Which of the following are true statements about the cost-plus pricing method check all that apply

Which of the following are true statements about the cost-plus pricing method check all that apply

Pricing can be the most challenging due to different market forces and pricing structures around the world. What determines a successful export pricing strategy? The key elements include assessing your company’s foreign market objectives, product-related costs, market demand, and competition. Other factors to consider are transportation, taxes and duties, sales commissions, insurance, and financing. 

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Pricing U.S. Products for Export 

As in the domestic market, the price at which a product or service is sold directly determines your company’s revenues. Your firm’s market research should include an evaluation of all variables that may affect the price range for your product or service. If your company’s price is too high, the product or service will not sell. If the price is too low, export activities may not be sufficiently profitable or may actually create a net loss.    

  • Traditional components for determining proper pricing are costs, market demand, and competition. Each component must be compared with your company’s objective in entering the foreign market. An analysis of each component from an export perspective may result in export prices that are different from domestic prices.  
  • There are additional costs that are typically borne by the importer. These include tariffs, customs fees, currency fluctuation, transaction costs (including shipping), and value-added taxes (VATs). These costs can add substantially to the final price paid by the importer, sometimes resulting in a total that is more than double the price charged in the United States. U.S. products often compete better on quality, reputation, and service than they do on price—but buyers consider the whole package. 

Pricing Considerations  

As you develop your export pricing strategy, these considerations will help determine the best price for your product overseas:  

  • What type of market positioning (i.e., customer perception) does your company want to convey from its pricing structure?  
  • Does the export price reflect your product’s quality?  
  • Is the price competitive?  
  • What type of discount (e.g., trade, cash, quantity) and allowances (e.g., advertising, trade-offs) should your company offer its foreign customers?  
  • Should prices differ by market segment?  
  • What should your company do about product-line pricing?  
  • What pricing options are available if your company’s costs increase or decrease?  
  • Is the demand in the foreign market elastic or inelastic?  
  • Is the foreign government going to view your prices as reasonable or exploitative?  
  • Do the foreign country’s antidumping laws pose a problem? 

Key Elements of Pricing Analysis  

Foreign Market Objectives  

An important aspect of your company’s pricing analysis is the determination of market objectives. For example, is your company attempting to penetrate a new market, seeking long-term market growth, or looking for an outlet for surplus production or outmoded products? Marketing and pricing objectives may be generalized or tailored to particular foreign markets. For example, marketing objectives for sales to a developing nation, where per capita income may be one-tenth of that in the United States, necessarily differ from marketing objectives for sales to Europe or Japan. 

Costs  

The actual cost of producing a product and bringing it to market is key to determining if exporting is financially viable.  

  • Cost-plus method is when the exporter starts with the domestic manufacturing cost and adds administration, research and development, overhead, freight forwarding, distributor margins, customs charges, and profit. However, the effect of this pricing approach may be that the export price escalates into an uncompetitive range once exporting costs have been included.  
  • Marginal cost pricing is a more competitive method of pricing a product for market entry. This method considers the direct out-of-pocket expenses of producing and selling products for export as a floor beneath which prices cannot be set without incurring a loss. For example, additional costs may occur because of product modification for the export market. Costs may decrease, however, if the export products are stripped-down versions or made without increasing the fixed costs of domestic production. 
  • Other costs should be assessed for domestic and export products according to how much benefit each product receives from such expenditures, and may include:  
  • Fees for market research and credit checks  
  • Business travel expenses  
  • International postage and telephone rates  
  • Translation costs  
  • Commissions, training charges, and other costs associated with foreign representatives  
  • Consultant and freight forwarder fees  
  • Product modification and special packaging costs  

After the actual cost of the export product has been calculated, you should formulate an approximate consumer price for the foreign market.  

Market Demand  

For most consumer goods, per capita income is a good gauge of a market’s ability to pay. Some products (for example, popular U.S. fashion labels) create such a strong demand that even low per capita income will not affect their selling price. Simplifying the product to reduce its selling price may be an answer for your company in markets with low per capita income. Your company must also keep in mind that currency fluctuations may alter the affordability of its goods.   

Competition  

In the domestic market, U.S. companies carefully evaluate their competitors’ pricing policies. You will also need to evaluate competitor’s prices in each potential export market. If there are many competitors within the foreign market, you may have to match the market price or even underprice the product or service for the sake of establishing a market share. If the product or service is new to a particular foreign market, however, it may actually be possible to set a higher price than is feasible in the domestic market. 

Pricing Summary 

 It’s important to remember several key points when determining your product’s price:  

  • Determine the objective in the foreign market.  
  • Compute the actual cost of the export product.  
  • Compute the final consumer price.  
  • Evaluate market demand and competition.  
  • Consider modifying the product to reduce the export price.  
  • Include “non-market” costs, such as tariffs and customs fees.  
  • Exclude cost elements that provide no benefit to the export function, such as domestic advertising. 

Learn More 

  • Find the latest country-specific pricing information in the Country Commercial Guides by viewing the ”Selling U.S. Products and Services” chapters.   

Cost-plus pricing is a pricing strategy by which the selling price of a product is determined by adding a specific fixed percentage (a "markup") to the product's unit cost. Essentially, the markup percentage is a method of generating a particular desired rate of return.[1][2] An alternative pricing method is value-based pricing.[3]

Cost-plus pricing has often been used for government contracts (cost-plus contracts), and has been criticized for reducing incentive for suppliers to control direct costs, indirect costs and fixed costs whether related to the production and sale of the product or service or not.

