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Chapter 12: Problem 10

What is cost-plus pricing?

Short Answer

Expert verified
Cost-plus pricing adds a markup to the production cost to set the selling price.

Step by step solution

01

Understand the Concept of Cost-plus Pricing

Cost-plus pricing is a pricing strategy where a fixed percentage or fixed amount is added to the production cost of a product to determine its selling price. The goal is to ensure all costs are covered and to achieve a profit margin.
02

Determine the Total Costs

Calculate the total costs involved in producing the product. This includes both fixed costs, like rent and salaries, and variable costs, such as raw materials and production hours.
03

Decide the Markup Percentage or Amount

Choose a markup percentage or a fixed amount that you want to add on top of the total costs. This markup will constitute the profit margin for each unit sold.
04

Calculate the Selling Price

Add the selected markup (either percentage or fixed amount) to the total costs to determine the final selling price of the product. For example, if the total cost is $100 and the markup is 20%, the selling price would be $120.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Pricing Strategy
Pricing strategy is a fundamental aspect of marketing that revolves around setting the right price for a product or service. It's not just about covering the costs but also ensuring competitiveness in the market. One common approach to this is cost-plus pricing. This strategy helps businesses determine a fair selling price by adding a predetermined profit margin to their costs. Organizations often use this method for its simplicity and the assurance it gives in covering all costs and achieving profit. This strategy requires careful consideration of market factors and competitor prices to avoid pricing that is too high or too low.
Fixed Costs
Fixed costs are expenses that remain constant, regardless of the production volume. They are essential to understand because these costs have to be covered, no matter how many units are produced. Examples include rent, salaries, insurance, and equipment leases. Understanding fixed costs is crucial for businesses to ensure they do not set prices below levels that would cover these essentials. In cost-plus pricing, fixed costs are part of the total costs calculation. They stay the same even if you produce more or fewer units. This means that as production increases, the cost per unit decreases because the fixed costs are spread over more units.
Variable Costs
Variable costs fluctuate with the level of production or sales volume. These include costs like raw materials, packaging, and direct labor. For every unit produced, these costs are incurred. Therefore, understanding variable costs is key to calculating the total cost per unit. Businesses must estimate these costs precisely to set a competitive and profitable selling price. When applying cost-plus pricing, summing the fixed costs and the increasing variable costs related to production determines the basis for setting the final price. This is why businesses monitor variable costs closely to ensure that the price remains competitive and profitable.
Profit Margin
Profit margin represents the portion of sales revenue that exceeds the total costs. It is the reward a business receives for its efforts and risk. In cost-plus pricing, a specific profit margin is added to the sum of fixed and variable costs to determine the product's selling price. The key to setting a profit margin is understanding the market and competition to ensure that the price remains attractive to customers while generating sufficient profits. A larger profit margin could mean higher prices, which risks losing potential sales unless justified by added value or superior quality.

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Most popular questions from this chapter

How is activity-based costing useful for pricing decisions?

Burst, Inc., cans peaches for sale to food distributors. All costs are classified as either manufacturing or marketing. Burst prepares monthly budgets. The March 2012 budgeted absorption-costing income statement is as follows: Monthly costs are classified as fixed or variable (with respect to the number of crates produced for manufacturing costs and with respect to the number of crates sold for marketing costs): Burst has the capacity to can 2,000 crates per month. The relevant range in which monthly fixed manufacturing costs will be "fixed" is from 500 to 2,000 crates per month. 1\. Calculate the markup percentage based on total variable costs 2\. Assume that a new customer approaches Burst to buy 200 crates at \(\$ 55\) per crate for cash. The customer does not require any marketing effort. Additional manufacturing costs of \(\$ 3,000\) for special packaging) will be required. Burst believes that this is a one-time-only special order because the customer is discontinuing business in six weeks' time. Burst is reluctant to accept this 200-crate special order because the \(\$ 55\) -per-crate price is below the \(\$ 65\) -per-crate full manufacturing cost. Do you agree with this reasoning? Explain. 3\. Assume that the new customer decides to remain in business. How would this longevity affect your willingness to accept the \(\$ 55\) -per-crate offer? Explain.

New Life Metal Recycling and Salvage has just been given the opportunity to salvage scrap metal and other materials from an old industrial site. The current owners of the site will sign over the site to New Life at no cost. New Life intends to extract scrap metal at the site for 24 months, and then will clean up the site, return the land to useable condition, and sell it to a developer. Projected costs associated with the project follow: $$\begin{array}{lllc} & & \text { Fixed } & \text { Variable } \\ \hline \text { Months 1-24 } & \text { Metal extraction and processing } & \$ 4,000 \text { per month } & \$ 100 \text { per ton } \\ \text { Months 1-27 } & \text { Rent on temporary buildings } & \$ 2,000 \text { per month } & \- \\ & \text { Administration } & \$ 5,000 \text { per month } & \- \\ \text { Months 25-27 } & \text { Clean-up } & \$ 30,000 \text { per month } & \- \\ & \text { Land restoration } & \$ 475,000 \text { total } & \- \\ & \text { cost of selling land } & \$ 150,000 \text { total } & - \end{array}$$ Ignore time value of money. 1\. Assuming that New Life expects to salvage 50,000 tons of metal from the site, what is the total project life cycle cost? 2\. Suppose New Life can sell the metal for \(\$ 150\) per ton and wants to earn a profit (before taxes) of \(\$ 40\) per ton. At what price must New Life sell the land at the end of the project to achieve its target profit per ton? 3\. Now suppose New Life can only sell the metal for \(\$ 140\) per ton and the land at \(\$ 100,000\) less than what you calculated in requirement 2. If New Life wanted to maintain the same mark-up percentage on total project life- cycle cost as in requirement \(2,\) by how much would it have to reduce its total project life-cycle cost?

The Marino Repair Shop repairs and services machine tools. A summary of its costs (by activity) for 2011 is as follows: a. Materials and labor for servicing machine tools \(\quad \$ 800,000\) b. Rework costs 75,000 c. Expediting costs caused by work delays 60,000 d. Materials-handling costs 50,000 e. Materials-procurement and inspection costs 35,000 f. Preventive maintenance of equipment 15,000 g. Breakdown maintenance of equipment 55,000 1\. Classify each cost as value-added, nonvalue-added, or in the gray area between. 2\. For any cost classified in the gray area, assume \(65 \%\) is value-added and \(35 \%\) is nonvalue-added. How much of the total of all seven costs is value-added and how much is nonvalue-added? 3\. Marino is considering the following changes: (a) introducing quality- improvement programs whose net effect will be to reduce rework and expediting costs by \(75 \%\) and materials and labor costs for servicing machine tools by \(5 \%\); (b) working with suppliers to reduce materials-procurement and inspection costs by \(20 \%\) and materials-handling costs by \(25 \%\); and (c) increasing preventive-maintenance costs by \(50 \%\) to reduce breakdown- maintenance costs by \(40 \%\). Calculate the effect of programs (a), (b), and (c) on value-added costs, nonvalue-added costs, and total costs. Comment briefly.

Describe two alternative approaches to long-run pricing decisions.
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