Explanation for the widespread use of Full–cost Pricing

September 13, 2023 Globalinfo247

A clear explanation cannot be given for the widespread use of full–cost pricing, as firms vary greatly in size, product characteristics, and product range, and face varying degrees of competition in markets for their products. However, the following points may explain its popularity:

Price based on full–cost looks factual and precise and may be more defensible on moral grounds than prices established by other means.

Firms preferring stability, use full-cost as a guide to pricing in an uncertain market where knowledge is incomplete. In cases where the costs of getting information are high and the process of trial and error is costly, they use it to reduce the cost of decision-making.

In practice, firms are uncertain about the shape of their demand curve and about the probable response to any price change. This makes it too risky to move away from full–cost pricing.

Fixed costs must be covered in the long run and firms feel insecure if they are not covered in the long run either.

A major uncertainty in setting a price is the unknown reaction of rivals to that price. When products and production processes are similar, cost-plus pricing may offer a source of competitive stability by setting a price that is more likely to yield acceptable profit to most other members of the industry also.

Management tends to know more about product costs than factors that are relevant to pricing.

Cost-plus pricing is especially useful in the following cases:

Public utilities such as electricity supply, and transport, where the objective is to provide basic amenities to society at a price that even the poorest can afford.

Product tailoring, i.e. determining the product design when the selling price is predetermined. The selling price may be determined by a government, as in the case of certain drugs, cement, and fertilizers.

By working back from this price, the design and the permissible cost are decided upon. This approach takes into account the market realities by looking from the viewpoint of the buyer in terms of what he wants and what he will pay.

Pricing products that are designed to the specification of a single buyer as applicable in the case of a turnkey project. The basis of pricing is the estimated cost plus gross margin that the firm could have gotten by using facilities otherwise.

Monophony buying – where the buyers know a great deal about suppliers’ costs as in the case of an automobile maker buying components from its ancillary units. They may make the products themselves if they do not like the price.

The more relevant cost is the cost that the buying company, say the automobile manufacturer, would incur if it made the product itself.

Pricing for a Rate of Return

An important problem that a firm might have to face is of adjusting the prices to changes in costs. For this, popular policies that are often followed are as:

Revise prices to maintain a constant percentage markup over costs.

Revise prices to maintain profits as a constant percentage of total sales.

Revise prices to maintain a constant return on invested capital The use of the above policies is illustrated below:

ILLUSTRATION

A firm sells 100,000 units per year at a factory price of N12 per unit. The various costs are given below:

Variable Costs Materials N360,000

Labour N420,000

Fixed Costs Overhead N120,000

Selling & Administrative charges N180,000

Total investment in cash, inventory, and equipment N800,000

Suppose the labor and materials cost increases by 10 percent. The question is how to revise the price according to the three policies discussed above.

The above data reveal that costs are N1,080,000. The profits as a percentage of costs, sales, and capital employed (according to the three policies are):

1 Percentage over Costs 120,000 = 11.1

1,080,000

2 Percentage of Sales 120,000 = 10

1,200,000

3 Percentage of Capital employed 120,000 = 15

800,000

The revised costs are N1,158,000 (N1,080, 000 + 36,000 + 42,000)

According to the first formula, we have to earn a profit of 11.1 percent on costs. Our revised profits should be #128,667 and sales volume on this basis would be N1,286,667. The selling price would therefore be N12.87 per unit.

Under the second formula, the profit should be 10 percent of sales. If sales are (S), the profit would be S/10 and the cost would be 9S/10. The cost is known to us and we have to find out the sales.

If 9S/10 = N1,158,000 then S = N1,286,667

Therefore, the price per unit is N12.87.

Under the third formula, we assume that the capital investment is the same. Therefore, the required profit is N120, 000 (15 percent on N800,000). The sales value would then be N1,278, 000 and the selling price per unit would be N12.78.

Rate of return pricing is a refined variant of full-cost pricing. Naturally, it has the same inadequacies, viz. it tends to ignore demand and fails to reflect competition adequately. It is based upon a concept of cost, which may not be relevant to the pricing decision at hand and overplays the precision of allocated fixed costs and capital employed.

