Markup Pricing
Markup pricing is a strategy in which a company first calculates the cost of the product, then adds a proportion of it as markup.
LEARNING OBJECTIVES
Examine the rationale behind the use of markup pricing as a general pricing strategy
KEY TAKEAWAYS
Key Points
- Markup pricing is used primarily because it is easy to calculate and requires little information.
- The first step to determine markup price involves calculation of the cost of production, and the second step is to determine the markup over costs.
- In markup pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed.
Key Terms
- marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. The additional cost associated with producing one more unit of output.
- discretion: The freedom to make one’s own judgements.
Markup Pricing
Several varieties of markup pricing – also known as cost-plus pricing – exist, but the common thread is that one first calculates the cost of the product, then adds a proportion of it as markup. The amount to be marked up is decided at the discretion of the company. Basically, this approach sets prices that cover the cost of production and provide enough profit margin to the firm to earn its target rate of return.
Cost-plus pricing is used primarily because it is easy to calculate and requires little information. Information on demand and costs is not easily available; however, this information is necessary to generate accurate estimates of marginal costs and revenues. Moreover, the process of obtaining this additional information is expensive. Therefore, cost-plus pricing is often considered a rational approach to maximizing profits. Cost-plus pricing is especially useful in the following cases:
- Public utility pricing
- Finding out the design of the product when the selling price is predetermined, which is also known as product tailoring
- Pricing products that are designed to the specification of a single buyer
- “Monopsony Buying” – buyers have enough knowledge about the costs of a supplier. Thus, they may make the product themselves if they do not comply with the offered prices. So the relevant cost would be the cost that a buying company would incur if it made the product itself.
Calculating a Markup Price
There are two steps which form this approach. The first step involves calculation of the cost of production, and the second step is to determine the markup over costs. The total cost has two components: total variable cost and total fixed cost. In both cases, costs are computed on an average basis. In cost-plus pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed. This rate of output is based on some percentage of the firm’s capacity. The objective of determining markup over costs is to set prices in a manner that a firm earns its targeted rate of return. This return can be considered RsX, where Rs is the ratio of the respective share of total profit. Therefore, the markup over costs on each unit of output will be X/Q. Price will be calculated through the formula in.
Cost-Plus Price Equation: A cost-plus price is equal to the average variable costs plus average fixed costs plus markup per unit.
Total Average Cost Equation: The total average cost for a product is determined by dividing the total fixed costs (TFC) and total variable costs (TVC) by the quantity of the product produced and then adding them together.
Reasons For Widespread Use
The following points explain as to why this approach is widely used:
- Even if a firm handles many products, this approach provides the means by which fair prices can be easily found.
- This approach involves calculation of full cost. Prices based on full cost look factual and precise and may be more defensible on moral grounds than prices established by other means.
- This approach reduces the cost of decision-making. Firms which prefer stability use cost-plus pricing as a guide to price products in an uncertain market where knowledge is incomplete.
- Firms are never too sure about the shape of their demand curve; neither are they very sure about the probable response to any price change. It thus becomes risky for a firm to move away from cost-plus pricing.
- The reaction of rivals to the set price is a major uncertainty. When products and production processes are similar, competitive stability is achieved by usage of cost-plus pricing. This competitive stability is achieved by setting a price that is likely to yield acceptable returns to other members of the industry.
- Management tends to know more about product costs than any other factors which can be used to price a product.
- Markup pricing ensures a seller against unpredictable or unexpected later costs.
- Price increases can be justified in terms of cost increases.
Disadvantages Of Markup Pricing
Disadvantages of this strategy include:
- Provides incentive for inefficiency
- Tends to ignore the role of consumers
- Tends to ignore the role of competitors
- Uses historical rather than replacement value
- Uses “normal” or “standard” output level to allocate fixed costs
- Includes sunk costs rather than just using incremental costs
- Ignores opportunity cost