Advantages And Disadvantages Of Full-cost-plus And Marginal Cost Pricing Method In Product Price Calculation

This report will discuss management costs that influence pricing decisions as well as to argue “the cost-based pricing” approach, which is one of the easiest ways to calculate the price of a product.

Normally, management teams make these crucial pricing decisions. If the price is too high, demand for the product will be too low; but if they price too low, they will fail to maximize their profits. Such pricing decisions usually involve the consideration of several factors including the likely response of customers, competitor response, cost structure, as well as political and legal constraints. Pricing is, therefore, one of the most difficult yet important things to get right in business.

Customers can influence pricing decisions based on whether they choose to buy a product at a particular price or not. This is why it is important for businesses to envisage the customer's perspective. Customers often reject products or services when they feel the price is too high and may subsequently choose an alternative product from a competitor.

Competitors are also a key factor in pricing. When competitors offer similar products or services at a lower price, a business may have to lower its own prices in order to remain competitive. At the other end of the spectrum, if there is no competition at all and a business has a monopoly over a particular market and can charge whatever it likes. Costs also have a key role in pricing decisions and should be the primary consideration. No business is viable if costs exceed revenue from sales.

This essay will focus only on costs and consider the advantages and disadvantages of the “full cost-plus pricing” and “marginal cost pricing” approaches.

Pricing

To explore the relationship between 'pricing' and 'cost' it is worth considering the definition of pricing. The businessdictionary.com website states:

“Pricing is a method adopted by a firm to set its selling price. It usually depends on the firm’s average costs and the customer’s perceived value of the product in comparison to his or her perceived value of the competing products”.

The price of a product will depend on cost, as well as other factors such as competition, advertising, and sales promotions. Supply and demand is also an issue. If many other businesses are offering a similar product, supply is therefore high and it will be harder to charge a high price. But where demand for a product is high, possibly to the point where it even exceeds supply, it is easier to charge a higher price. Management has to examine all the relevant factors and decide on a price that will result in the highest profits for the business.

Meeting objectives and targets

Maximizing current profits will usually be the central objective of pricing decisions. A company will aim to set a price so that it is not too high so as to deter buyers, but will still lead to maximum profits. A company, through its pricing decisions, will also be aiming to meet other business targets. These might include achieving and sustaining the business's share of the market; maintaining profit motivation and remaining competitive; maintaining stable and consistent pricing as far as possible, and to achieve all of the above effectively and efficiently.

Given that the price of a product must exceed the cost of making it if a company is to make a profit, a company must have access to product-cost information to help inform their pricing decisions. ssueIf a product is priced too high, this may lead to a loss of sales. On the other hand, if it is priced too low is an issue, a company may be left with an inventory of unprofitable products.

As Weetman argues, pricing decisions will largely depend on the circumstances of a business. If there is strong competition, a company will be aiming to achieve the highest percentage of sales, and will therefore have to work around the market price and control costs to maximise profits. Weetman also mentions how customers can put pressure on a company to reduce the selling price, in which case the business would need to evaluate the lower price against costs. Finally, where a company has the ability to control the price, it would need to 'decide on a price related to what the market will bear and related to covering its costs' (Pauline Weetman).

Cost Structure

In order to make the best pricing decisions, the management must be able to determine which information is relevant, which is not, and the costs and benefits of acquiring this information. Some costs are relevant, which means that they can influence the decision. These are also known as differential costs.

Relevant Cost (CIMA)

Relevant costing involves managers being able to identify and separate costs and revenues that will affect pricing decisions from those factors that are irrelevant.

According to CIMA, relevant costs are 'costs appropriate to a specific management decision. These are represented by future cash flows whose magnitude will vary depending upon the outcome of the management decision made' (CIMA).

Generally, the fixed costs are not relevant to decision making unless they can be avoided by a specific course of action (Pauline Weetman), whereas variable costs are relevant.

A relevant cost will vary depending on the decision a company makes. Any cost which cannot be changed, regardless of the decision taken, will be an unavoidable and therefore irrelevant cost. An avoidable cost is a cost that would be incurred if a company makes a particular decision, but which would not exist at all if it made a different decision. Therefore, avoidable costs are always relevant to pricing decisions because these will vary according to the decision taken.

Another issue is opportunity costs versus sunk costs. An opportunity cost is what a company gives up in its second best choice when it opts for what it has decided is its best choice. Opportunity costs are always relevant as what we give up depends on what we choose. By contrast, there is no decision that can affect sunk costs because these have already occurred. Sunk costs are therefore irrelevant to pricing decisions and can be ignored.

During the process of making pricing decisions, it is also essential to take qualitative issues into consideration. These are factors that may influence decision-makers to choose a particular option even if does not appear to be the best one available in terms of revenues and costs. A management team must evaluate all factors as well as the numbers before them, and then choose the best option based on all of the information available.

Relevant costs, therefore, include future costs, cash flows and incremental costs, but not depreciation, as this does not relate to cash flow, nor future or incremental costs. However, if using a machine to produce a new product causes additional wear and tear, the additional becomes relevant.

Cost-based pricing requires determining prices based on production and distribution costs, as well as the cost of selling the product. Companies can also add a fair rate of return to compensate for efforts and risks.

Companies that are well-known for using cost-based pricing include Ryanair and Walmart, whose objective is to become low-cost producers in their industries. These companies routinely reduce costs wherever possible, which allows them to set lower prices. Although this leads to smaller margins, they still manage to maximise sales and profits. Companies with higher prices can also utlitise cost-based pricing, but they usually generate higher costs on purpose to claim higher prices and margins.

