Solution:

• There are several ways of determining cost, and the profit can be added as either a percentage markup or an absolute amount. One example is:

P = (AVC + FC%) x (1 + MK%)

Where:

• P = price

• AVC = average variable cost

• FC% = percentage allocation of fixed costs

• MK% = percentage markup

For example: If variable costs are 30 yen, the allocation to cover fixed costs is 10 yen, and If you feel you need a 50% markup then you would charge a price of 60 yen:

• P = (30 + 10) x (1 + 0.50)

• P = 40 x 1.5

• P = 60

An alternative way of doing the same calculation is:

• P = (AVC + FC%) / (1 ? MK%)

• To make things simpler, some firms, particularly retailers, ignore fixed costs and just use the the purchase price paid to their suppliers as the cost term.

• They indirectly incorporate the fixed cost allocation into the markup percentage. To simplify things even further, sometimes a fixed amount is applied rather than a percentage.

• This fixed amount is usually determined by head office to make it easy for franchisees and store managers. This is sometimes referred to as turnkey pricing. Another variant of cost-plus pricing is activity-based pricing.

• This involves being more careful in determining costs. Instead of using arbitrary expense categories when allocating overhead, every activity is linked to the resources it uses.

Advantages of cost-plus pricing:-

• 1. easy to calculate
• 1. minimal information requirements
• 1. easy to administer
• 1. tends to stabilize markets - insulated from demand variations and competitive factors
• 1. ethical advantages

Disadvantages of cost-plus pricing:-

• 1. tends to ignore the role of consumers
• 1. tends to ignore the role of competitors
• 1. use of historical accounting costs rather than replacement value
• 1. inclusion of sunk costs rather than just using incremental costs
• 1. ignores opportunity costs