Alternative Cost-Plus Methods

Computing the specific amount of capital invested in a product is challenging because it requires difficult and sometimes arbitrary allocations of investments in equipment and buildings to individual products. The following table uses alternative cost bases (without supporting calculations) and assumed markup percentages to set prospective selling prices for Provalue II without explicitly calculating invested capital to set prices.

The different cost bases and markup percentages give four prospective selling prices that are close to each other. The markup percentages in the preceding table vary a great deal, from a high of 65% on variable manufacturing cost to a low of 12% on full cost of the product. Why the wide variation? When determining a prospective selling price, a cost base such as variable manufacturing cost that includes fewer costs requires a higher markup percentage because the price needs to be set to earn a profit margin and to recover the costs (fixed manufacturing costs and all nonmanufacturing costs) that have been excluded from the cost base.

Surveys indicate that many managers use the full cost of the product for cost-based pricing decisions—that is, they include variable costs and costs that are fixed in the short run when calculating the cost per unit. Managers include the fixed cost per unit in the cost base for several reasons:

1. FULL RECOVERY OF ALL COSTS OF THE PRODUCT. In the long run, the price of a product must exceed the full cost of the product if a company is to remain in business. Using just the variable cost as the base may tempt managers to cut prices as long as prices are above variable cost and generate a positive contribution margin. As the experience in the airline industry has shown, price wars, when airline companies cut prices as long as they exceed variable costs, have caused airlines to lose money because revenues are too low to recover the full cost of the product. Using the full cost of the product as the basis for pricing reduces the temptation to cut prices below full costs.
2. PRICE STABILITY. Using the full cost of a product as the basis for pricing decisions limits the ability and temptation of salespeople to cut prices, which also promotes price stability. Stable prices facilitate more accurate forecasting and planning for both sellers and buyers.
3. SIMPLICITY. A full-cost formula for pricing does not require the management accountant to perform a detailed analysis of cost-behavior patterns to separate product costs into variable and fixed components. Variable and fixed cost components are difficult to identify for many costs such as testing, inspection, and setups, and in many service businesses such as accounting and management consulting.

Including fixed cost per unit in the cost base for pricing decisions can be challenging. Allocating fixed costs to products can be arbitrary. Also, calculating fixed cost per unit requires a denominator level that is based on an estimate of capacity or expected units of future sales. Errors in these estimates will cause actual full cost per unit of the product to differ from the estimated amount. Despite these challenges, managers generally include fixed costs when making cost-based pricing decisions.