Salient Points on Minimum Pricing:

• For this type of pricing, the selling price is the lowest price that a company may sell its product.

• Normally the price will be the Total Relevant Costs of Manufacturing.

• Useful method in situations where there is a lot of intense competition, surplus production capacity, clearance of old stocks, getting special orders and or improving market share of the product.

• Minimum Price is Incremental costs of manufacturing + Opportunity Costs ( if any)

Simple Illustration:

Assuming the following details of product X:

Material                              $2.50

Labor( 2 hrs @ $3.00)           $6.00

Variable production overhead $2.50

Fixed production overhead     $1.20

Total                                   $9.70

Say that the labor is in short supply and is used for other product Y which generates a contribution of $6 per unit and requires 2 hours of the same labor.

Material                                 $2.50

Labor                                    $6.00

Variable production overhead   $2.50

Add:

Opportunity cost from labor scarcity:

$6 / 2 hours= $3.00 per hr x 2 hr = $6.00

Minimum price =  $17.00

Salient Points on Break-Even Pricing:

• For this type of pricing, the price at which the products will break-even is used. This break-even price will then be added a profit mark up.

Simple Illustration:

Fixed Cost     $25,000

Variable cost $2.00 per unit

Number of Units produced  4,000

Mark-up is 15% on the break-even price

What will be selling price to the customers?

Solution:

Break-even price

= Fixed Cost + Variable cost/marginal cost

Total Number of units produced

= $25,000+ $8,000

         4,000

= $8.25

+ mark up of 15% ($1.24)

=$9.50 which is the selling price to the customer.

Salient Points on Rate Of Return Pricing:

• For this type of pricing, the company needs to specify the rate of return on its capital invested;

• Similar to Cost plus pricing the difference is that the  marked up will be based on the target rate of return;

• The target rate of return varies with market norm or what management considers a fair return.

• Useful method to use when a business has invested too much on the project or products

• However, difficult to use where a company has too many product lines or competes in many markets

Simple Illustration:

Capital invested / employed  $2,000,000

Target return  10%

Estimated costs $500,000

Mark up

= 10% x $2,000,000

       $500,000

=40%

Salient Points on Variable/Marginal Cost Plus pricing:

• Selling price is determined by adding a mark up or margin on the total variable costs (marginalcost);

• Based on the assumption that any price above variable cost would generate a certain level of contribution towards meeting fixed costs;

• Consistent with the marginal costing technique;

• When using this pricing method, need to be careful to ensure that it is sufficient to cover all fixed cost and to generate sufficient margin for profit otherwise the long term survival of the business might be at stake;

Simple Illustration:

Let’s look at Product A:

Production cost as follows:

Variable/direct material                $1.50

Variable/direct labor                     $1.50

Variable Production overheads       $1.00

Variable Administrative overheads  $0.50

Variable Selling overheads             $0.10

Total variable costs                       $4.60

Say required mark up of 65% $3.00

Variable Cost Plus Pricing $7.60

The selling price is determined at $7.60 where the company wants Product A to at least cover its total variable cost and contribute towards recovery fixed costs and profit.

Advantages Of Variable/Marginal Cost Plus Pricing:

• As it adopts the margin cost approach, it provides better information as it segregate the variable and fixed costs;

• Highlights the importance of contribution;

• Useful for contract bidding where competition could be quite intense;

• Eliminates the difficulty of computing fixed costs into the products.

Disadvantages Of Variable/Marginal Cost Plus Pricing:

·      For short term pricing decision, it’s alright otherwise needs to be very careful the pricing in the long term can recover fixed costs and generate sufficient profit for the business;

·       Might be unsuitable for production costs consist a lot of fixed costs.

Salient Points on Full Cost Plus Pricing:

• Traditional method of pricing a product;
• Most commonly used method;
• Prices are set by adding a percentage of profit ( either a mark up or a margin) to the total cost of the product;
• Consistent with the absorption costing technique;
• Commonly used by wholesalers, retailers, construction contractors, services, government contractors;

• Useful in situation where:

•  Products are made based on specification by the customers;

•  Main objective is to make profit after considering fixed costs of  the  business;

• The costs are difficult to estimate in advance;

•  Expected demand at different price levels is difficult to estimate.

Simple Illustration:

Let’s look at Product A:

Production cost as follows:

Variable cost -material $1.50

Variable cost- labor     $1.50

Total variable cost      $3.00

Fixed cost                  $3.00

(excludes administrative and selling overheads)

Required 50% mark up on total production cost.

For Full-Cost Plus Pricing:

Total cost = $3.00+$3.00 =$6.00

50% on total/full cost = 50% x $6.00 =$3.00

Hence, Selling price = $6.00+$3.00 =$9.00 per unit.

By pricing at $9.00, the company wants Product A to at least cover its total production cost.

Advantages Of Full Cost Plus Pricing:

• Easy and simple to understand;
• Pricing decisions become standardized;
• Adopts a conservative approach that in the long run to at least ensure the recovery of fixed cost of a business;
• Difficult of estimating demands can be avoided.

Disadvantages Of Full Cost Plus Pricing:

·     Tendency to set prices on inaccurate estimates;

·      Challenges of apportioning the fixed overheads properly into different products

·       Unsuitable for short term decisions making particularly in situation like surplus production capacity, tendering for contracts price and others;

·      Ignores competition and price elasticity of demand and

·      Ignores opportunity costs and relevant costs.

Before a decision on the pricing is made, certain factors need to be consider:

• What are the objectives of the company-to maximize profit?, to gain market share?, to penetrate the new market and others;
• What is the existing economic conditions;
• Any government regulations;
• Cost structure of the organization;
• Demand for the product which should includes a study of the price elasticity of demand;
• Inflation;
• Surplus production capacity
• Level of competition and
• Political scenario