Marginal Cost Pricing

Under full-cost and rate-of-return pricing, prices are based on total costs comprising fixed and variable costs. Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal cost. The firm uses only those costs that are directly attributable to the output of a specific product.

With marginal cost pricing, the firm seeks to fix its prices so as to maximize its total contribution to fixed costs and profit. Unless the manufacturer’s products are in direct competition with each other, this objective is achieved by considering each product in isolation and fixing its price at a level, which is calculated to maximize its total contribution.

Advantages

With marginal cost pricing, prices are never rendered uncompetitive merely because of a higher fixed overhead structure. The firm’s price will be rendered uncompetitive by higher variable costs, and these are controllable in the short run while certain fixed costs are not.

Marginal cost pricing permits a manufacturer to develop a far more aggressive pricing policy than full-cost pricing. An aggressive pricing policy should lead to higher sales and possibly reduced marginal costs through increased marginal physical productivity and lower input factor prices.

Marginal cost pricing is more useful over the life-cycle of a product, which requires short-run marginal cost and separable fixed data relevant to each particular state of the cycle, not long-run full-cost data.

Marginal cost pricing is more effective than full-cost pricing because of two characteristics of modern business:

The prevalence of multi-product, multi-process, and market concerns makes the absorption of fixed costs into product costs absurd. The total costs of separate products can never be estimated satisfactorily, and the optimal relationships between costs and prices will vary substantially both among different products and between markets.

In many businesses, the dominant force is an innovation combined with constant scientific and technological development, and the long-run situation is often highly unpredictable. There is a series of short runs.

When rapid developments are taking place, fixed costs and demand conditions may change from one short run to another, and only by maximizing contribution in each short run will the profit be maximized in the long range.

Limitations

The encouragement to take on business, which makes only a small contribution to the business, arises. Such business may have to be foregone because of inadequate free capacity, unless there is an expansion in organization and facilities, with the attendant increase in fixed costs.

In a period of business recession, firms using marginal cost pricing may lower prices in order to maintain business and this may lead other firms to reduce their prices, leading to cut-throat competition.

With the existence of idle capacity and the pressure of fixed costs, firms may successively cut down prices to a point at which no one is earning sufficient total contribution to cover its fixed costs and earn a fair return on capital employed.

In spite of its advantage, due to its inherent weakness of not ensuring the coverage of fixed costs, marginal cost pricing has usually been confined to pricing decisions relating to special orders.

Going-Rate Pricing

Instead of the cost, the emphasis here is on the market. The firm adjusts its own price policy to the general pricing structure in the industry. Where costs are particularly difficult to measure, this may seem to be the logical first step in a rational pricing policy.

Many cases of this type are situations of pricing leadership. Where price leadership is well established, charging according to what competitors are charging may be the only safe policy.

It must be noted that ‘going-rate pricing’ is not quite the same as accepting a price impersonally set by a near-perfect market. Rather it would seem that the firm has some power to set its own price and could be a price maker if it chooses to face all the consequences. It prefers, however, to take the safe course and conform to the rice of others.

Customary Pricing

Prices of certain goods become more or less fixed, not by deliberate action on the seller’s part but as a result of their having prevailed for a considerable period of time. With such goods, changes in costs are usually reflected in changes in quality or quantity. Costs change significantly only when the customary prices of these goods are changed.

Customary prices may be maintained even when products are changed. For example, the new model of an electric fan may be priced at the same level as the discontinued model. This is usually so even in the face of lower costs.

A lower price may cause an adverse reaction from the competitors leading to a price war so also on the consumers who may think that the quality of the new model is inferior. Perhaps, going with the prices as long as possible is a factor in the pricing of many products.

If a change in customary prices is intended, the pricing executive must study the pricing policies and practices of competing firms and the behavior and emotional make-up of his opposite number in those firms.

Another possible way out, especially when an upward move is sought is to test the new prices in a limited market to determine the consumer reaction.