Pricing decision on the basis of Cost-Plus Pricing Theory

The pricing policy and pricing method depends on the objective of a firm sets for it. Cost-Plus Pricing is also known as Mark-up or Average Cost or Full Cost Pricing. The Cost-Plus Pricing is the most common method of pricing of a product by the manufacturing firms. The general practice under this method into adds a ‘fair’ percentage of profit marginal to the average variable cost (AVC).
The price is set on:
P = AVC + AVC(m)
Where, P = Price, M = Mark-up percentage, AVC(m) = Gross profit margin (GPM)

The mark-up percentage (m) is fixed so at to cover average fixed cost (AFC) and a net profit margin (NPM).

Thus, AVC (m) = AFC + NPM

The procedure of arriving at AVC and price fixation may be summarized as follows:
  1. The first step in pricing fixation is to estimate the AVC. For this, the firm has to ascertain the volume of its output for a given period of time, generally a fiscal year. To ascertain the output, the firm uses figures of its ‘planned’ or ‘budgeted’ output or takes into account its normal level of production. If the firm is in a position to compute its optimum level of output or the capacity output, the same is used as standard output in computing the AC.
  2. The another step is to compute the total variable cost (TVC) of the ‘standard output’. The TVC includes direct costs, i.e., cost of labour and raw materials and other variable costs. These costs added together give the total variable cost. The AVC is then obtained by dividing the TVC by the standard output (Qs).
Hence, AVC = TVC/Qs
After AVC is obtained, a ‘mark-up’ of some percentage of AVC is added to it for profit and the price is fixed while determining the mark-up, firms always take into account ‘what the market will bear’ and the competition in the market.

Given the possibility that cost-plus pricing might result in a non-optimal pricing/output decision. There are, indeed, reasons for this use, and on examination of the deviations between the basic micro economic model of the firm and the actual environment faced by the business explain why cost-plus pricing is so popular.

Although micro economic theory is based on an assumed goal of value maximization, much of it is developed around a static construct in which the firm is assumed to operate so as to maximize short-run profits. Implicit in this is the assumption that continual maximization of short-run profits, coupled with proper adjustments to the physical plant as technology, factor prices, and demand change, will lead to long-run profit and value maximization.

The real world is more complicated than this model suggests. Actions taken at one time affect results in subsequent times, and wise business managers recognize this fact. Accordingly, because short-run profit maximization is seldom entirely consistent with long-run wealth maximization, firms do not focus solely on short run profit maximization.

Consider the case of a firm that sets the current price of its product below the short-run profit maximizing level in order to expand its market rapidly. Such a policy can lead to long-run profit maximization if the firm is able to secure a larger permanent market share by its action. A similar policy might also be used to forestall competitive entry into the market. Form a legal standpoint, a policy of accepting less than maximum short-run profit could reduce the threat of antitrust suits or government regulation, thereby again leading to long-run profit and wealth maximization.

The existence of uncertainty in the real world is another complication that causes firms to depart from the theoretical micro economic pricing solution. Pricing under micro economic theory is based on the assumption that firms have precise knowledge of the marginal relationships in their demand and cost functions. Given these knowledge, it would be easy to operate so as to equate marginal revenue and marginal cost. However, firms know their cost and revenue functions only to an approximation, when the uncertainties of the future-economic condition, the weather, labour contract settlements and so on are added, it is abundantly clear why managers might do something other than equate marginal revenue and marginal cost when making price/output decisions.

Although the pricing corollaries of micro economic theory are far too limited to be applied without modification in actual pricing problems, the theory does not provide a useful basis for analyzing a firm’s pricing decision.

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