Target Selling Price and Cost Plus Pricing Notes

Learning Objective: Target Selling Price using Cost Plus Pricing

  • Definition of Cost Plus Pricing
    Cost plus pricing is a method where the selling price is determined by adding a markup to the costs of the product. This approach is used in environments with little to no competition, allowing a company to set their own prices based on costs and desired profits.

  • Competitive Pricing Context

    • In a situation like the pencil makers, companies cannot set their own prices due to fierce market competition. Instead, they must accept the market price.
    • Contrast this with cost plus pricing where companies can decide their pricing based on production costs and markup.

  • Steps to Calculate Selling Price

    1. Determine Product Costs: Compute total costs of production, which includes both variable and fixed costs.
    • Example:
      • Variable Costs:
        • Direct materials: $23
        • Direct labor: $17
        • Variable manufacturing overhead: $12
        • Variable selling/admin: $8
        • Total Variable Cost per Unit: $60
      • Fixed Costs:
        • Fixed manufacturing overhead: $350,000
        • Fixed selling/admin: $300,000
        • Total Fixed Cost per Unit: $30
      • Total Cost per Unit: $125
    1. Determine Desired Profit: Establish the profit expected per unit.
    • Example: For an investment of $2,000,000, with a desired return of 20%, the expected profit would be $400,000.
    • Per unit return on investment is calculated as:
      • $400,000 / 10,000 = $40
    1. Calculate Selling Price:
    • Selling Price = Total Cost + Desired Profit
    • Example: Selling Price = $125 + $40 = $165

  • Markup Percentage Calculation

    • To find the markup percentage, divide the desired profit ($40) by the total cost per unit ($125).

    • Markup Percentage Formula:

      [
      \text{Markup Percentage} = \frac{\text{Desired Profit}}{\text{Total Cost per Unit}}
      ]

      = \frac{40}{125} = 0.32 or 32%

  • Impact of Production Volume on Costs

    • If production volume changes (i.e., from 10,000 units to 5,000 units), fixed cost per unit will increase because fixed costs are spread over fewer units, whereas variable costs remain constant per unit.
    • Example:
    • Fixed cost per unit increases if selling only 5,000 units from $30 to $35, while variable cost remains at $60.

  • Understanding Break-even Point

    • If the selling price is set at total cost (e.g., $125), profit will be zero, leading the company to merely break even. To achieve profitability, the selling price must exceed the total cost plus desired profit.

  • Conclusion

    • Cost plus pricing is a strategic method to ensure that production costs and profit margins are adequately covered when setting suitable selling prices, especially in less competitive environments, allowing the company to maintain profitability while covering fixed and variable costs.