Q.
a) Effective customer oriented pricing involves understanding how much value consumers place on the benefits they receive from the product in setting a price that captures this value. Explain the differences between value-based pricing and cost-based pricing. (20 marks)
b) Clarify cost-plus pricing method in setting the price of the product. (5 marks)
(25 marks, 2017 Q5)
A.
a) Differences between value-based pricing and cost-based pricing
See earlier post
Value-based pricing vs cost-based pricing
2013 Q6b
b) Cost-plus pricing method
Cost plus pricing is a cost-based method for setting the prices of goods and services. Under this approach, you add together the direct material cost, direct labor cost, 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. Cost plus pricing can also be used within a customer contract, where the customer reimburses the seller for all costs incurred and also pays a negotiated profit in addition to the costs incurred.
The Cost Plus Calculation
As an example, ABC International has designed a product that contains the following costs:
- Direct material costs = $20.00
- Direct labor costs = $5.50
- Allocated overhead = $8.25
The company applies a standard 30% markup to all of its products. To derive the price of this product, ABC adds together the stated costs to arrive at a total cost of $33.75, and then multiplies this amount by (1 + 0.30) to arrive at the product price of $43.88.
Advantages of Cost Plus Pricing
- Simple. It is quite easy to derive
- a product price using this method, though you should define the overhead allocation method in order to be consistent in calculating the prices of multiple products.
- Assured contract profits. Any contractor is willing to accept this method for a contractual agreement with a customer, since it is assured of having its costs reimbursed and of making a profit. There is no risk of loss on such a contract.
- Justifiable. In cases where the supplier must persuade its customers of the need for a price increase, the supplier can point to an increase in its costs as the reason for the increase.
Disadvantages of Cost Plus Pricing
- Ignores competition. A company may set a product price based on the cost plus formula and then be surprised when it finds that competitors are charging substantially different prices. This has a huge impact on the market share and profits that a company can expect to achieve. The company 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.
- Contract cost overruns. From the perspective of any government entity that hires a supplier under a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures - on the contrary, it will likely include as many costs as possible in the contract so that it can be reimbursed. Thus, a contractual arrangement should include cost-reduction incentives for the supplier.
- Ignores replacement costs. The method is based on historical costs, which may have changed. The most immediate replacement cost is more representative of the costs incurred by the entity.
Ref:
https://www.accountingtools.com/articles/2017/5/16/cost-plus-pricing