Full cost plus pricing is a price-setting method under which you add together the direct material cost, direct labor cost, selling and administrative costs, and overhead costs for a product, and add to it a markup percentage (to create a profit margin) in order to derive the price of the product. The pricing formula is:
(Total production costs + Selling and administration costs + Markup) ÷
Number of units expected to sell
This method is most commonly used in situations where products and services are provided based on the specific requirements of the customer; thus, there is reduced competitive pressure and no standardized product being provided. The method may also be used to set long-term prices that are sufficiently high to ensure a profit after all costs have been incurred.
The Full Cost Plus Calculation
ABC International expects to incur the following costs in its business in the upcoming year:
- Total production costs = $2,500,000
- Total sales and administration costs = $1,000,000
The company wants to earn a profit of $100,000 during that time. Also, ABC expects to sell 200,000 units of its product. Based on this information and using the full cost plus pricing method, ABC calculates the following price for its product:
($2,500,000 Production costs + $1,000,000 Sales/admin costs + $100,000 markup) ÷ 200,000 units
= $18 Price per unit
Advantages of Full Cost Plus Pricing
The following are advantages to using the full cost plus pricing method:
- Simple. It is quite easy to derive a product price using this method, since it is based on a simple formula. Given the use of a standard formula, it can be derived at almost any level of an organization.
- Likely profit. As long as the budget assumptions used to derive the price turn out to be correct, a company is very likely going to earn a profit on sales if it uses this method to calculate prices.
- Justifiable. In cases where the supplier must persuade its customers of the need for a price increase, the supplier can show that its prices are based on costs, and that those costs have increased.
Disadvantages of Full Cost Plus Pricing
The following are disadvantages of using the full cost plus pricing method:
- Ignores competition. A company may set a product price based on the full cost plus formula and then be surprised when it finds that competitors are charging substantially different prices.
- Ignores price elasticity. The company may be pricing too high or too low in comparison to what buyers are willing to pay. Thus, it either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues.
- Product cost overruns. Under this method, the engineering department has no incentive to prudently design a product that has the appropriate feature set and design characteristics for its target market. Instead, the department simply designs what it wants and launches the product.
- Budgeting basis. The pricing formula is based on budget estimates of costs and sales volume, both of which may be incorrect.
- Too simplistic. The formula is designed to calculate the price of only a single product. If there are multiple products, then you need to adopt a cost allocation methodology to decide on which costs are to be assigned to which product.
Evaluation of Full Cost Plus Pricing
This method is not acceptable for deriving the price of a product that is to be sold in a competitive market, for several reasons:
- It does not factor in the prices charged by competitors
- It does not factor in the value of the product to the customer
- It does not give management an option to reduce prices if it wants to gain market share
- It is more difficult to derive if there are multiple products, since the costs in the pricing formula must now be allocated among multiple products