Cost-based pricing is the easiest way to calculate an appropriate price for a product. There are two forms of cost-based pricing: full-cost pricing (also known as cost-plus pricing) and margin-cost pricing. Full-cost pricing takes into consideration both variable and fixed costs and adds a percentage markup, whereas margin-cost pricing considers only variable costs plus a percentage markup.

Full-cost-plus pricing

Full-cost-plus pricing is a price-setting method where the direct costs of material and labour are added to any selling costs, administrative costs and overheads. A markup percentage is then added to determine the price of the product and create a profit margin. In other words, price-setting must cover the total amount that it costs to produce a product.

The pricing formula is:

(Total production costs + selling and administration costs + markup) ÷number of units expected to sell

It is common to use this method for tailor-made or customized products and services, where there is less competitive pressure and no standardized product. The method is also effective in long-term pricing as it helps determine prices that are high enough to ensure a profit after all costs have been incurred.

Advantages of Full Cost Pricing

When using the full-cost pricing method, it is easy to derive a product price as it is based on a simple formula. This standard formula means that a price can be derived at almost any level of an organization.

Full-cost pricing also increases the likelihood of making a profit. As long as the assumed figures used in the formula to derive the price are correct, a company has a high chance of turning a profit on sales using this method.

Finally, it is easier to justify price increases to customers when you are using the full-cost pricing method, as it is easy to explain that prices are based on cost and demonstrate where costs have increased.

Disadvantages of Full Cost Pricing

Competition

One disadvantage is that this method does not take competition into account. A company may use this formula to set a product price but then find that competitors are charging significantly different prices. Competitors' prices should never be ignored when determining prices, as this could carry huge risks and result in potential losses to a company.

Price elasticity

The full-cost pricing method also makes no consideration of price elasticity. The market condition, or the supply of and demand for a product, should be an important factor in informing pricing decisions. If a company prices a product too low, they lower their potential profits. However, if they price too high, this can deter customers and lead to lower revenues.

Budgeting errors

Another point that the full-cost pricing formula does not take into account is possible budgeting errors in terms of the estimates of costs and sales volume. If there are errors within the equation, then the number produced by the formula may not correspond with the most appropriate product price.

Profit Margin Decisions

Management takes profit margin decisions, for which there is no mechanism. Biased decision-making when it comes to profit margins could negatively impact on product sales.

The formula is too simplistic

The full-cost pricing formula calculates the price of a single product only. Where there are various products, it is necessary to adopt a cost allocation methodology when making pricing decisions. Full-cost pricing is not a simple task, and in many cases, it is not possible to calculate the full cost of a product. For example, if a product is very small, or if there are different varieties of a product being manufactured under the same roof.

Marginal Cost-Plus Pricing

“In the short term, a business may decide to accept a price that is lower than full cost providing the price offered is greater than the variable cost, so that there is a contribution to fixed overhead costs. This reflects the economist’s position that business will continue to sell, providing the marginal revenue exceeds the marginal cost. It is therefore called marginal cost pricing.” ( Pauline Weetman)

When a company sets prices according to the marginal cost pricing method, the price is set at or above the variable cost of producing it. This approach is usually used in short-term price setting situations, which may arise in one of two circumstances: either a company has a small amount of unused production capacity available that it wishes to use, or it is unable to sell at a higher price.

The first scenario would normally occur in a financially stable company that wanted to maximise profits by making a few more sales. The second scenario is a last resort, where there would appear to be no other means for a company to achieve sales. Prices set this low are not expected to offset the fixed costs of a business. Therefore, this is not intended as a long-term pricing strategy.

Advantages of Marginal Cost Pricing

Some customers will not buy from a company unless they lower their prices through marginal-cost pricing. So by pricing according to this method, a company can win over some additional customers and earn some incremental profits.

Another advantage is that if a company is willing to sacrifice profits in the short term, marginal cost pricing can facilitate entry into a market by helping them to acquire more price-sensitive customers.

Finally, if customers are willing to buy product accessories or services at a healthy margin, it may seem logical to use marginal cost pricing to sell products on an ongoing basis, and then acquire profits from these later sales.

Disadvantages of Marginal Cost Pricing

On disadvantage is that this method does not work for long-term price setting as these prices will not cover a company's fixed costs.

Moreover, marginal cost pricing keeps prices at an absolute minimum. Thus if a company routinely used this methodology to set prices instead of setting prices closer to the market rate, it would most likely miss out on an enormous amount of margin.

It also makes price increases difficult. If a company routinely uses the marginal cost pricing method and then wants to raise prices, it may lose a significant portion of its customer base who may not accept paying a higher price for the same product or service.

Finally, with the margin cost pricing method a company has to keep costs down if it wants to generate a profit. This method would, therefore, impede a company that wanted to move into a higher-quality market niche where costs would be higher.

Conclusion

In conclusion, the full-cost-plus pricing method is more appropriate for making long-term pricing decisions, whereas the margin cost-plus pricing may be more suitable for short-term pricing decisions. When making pricing decisions, managers must have the ability to separate relevant costs from irrelevant costs. Different organizations will have different ideas on which costs they want to cover in a “cost-based pricing” approach. What matters most is that the organization understands its cost structure and ensures that its overheads are covered by revenue in the longer term. (Pauline Weetman)

The “full cost-plus pricing” calculation itself is simple. Once the true unit costs are calculated, the cost-plus value is simply added to the unit cost. The method works well for setting long-term prices higher enough to ensure a profit after all costs have been incurred. However, as mentioned above, this method does not take into account all market factors or influences, such as price elasticity and competition, nor demand for the product.

Marginal cost-plus pricing is based on the variable production costs. This method ignores fixed costs and overheads and can be useful for short-term exceptional pricing decisions. However, in the long term, both fixed and variable costs must be covered to determine the profitability of a product.