cost-based pricingPricing methods which determine the PRICE of a product on the basis of its production, distribution and marketing COSTS. Three cost-based pricing methods may be distinguished:
- full-cost or mark-up or average cost pricing of a product is determined by adding a percentage profit mark-up to average or unit total cost, unit total cost being composed of average or unit variable cost and average or unit fixed cost (both of which can be determined from MANAGEMENT ACCOUNTING records). Fig. 29 shows an example of full-cost pricing based on an estimated sales/production volume of 1000 units per month. Unit variable costs (costs which vary with the level of output, such as raw materials and direct labour) are £2. Total fixed costs (costs which do not vary with output, such as depreciation and factory rent) are £1000 per month so that average fixed cost at a volume of 1000 units is £1. Unit total cost is the sum of average variable cost and average fixed cost, and managers decide on the percentage profit mark-up (here 50%) to add to total cost to arrive at a selling price (here £4.50). At this price, revenue would be £4.50 x 1000 units or £4,500 per month and profits £1.50 x 1000 units or £1,500 per month, provided that 1000 units per month can be sold at this price;
- cost-plus pricing is very similar to full-cost or mark-up pricing, in so far as the price of a product is determined by adding a percentage profit mark-up to the product's unit total cost. Indeed the terms are often used interchangeably. However, cost-plus pricing is used more specifically to refer to an agreed price between a purchaser and the seller, where the price is based on actual costs incurred plus a fixed percentage of actual cost or a fixed amount of profit per unit. Such pricing methods are often used for large capital projects or high technology contracts where the length of time of construction or changing technical specifications lead to a high degree of uncertainty about the final price;
- break-even or target-profit or marginal cost pricing of a product is based upon the CONTRIBUTION needed for the product to BREAK EVEN or provide a predetermined target profit. Fig. 30 shows an example of break-even pricing based on an estimated sales/production volume of 1,000 units per month and total fixed costs (depreciation, rent, etc.) of £1,000 per month.
Unit contribution is simply the difference between selling price and unit variable cost or marginal cost. Unit contribution, when multiplied by sales/production volume gives total contribution, and this total contribution should provide sufficient money to cover fixed costs (to break even) or fixed costs and target profit. Fig. 30 shows the unit contribution required in each case. To calculate selling price it is necessary to add unit contribution to unit variable cost or marginal cost as shown in Fig. 30.
All three pricing methods are cost-based and to this extent appear to ignore demand. However, demand and competition cannot be ignored in setting prices. For instance, in full-cost and break-even pricing, estimates of sales volume are necessary to calculate average fixed cost and required unit contribution respectively. Yet in both cases the price charged will affect sales volume. In practice, managers take account of demand or competition, so that in using full-cost pricing they tend to vary the percentage mark-up over time to reflect fluctuations in demand, and to use different percentage mark-ups for different products to reflect differences in the intensity of competition. See DEMAND-BASED PRICING, COMPETITION-BASED PRICING.