is hard to gain a certainty on how your demand curve is going to fluctuate, the strategy offers a general price.
Moreover, as it is working for uncertain markets, for the managers is easier to know more and be sure about production costs rather than consumers and competitors behaviors. The simplicity and availability of this strategy is what makes it quite popular among companies.
Dating back to medieval times, the present strategy is being used in USA as well as China and India.
However, the strategy can offer wrong perspectives. If we were to take for example a piece of furniture produced in China, the way to calculate the price through the cost-up pricing strategy is to identify the cost of production and add the profit margin you wish to achieve.
But it depends on the sales target as if the sales are low than you have expected than you might result in losses. Another thing is that if the Chinese company tries to sell its furniture in China but also on international markets, such as France, the success of the company depends highly on customers’ behaviors and perceptions, as French people will believe that the Chinese products are of poor quality if the prices are set lower than their expectations.
Also read – Is cost plus pricing the best pricing strategy today?
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