While managers use market-based approaches for long-run pricing decisions in competitive markets, they sometimes use a cost-based approach when pricing distinct products or services. The general formula for setting a cost-based selling price is to add a markup component to the cost base. Because a markup is added, cost-based pricing is often called cost-plus pricing, where the plus refers to the markup component. When using the cost-plus pricing formula, managers use the cost base as a starting point. The markup component is usually flexible, depending on the behavior of customers and competitors. In other words, market conditions ultimately determine the size of the markup component.* Consider, for example, Costco, the large warehouse store. Costco uses cost-plus pricing when setting product prices. Costco’s managers, however, will reduce prices if competitors such as Sam’s Club offer similar products at lower prices.
Suppose Astel uses a 12% markup on the full unit cost of Provalue II to compute the selling price. The cost-plus price is as follows:
The table depicts cost-plus price for Provalue II. The details of the table are as follows:
1. Cost base, full unit cost of Provalue II: 720.00 dollars
2. Markup component of 12 percent, 0.12 times 720 dollars: 86.40 dollars
3. Prospective selling price: 806.40 dollars
How do managers determine the markup percentage of 12% of full unit costs? One way is to choose the markup based on a target rate of return on investment, which is the target annual operating income divided by invested capital. Invested capital can be defined in many ways. In this chapter, we define it as total assets—that is, long-term assets plus current assets. Suppose Astel’s (pretax) target rate of return on investment is 15%, and Provalue II’s capital investment (total assets) is $115.2 million. The target annual operating income for Provalue II is:
The table depicts target annual operating income for Provalue II. The details of the table are as follows:
1. Invested capital: 115,200,000 dollars
2. Target rate of return on investment: 15 percent
3. Target annual operating income, 0.15 times 115,200,000 dollars: 17,280,000 dollars
4. Target operating income per unit of Provalue II, 17,280,000 dollars divided by 200,000 units: 86.40 dollars
This calculation indicates that Astel needs to earn a target operating income of $86.40 on each unit of Provalue II. The markup ($86.40) expressed as a percentage of the full unit cost of the product ($720) equals
Do not confuse the 15% target rate of return on investment with the 12% markup percentage.
Astel uses the target rate of return on investment to calculate the markup percentage.