Customized products or services relate to situations where products or services tend to be unique so that no comparable market prices exist for them. Since sales revenues must cover costs for a firm to make a profit, many companies use product costs as an input to establish selling prices. Product costs are calculated and a desired prof it margin is added to determine the selling price. This approach is called cost-plus pricing.
For example, garages undertaking vehicle repairs establish the prices charged to customers using cost-plus pricing. Similarly, firms of accountants use cost-plus pricing to determine the price for the accountancy services that they have provided for their customers. Companies use different cost bases and mark-ups (i.e. the desired profit margin) to determine their selling prices.
Consider the following information:
In the above illustration three different cost bases are used resulting in three different selling prices. In row (1)only direct variable costs are assigned to products for cost-plus pricing and a high percentage mark-up (150 per cent) is added to cover direct fixed costs and indirect costs and also provide a contribution towards prof it The second cost base is row (3) Here a smaller percentage margin (70 per cent) is added to cover indirect costs and a profit contribution. The final cost base shown in row (5) includes the assignment of a share of company overheads to each product, and when this is added to direct costs a total product cost is computed. This cost (also known as full cost or long-run cost) is the estimated sum of all those resources that are committed to a product In the long run. It represents an attempt to allocate a share of all costs to products to ensure that all costs are covered in the cost base The lowest percentage mark-up (35 per cent) is therefore added since the aim is to provide only a profit contribution.
The above illustration is applicable to both manufacturing and non-manufacturing organizations. However, manufacturing organizations generally divide overhead costs (row 4) into manufacturing and non-manufacturing overheads. For example, if the overheads of [80 contrast of e6O manufacturing and f20 non-manufacturing then !60 would be added to row (3) above to produce a total manufacturing cost of t360. Assuming that a prof it margin of 40 per cent is added to the total manufacturing cost the selling price would be t504.
Mark-ups are related to the demand for a product. A firm is able to command a higher mark-up for a product that has a high demand, Mark-ups are also likely to decrease when competition is intensive. Target mark-up percentages tend to vary from product line to product line to correspond with well-established differences in custom, competitive position and likely demand For example, luxury goods with a low sales turnover may attract high profit margins whereas non-luxury goods with a high sales turnover may attract low profit margins.
Note that once the target selling price has been calculated, it is rarely adopted without amendment The price is adjusted upwards or downwards depending on such factors as the future capacity that is available, the extent of competition from other firms, and management’s general knowledge of the market. For example, if the price calculation is much lower than that which management considers the customer will be prepared to pay the price may be increased,
We may ask ourselves the question, ‘Why should cost-based pricing formula be used when the final price is likely to be altered by management?’ The answer is that cost-based pricing formula provide an initial approximation of the selling price. It is a target price and is important information, although by no means the only information that should be used when the final pricing decision is made Management should use this information, together with their knowledge of the market and their intended pricing strategies, before the final price is set.