Chapter 4

Chapter 4
Marginal costing
3 Pricing decisions
3.1 Full cost plus pricing
A price determined using full cost plus pricing is based on full cost plus a percentage mark-up for profit.
In full cost plus pricing, the full cost may be a fully absorbed production cost only, or it may include some absorbed
administration, selling and distribution overhead.
A business might have an idea of the percentage profit margin it would like to earn and so might decide on an average
profit mark-up as a general guideline for pricing decisions. This would be particularly useful for businesses that carry
out a large amount of contract work or jobbing work, for which individual job or contract prices must be quoted
regularly to prospective customers.
The percentage profit mark-up does not have to be fixed, but can be varied to suit the circumstances. In
particular, the percentage mark-up can be varied to suit demand conditions in the market.
3 Pricing decisions
3.1.1 Problems with full cost plus pricing
(a) Prices must be adjusted to market and demand conditions, the decision cannot simply be made on a cost
basis only. A company may need to match the prices of rival firms when these take a price-cutting
initiative.
(b) A full cost plus basis for a pricing decision is a means of ensuring that, in the long run, a company
succeeds in covering all its fixed costs and making a profit out of revenue earned. However, in the short
term it is inflexible.
(1) A firm tendering for a contract may quote a cost plus price that results in the contract going
elsewhere, although a lower price would have been sufficient to cover all incremental costs and
opportunity costs.
(2) In the short term, rapidly-changing environmental factors might dictate the need for lower (or
higher) prices than long-term considerations would indicate.
(c) Where more than one product is sold by a company, the price decided by a cost plus formula depends on
the method of apportioning fixed costs between the products.
3.1.2 Example: full cost plus pricing with
more than one product
3 Pricing decisions
3.1.3 Advantages of full cost plus pricing
(a) Since the size of the profit margin can be varied at management's discretion, a decision based on a price
in excess of full cost should ensure that a company working at normal capacity will cover all its fixed costs
and make a profit. Companies may benefit from cost plus pricing in the following circumstances.
(i) When they carry out large contracts which must make a sufficient profit margin to cover a fair
share of fixed costs
(ii) If they must justify their prices to potential customers (for example for government contracts)
(iii) If they find it difficult to estimate expected demand at different sales prices
(b) It is a simple, quick and cheap method of pricing which can be delegated to junior managers. This may
be particularly important with jobbing work where many prices must be decided and quoted each day.
3.1.4 Generating a return on sales or investment
• Full cost plus pricing is a form of target pricing, which means setting a price so as to achieve a target return on
sales or investment.
• Let's start with looking at a target return on sales.
• Suppose LM Company wishes to make a 20% return on sales. The full cost of product K is $100. The price that
LM. Company needs to set is therefore calculated as follows.
Let the selling price = P
P– full cost = 20% of P= 0.2P
Therefore P – 0.2P = full cost
Therefore 0.8P = full cost = $100
Therefore P = $100/0.8 = $125
• Now let's look at a target return on investment.
• Suppose sales of product Z for the coming year are expected to be 500 units. A return of 15% in the coming year
is required on the annual investment of $250,000 in product Z. The full cost of product Z is $175. The required
selling price is calculated as follows.
Required return = 15% × $250,000 = $37,500
Expected cost = 500 × $175 = $87,500
Required revenue – expected cost = required return
Therefore expected revenue = $(37,500 + 87,500) = $125,000
Therefore selling price = $125,000/500 = $250
3.1.4 Generating a return on sales or investment
3.2 Marginal cost plus pricing
Marginal cost plus prices are based on the marginal cost of production or the marginal cost of sales, plus a profit
margin.
Instead of pricing products or services by adding a profit margin on to full cost, a business might add a profit margin on to
marginal cost (either the marginal cost of production or else the marginal cost of sales).
For example, if a company budgets to make 10,000 units of a product for which the variable cost of production is $3 a
unit and the fixed production cost $60,000 a year, it might decide to fix a price by adding, say, 331/3% to full production
cost to give a price of $9 × 11/3 = $12 a unit. Alternatively, it might decide to add a profit margin of, say, 250% on to the
variable production cost, to give a price of $3 × 350% = $10.50.

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