Full Cost Plus Pricing
Full cost plus pricing, also known as cost-plus pricing, is a pricing strategy where a company calculates the total cost to produce a product (i.e., the full cost, including both direct and indirect costs) and then adds a markup percentage to determine the selling price.
Here’s a basic outline of the steps a company would follow under this strategy:
- Calculate Full Cost: First, the company calculates the full cost of producing the product. This includes direct costs, such as raw materials and labor directly involved in production, as well as indirect costs, such as overhead expenses (like utilities, rent, and administrative costs).
- Determine markup Percentage: Next, the company decides what percentage of profit it wants to make on each product, known as the markup. The markup can vary widely depending on the industry, the company’s strategy, and other market conditions.
- Set the Price: Finally, the company adds the markup to the full cost to determine the selling price.
Here’s a simplified example:
Suppose it costs a furniture manufacturer $200 to make a chair, factoring in both direct and indirect costs. If the company wants a profit margin of 25%, it would add a markup of $50 (25% of $200) to the cost. The selling price for the chair would thus be set at $250.
One advantage of the full cost plus pricing strategy is its simplicity. It’s straightforward to calculate and ensures all costs are covered, and a profit margin is achieved if the product sells at the set price.
However, one major drawback is that it doesn’t consider demand, competition, and price sensitivity – factors that are crucial to a successful pricing strategy. In markets with strong competition or price-sensitive customers, a cost-plus pricing strategy might result in prices that are too high to attract customers. Conversely, in markets with high demand and less competition, it could result in prices that are lower than what customers would be willing to pay, leaving potential profits on the table.
Example of Full Cost Plus Pricing
Let’s consider a more detailed example:
Let’s say you run a business called “HealthyBread Bakery” that produces organic, gluten-free bread.
- Calculate Full Cost: First, you calculate the full cost of producing a loaf of bread. The direct costs include raw materials like flour, yeast, and salt, and direct labor like the bakers’ wages. Suppose this amounts to $2 per loaf.Then, you add indirect costs, or overheads, such as rent for the bakery, utilities, insurance, and the salaries of administrative staff. Let’s say after distributing these overhead costs over the number of bread loaves you produce in a month, the indirect cost comes to $1 per loaf.So, the full cost of producing a loaf of bread is $2 (direct costs) + $1 (indirect costs) = $3.
- Determine Markup Percentage: You decide that you want a profit margin of 50% on each loaf of bread.
- Set the Price: Now, you add the markup to the full cost to set the price. A 50% markup on a $3 cost is $1.50 ($3 * 50%). Therefore, you would set the selling price of each loaf of bread at $4.50 ($3 cost + $1.50 markup).
Using the full cost plus pricing method, you’ve ensured that all your costs are covered, and you’re making a 50% profit on each loaf sold.
However, as mentioned before, this method doesn’t take into account external market factors. If other bakeries are selling similar bread for $4, you might lose customers due to your higher price. On the other hand, if customers highly value organic, gluten-free bread and are willing to pay more for it, you might have been able to charge more than $4.50 and increase your profits. This emphasizes the need to consider various factors, not just costs, when setting prices.