Companies using this strategy need to record their costs in detail to ensure they have a comprehensive understanding of their overall costs.[2] This information is necessary to generate accurate cost estimates.

Cost-plus pricing is especially common for utilities and single-buyer products that are manufactured to the buyer's specification, such as for military procurement.

The three parts of computing the selling price are computing the total cost, computing the unit cost, and then adding a markup to generate a selling price (refer to Fig 1).

 

Fig 1: Cost-plus pricing steps

Step 1: Calculating total cost

Total cost = fixed costs + variable costs

Fixed costs do not generally depend on the number of units, while variable costs do.

Step 2: Calculating unit cost

Unit cost = (total cost/number of units)

Step 3a: Calculating markup price

Markup price = (unit cost * markup percentage)

The markup is a percentage that is expected to provide an acceptable rate of return to the manufacturer.[3]

Step 3b: Calculating Selling Price (SP)

Selling Price = unit cost + markup price

A shop selling a vacuum cleaner will be examined since retail stores generally adopt this strategy.

Total cost = $450

Markup percentage = 12%

Markup price = (unit cost * markup percentage)

Markup price = $450 * 0.12

Markup price = $54

SP = unit cost + markup price

SP = $450 + $54

SP = $504

Ultimately, the $54 markup price is the shop's margin of profit.

Buyers may perceive that cost-plus pricing is reasonable. In some cases, the markup is mutually agreed upon by buyer and seller. For markets that feature relatively similar production costs, companies do not have a dominant strategy.[4] Therefore, cost-plus pricing can offer competitive stability, decreasing the risk of price competition (such as price wars), if all companies adopt cost-plus pricing. The strategy enables price changes to goods and services relative to increases or decreases in the product cost which are simple to communicate and justify to customers.[5] When there is little market intelligence, the use of a cost-plus pricing strategy compensates for the lack of information by setting prices based on actual costs.[6] This method is generally adopted by retail companies such as grocery or clothing stores.[5]

Cost-based pricing is a way to induce a seller to accept a contract the costs of which represent a large fraction of the seller's revenues, or for which costs are uncertain at contract signing, as for example for research and development.

Cost-plus pricing is not common in markets that are (nearly) perfectly competitive, for which prices and output are such that marginal cost (the cost of producing an additional unit) equals marginal revenue. In the long run, marginal and average costs (as for cost-plus) tend to converge, reducing the difference between the two strategies. It works well when a business is in need of short-term finance.

Although this method of pricing has limited application as mentioned above, it is used commonly for the purpose of ensuring a business covers its costs by "breaking even" and not operating at a loss whilst generating at least a minimum rate of profit.[7] In spite of its ubiquity, economists rightly point out that it has serious flaws. Specifically, the strategy requires little market research hence it does not account for external factors such as consumer demand and competitor's prices when determining an appropriate selling price.[1] There is no way in advance of determining if potential customers will purchase the product at the calculated price. Regardless of which pricing strategy a company chooses, price elasticity (sensitivity of demand to price) is a vital component to examine.[8] To compensate for this, some economists have tried to apply the principles of price elasticity to cost-plus pricing.[9]

We know that:

MR = P + ((dP / dQ) * Q)

where:

MR = marginal revenue
P = price
(dP / dQ) = the derivative of price with respect to quantity

Q = quantity

Since we know that a profit maximizer sets quantity at the point that marginal revenue is equal to marginal cost (MR = MC), the formula can be written as:

MC = P + ((dP / dQ) * Q)

Dividing by P and rearranging yields:

MC / P = 1 +((dP / dQ) * (Q / P))

And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:

(P / MC) = (1 / (1 – (1/E)))

where:

(P / MC) = markup on marginal costs
E = price elasticity of demand

In the extreme case where elasticity is infinite:

(P / MC) = (1 / (1 – (1/999999999999999)))
(P / MC) = (1 / 1)

Price is equal to marginal cost. There is no markup. At the other extreme, where elasticity is equal to unity:

(P /MC) = (1 / (1 – (1/1)))
(P / MC) = (1 / 0)

The markup is infinite. Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):

(P / AVC) = (1 / (1 – (1/E)))

Technically, AVC is a valid substitute for MC only in situations of constant returns to scale (LVC = LAC = LMC).

When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be, and often are, considering the price elasticity of demand, whether consciously or not.

  • Marketing
  • Markup (business)
  • Microeconomics
  • Outline of industrial organization
  • Price elasticity of demand
  • Pricing

  1. ^ a b Kenton, Will. "How Variable Cost-Plus Pricing Works". Investopedia. Retrieved 2021-04-26.
  2. ^ a b Carlson, Rosemary. "Defining and Calculating Cost-Plus Pricing". The Balance Small Business. Retrieved 2021-04-26.
  3. ^ a b Jain, Sudhir (2006). Managerial Economics. Pearson Education. ISBN 978-81-7758-386-1.
  4. ^ Park, Anna (2010). "Price-setting behaviour: Insights from Australian firms". RBA. Archived from the original on 2010-08-08.
  5. ^ a b "Cost plus pricing definition". AccountingTools. Retrieved 2021-04-26.
  6. ^ "Pricing - cost-plus strategies | Learn economics". www.learn-economics.co.uk. Retrieved 2021-04-26.
  7. ^ [1], McKinsey Quarterly, August 2003
  8. ^ "Pricing Strategies & Elasticity". Fundamentals of Marketing. 2014-12-16. Retrieved 2021-04-26.
  9. ^ Talkcosts - Cost Guides

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