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Pricing strategies based on costs involve determining manufacturing costs and adding some amount of markup to determine the wholesale price. The cost-plus method of pricing and return on investment pricing are discussed here. For the cost-plus method of pricing, wholesale price is determined multiplying unit cost by some "reasonable” markup. With the cost-plus method, accuracy of costing is critical. Costing processes must accurately reflect unit costs so that wholesale price will be sufficient to provide the firm a profit. The cost-plus method of pricing can be misleading. The problem is that the cost-plus method does not adjust for cost variations at different level, of output. There may be economies of scale that are realized when volume increases. However, if demand increases beyond plant capacity, additional costs may be incurred because of hiring contractors or purchasing additional equipment and production space.
If a firm has unused production facilities, as a short-run strategy, the markup may actually be set to cover less than total costs. If a plant or a portion of a plant is closed, many nonvariable costs remain. Thus, if the price covers variable costs and makes some contribution toward nonvariable costs the firm might be better off than when facilities are idle. The challenge the firm faces is to find a price-volume combination that will achieve the firm's goals and maximize profits.
Whatever the pricing strategy, managers and stock holders are usually concerned about the rate of return on investment(ROI) . ROI is the amount earned in direct proportion to the amount invested. Some companies eliminate divisions or drop products that do not yield adequate ROI . Target ROI is often some- where between 10 and 20% ROI after taxes. Target ROI might be accomplished by setting a percentage return on investment or identifying a specific total dollar return. The desired target return is added to the total cost (McCarthy, 1978, p. 479). Some firms use a long-run target return method based on the assumption that plants do not consistently run at fully capacity. On an average over several years, plants may produce at 80% of capacity. That level of production would be used as a basis for setting prices that yield the desired target return. A long-run strategy tends to produce more stable prices.
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