Cost–Plus Pricing
Cost-plus pricing sets a selling price by adding a profit to the cost of the product: either to its full (absorption) cost or to its marginal (variable) cost.
The profit may be expressed as a mark-up (a percentage of cost) or a margin (a percentage of selling price), or it may be set to achieve a target return on sales or return on investment. Read the question carefully: which cost, and which kind of percentage?
1 Introduction
An important decision for the management accountant is that of fixing a selling price.
Clearly, in order to be profitable, the selling price will be higher than the cost, and in this chapter we will look at several ways in which they may choose to decide on a selling price.
Management will take many things into account – for example the prices charged by competitors for similar products, and how many customers will buy at different prices. One common policy is to take the cost of the product and always add a fixed percentage for profit. This is cost-plus pricing.
2 Full cost-plus pricing
With full (or absorption) cost pricing, we determine the selling price by adding a profit to the absorption cost of the product.
The profit is calculated using either a mark-up or a margin.
When the profit is calculated as a percentage of cost, it is known as a mark-up.
Peter has prepared a cost card for a product as follows:
$ per unit | |
Materials | 10.00 |
Labour | 5.00 |
Variable overheads | 2.00 |
Fixed overheads | 3.00 |
Full cost | 20.00 |
He arrives at selling prices by adding a mark-up of 20% to the full product cost.
Calculate the selling price per unit.
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When the profit is calculated as a percentage of selling price, it is known as a margin.
Paul has prepared the following costing for a new job:
$ | |
Materials | 5,000 |
Labour | 6,000 |
Variable overheads | 4,000 |
Fixed overheads | 3,000 |
Full cost | 18,000 |
Paul requires a margin of 20% on sales revenue.
Calculate the selling price for this new job.
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Converting between a mark-up and a margin
The same profit can be described either way. Work from a selling price of $100 (for a margin) or a cost of $100 (for a mark-up):
Formula | Example | |
Selling price from a mark-up | Cost × (1 + mark-up) | $20 × 1.20 = $24 |
Selling price from a margin | Cost ÷ (1 − margin) | $18,000 ÷ 0.80 = $22,500 |
Margin from a mark-up | Mark-up ÷ (1 + mark-up) | 25% ÷ 1.25 = 20% |
Mark-up from a margin | Margin ÷ (1 − margin) | 20% ÷ 0.80 = 25% |
So in Example 2 the 20% margin is the same as a mark-up of 25% on cost ($4,500 ÷ $18,000). For the same percentage, a margin always gives a higher selling price than a mark-up.
3 Marginal cost plus pricing
With marginal cost plus pricing, we apply a mark-up to the marginal cost of the product.
Although this is less complicated than full cost pricing (because fixed overheads do not need to be absorbed) there is the problem of deciding what mark-up needs to be added to the variable cost in order to ensure that fixed overheads are covered and that a profit is made.
Marginal cost plus pricing is especially useful for one-off price decisions where production of the product in question will not change the total existing fixed overheads of the organisation.
Mary has prepared a cost card for a product as follows:
$ per unit | |
Materials | 8.00 |
Labour | 5.00 |
Variable overheads | 3.00 |
Marginal cost | 16.00 |
She arrives at selling prices by adding a mark-up of 40% to the marginal cost.
Calculate the selling price for this new product.
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4 Pricing to achieve a target return
Instead of a simple mark-up or margin, management may set the price to achieve a target return:
Target | Measured as | Price needed |
Return on sales (ROS) | Profit ÷ sales revenue × 100% | The same idea as a margin: price = full cost per unit ÷ (1 − target ROS) |
Return on investment (ROI) | Profit ÷ capital invested × 100% | Required profit = target ROI × capital invested; profit per unit = required profit ÷ expected sales units; price = full cost per unit + profit per unit |
A target return can also be met with marginal cost plus pricing: the total contribution must cover the fixed costs plus the required profit, so the mark-up on marginal cost is the contribution needed per unit as a percentage of the marginal cost.
The lecture for this chapter covers sections 1 to 3; return on sales and return on investment targets are covered in the notes only.
Adeyemi Ltd, a manufacturer in Nigeria, plans to launch a new product. It expects to sell 20,000 units a year. The variable cost is $14 per unit and the product’s fixed costs are $120,000 a year. The product needs an investment of $400,000 in equipment and working capital.
Calculate:
(a) the selling price per unit that will give a return on sales of 20%
(b) the selling price per unit that will give a return on investment of 15%
(c) the mark-up on marginal cost that gives the same selling price as in (b).
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5 Advantages and disadvantages of cost-plus pricing
Advantages | Disadvantages |
Quick and simple to apply once the cost per unit is known | It ignores demand: the price customers are willing to pay, and how many they will buy at each price |
The price covers the cost and includes a profit (if the expected volume is sold) | It ignores competitors’ prices – a price above theirs may sell nothing |
A consistent policy that can be applied across many products and justified to customers | Full cost depends on the volume assumed when absorbing fixed overheads, yet the volume sold depends on the price chosen |
Marginal cost plus avoids having to absorb fixed overheads, and is useful for one-off decisions | With marginal cost plus, the mark-up must be set high enough to cover fixed overheads – there is a risk of pricing too low |
For example, if the fixed overheads in Example 1 were $30,000 for a budgeted 10,000 units ($3 a unit), a lower price might sell 20,000 units, cutting the fixed cost to $1.50 a unit and justifying the lower price. Neither method is perfect; in the exam, follow the instructions – full cost or marginal cost, mark-up or margin.
6 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Cost–Plus Pricing
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