Mechanics of Cost-plus Pricing
There are two steps which form this approach. The first step involves calculation of the cost of production, and the second step is to determine the markup over costs.
1. Calculation of cost of production
The total cost has two components: Total Variable cost and Total fixed Cost.In either case,costs are computed on an average basis. That is
AC = AVC + AFC
Where
- AVC = TVC /Q
- AFC = TFC /Q
- AC = average cost
- AVC = Average variable cost
- AFC = Average fixed cost
- TVC = Total variable cost
- TFC = Total fixed cost
- Q = Quantity (the number of units produced)
In this approach, the quantity is assumed.In cost-plus pricing we use quantity to calculate price but price is the determinant of quantity.To avoid this problem, the quantity is assumed.This rate of output is based on some percentage of the firm's capacity.
2. Determining the markup over costs
The objective of this approach is to set prices in a manner that a firm earns its targeted rate of return. Now, if that return is Rs.X (Rs.= Ratio of the respective share) of total profit then the markup over costs on each unit of output will be X/Q and then the price will be: P = AVC + AFC + X /Q
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