Explain what is Full Cost Plus Pricing Method in Pricing Decisions ( Part 1 )

October 15th, 2006 Comments off
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In the earlier article, we have dealt with the importance of making the correct pricing decisions and the factors to consider before making a pricing decision.

This article refers to the various methods of pricing which include the following:

  • FULL COST PLUS pricing;
  • Variable/Marginal Cost Plus pricing
  • Rate of Return Pricing;
  • Break-even Pricing;
  • Minimum Pricing;
  • Standard Cost Plus

Salient Points on Full Cost Plus Pricing:

  • Traditional method of pricing a product;

  • Most commonly used method;

  • Prices are set by adding a percentage of profit ( either a mark up or a margin) to the total cost of the product;

  • Consistent with the absorption costing technique;

  • Commonly used by wholesalers, retailers, construction contractors, services, government contractors;

  • Useful in situation where:

· Products are made based on specification by the customers;

· Main objective is to make profit after considering fixed costs of the business;

· The costs are difficult to estimate in advance;

· Expected demand at different price levels is difficult to estimate.

Simple Illustration:

Let’s look at Product A:

Production cost as follows:

Variable cost -materia l $1.50

Variable cost- labor $1.50

Total variable cost $3.00

Fixed cost $3.00

(excludes administrative and selling overheads)

Required 50% mark up on total production cost.

For Full-Cost Plus Pricing:

Total cost = $3.00+$3.00 =$6.00

50% on total/full cost = 50% x $6.00 =$3.00

Hence, Selling price = $6.00+$3.00 =$9.00 per unit.

By pricing at $9.00, the company wants Product A to at least cover its total production cost.

Advantages Of Full Cost Plus Pricing:

  • Easy and simple to understand;

  • Pricing decisions become standardized;

  • Adopts a conservative approach that in the long run to at least ensure the recovery of fixed cost of a business;

· Difficult of estimating demands can be avoided.

Disadvantages Of Full Cost Plus Pricing:

· Tendency to set prices on inaccurate estimates;

· Challenges of apportioning the fixed overheads properly into different products

· Unsuitable for short term decisions making particularly in situation like surplus production capacity, tendering for contracts price and others;

· Ignores competition and price elasticity of demand and

· Ignores opportunity costs and relevant costs.

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Financial Accounting

 
 

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