Various firms use an alternative pricing method called the full cost or cost plus pricing. It is the most commonly used method for pricing.
Under this method, price is adjusted to cover costs and a predetermined percentage of profit. The general practice under this method is that a reasonable percentage of profit margins are added to average variable cost (AVC).
The mark-up percentage is fixed to cover average fixed cost (AFC) and net profit margin. This percentage is never alike among various firms in the industry and even products of the same concern.
ADVERTISEMENTS:
It is because of the differences in the degree of competition, differences in cost base and turnover rate with risk. It shows some vague idea of just profit.
The first step in fixing price, under these methods is estimation of average cost. To estimate the average cost the firm has to determine its level of output in a given period and for this the firm takes into account its planned production.
If optimum level of output is determinable then optimum level of output is taken as standard output to estimate the average cost of production.
ADVERTISEMENTS:
The next step is to calculate the total cost of that output which is taken as base to estimate the average cost of production.
Then the margin of profit is added to average cost of production to determine the price.
Limitations of the Cost plus Method:
Image Source : desertsojourn.com
(i) Demand is ignored:
There is no reciprocity between cost and demand for the goods. Demand is totally ignored in pricing.
(ii) Failure to show the forces of competition:
It fails to reflect the forces of competition fully.
(iii) Exaggeration of the precision of allocated costs:
ADVERTISEMENTS:
It exaggerates the precision of allocated costs.
(iv) Based on cost concept:
It is based on concept of cost that may not be relevant for the decision of the price.