UTS24760 Chap.6 Cost and Cost Based Pricing
Cost and Cost Based Pricing
Module 2 examines three basic pricing methods and where each applies, and it starts with cost, not because cost is the best input but because nothing else can be evaluated until the profit identity is second nature.
Price is described as the single most important component in a company's bottom line, alongside variable cost, sales volume and fixed cost, and the identity can be written four ways, ending in unit contribution times volume minus fixed cost. That final form separates what a price decision can touch, unit contribution, from what customers decide, volume, and from what the decision cannot move at all, fixed cost.
The chapter then narrows the question from what costs are to which costs belong in the decision. Prices are seldom set on cost alone, yet cost remains central to building a strategy, and the resolution is selectivity: only the costs that move the profit a decision produces belong in it. There are two tests.
A cost must be incremental rather than average, which includes incremental fixed costs such as the cost of printing new menus or of obtaining regulatory approval for an increase; and semifixed costs, which are fixed over a range of sales and vary outside it, mean the answer depends on how large a volume change is contemplated.
A cost must also be avoidable rather than sunk, which is the point of the retailer holding end of season inventory: the original purchase price is identical under both options and therefore irrelevant to the choice between them.
Cost plus pricing is then examined as the method it is, widely criticised and overwhelmingly used, with 75% of restaurants and 60% of manufacturers applying it and retailers commonly adding a 100% markup on wholesale cost. Its critical weakness is not crudeness but circularity: unit cost cannot be determined before price, because unit cost depends on volume, price affects volume, and volume affects cost.
The chapter demonstrates that with one product priced under three volume assumptions, and closes on the cases where cost plus is nonetheless correct.
What this chapter covers
- 01
The profit identity written four ways
- 02
Why unit contribution is the form to memorise
- 03
Relevant cost: the two tests
- 04
Incremental against average, including incremental fixed costs
- 05
Semifixed costs and why the size of the change matters
- 06
Avoidable against sunk, and the inventory decision
- 07
How widely cost plus is used and what its logic is
- 08
The circularity, and when cost plus is still the right answer
One product, three volume assumptions, three different costs
- +1At 25,000 units the unit fixed cost is 360,000 divided by 25,000 = $14.40, full unit cost is $35.40, and the price is 35.40 times 1.45 = $51.33.
- +1At 40,000 units the unit fixed cost is $9.00, full unit cost is $30.00, and the price is $43.50.
- +1At 60,000 units the unit fixed cost is $6.00, full unit cost is $27.00, and the price is $39.15. The same product, cost structure and markup rule produce prices from $39.15 to $51.33, a 31% range, entirely from the volume assumed before the calculation began.
- +1Read the direction. A pessimistic volume assumption produces a higher price, which in an elastic market produces lower volume, which then justifies the pessimism. The loop is self confirming in the wrong direction, and it is the standard mechanism behind a product priced out of its own market. Breaking it requires an external anchor: a competitor price or a customer benefit.
Key terms
- Relevant cost
- A cost that determines the profit impact of a pricing decision. It must pass two tests: it must be incremental, meaning it changes between the scenarios being compared, and avoidable, meaning it has not already been irrevocably committed.
- Incremental fixed cost
- A fixed cost that results directly from implementing a price change, such as reprinting menus at new prices or obtaining regulatory approval for an increase. It is fixed with respect to volume but incremental with respect to the pricing decision, so it belongs in the analysis.
- Semifixed cost
- A cost that is fixed over a range of sales but varies once sales move outside that range, for example spare capacity that absorbs a modest volume increase but requires new equipment beyond it. Whether it is relevant depends on the size of the volume change being considered.
- Sunk cost
- A cost already incurred that cannot be recovered under any of the options being compared. Because it is identical across every branch of the decision it cannot affect the choice, which is why an original purchase price is excluded from a clearance versus hold comparison.
- Cost plus pricing
- Working out what a product costs once every overhead has been apportioned to it, then adding enough on top to earn a reasonable return. It is simple and internally defensible, and it is circular, because the unit cost it starts from depends on the sales volume the resulting price will produce.
Cost and Cost Based Pricing FAQ
If cost plus is so flawed, why do most firms use it?
Because it is simple, internally defensible and safe in a narrow sense: if the volume assumption holds, the price guarantees a return over allocated cost. It also requires no research into demand and no competitive intelligence, so it can be applied by anyone with the accounts.
The usage figures in this subject are 75% of restaurants and 60% of manufacturers, with retailers commonly applying a double markup of 100% on wholesale cost and restaurants working to benchmarks such as twice for food and five times for liquor. Widespread use is a fact about cost of analysis, not evidence of accuracy.
When is cost plus actually the right method?
In two situations. First, where the price is contractually defined as a function of cost, as in a supply contract that calculates the unit price paid by the customer from cost by formula. Second, as a floor check in every other situation: whatever method you use to set the price, cost plus tells you what you must clear.
The mature position, and the one the case rubric rewards, is that cost tells you the minimum, not the answer.
What is the second weakness, after circularity?
That nobody in the calculation is a customer. A pure cost calculation reflects only what the firm spent, never what buyers want or what the product is worth to them, and plenty of buyers would have paid well above whatever the seller decided to ask.
A resale market makes this visible: tickets resold far above face value represent value the original seller created and did not capture, and no cost plus calculation could have found it. This is the gap that value based pricing exists to close.
Assessment move
Do the three volume calculation yourself on fresh numbers until the circularity is something you feel rather than something you can recite, because it is the argument you will need in a case whenever a firm defends a price by pointing at its unit cost. Build the small table of assumed volume, unit fixed cost, full unit cost and price, and keep it as a template.
For the relevant cost material, practise sorting rather than defining. Take any cost list and run the two questions in order: does it change with this decision, and can it still be avoided. Sunk costs are the ones students argue about, so deliberately practise the inventory style problem where the original purchase price is identical under both options, and say out loud that it cancels.
Being able to exclude a number confidently, and say why, is worth more marks than including it carefully.
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