Cost-plus pricing Simply put, this means adding a predetermined mark-up to the full cost of a product in order to arrive at a selling price. However, the full cost of a product will depend on the volume produced, and the volume produced will reflect the quantity that can be sold - and we know that this quantity is largely a function of the price charged for the product. It would thus appear that pricing on a cost-plus basis is an example of circular reasoning. This apparent illogicality is frequently pointed out in the academic literature, which emphasizes the importance of management judgement and market conditions in the selection of the mark-up to be added to cost, in order to give this approach the flexibility to respond to different demand circumstances. Empirical evidence suggests that most cost-based pricing formulae use normal absorption costing principles, and thus 'cost' will be a full production cost containing fixed manufacturing overheads. It may also contain selling, distribution and administrative expenses, variable and fixed, in which case the mark-up required to give an acceptable income need not be as high as would otherwise be the case if these costs had to be recovered through the profit margin. Obviously, the long-term prosperity of any firm will depend upon its ability to generate sufficient revenue from sales to cover not only the cost of the products sold, however calculated, but also the total of all other costs, including an adequate return on the capital employed, however defined. These additional costs form the basis for the calculation of the markup on cost. Although some businesses operate a standard mark-up - this is particularly true of contractors and companies in classic job-costing environments - most firms must vary the percentage to reflect different market conditions. In a multi-product firm, for example, it is highly unlikely that the mark-up will be the same for every type of product. Different products are faced with different markets and thus competitive circumstances; and individual products will require the measure of flexibility mentioned above if they are to respond effectively to the changing demand patterns of the various stages of their life cycles. Furthermore, it has also been pointed out that the adoption of 'normal' or 'customary' mark-ups within one industry or for particular product types is no guarantee of successful pricing in the long term, as local grocers found with the arrival of supermarkets, and retailers of electrical goods and furniture found with the advent of discount warehousing - classic examples of the triumph of simple volume over margins. Example 2 below shows the calculation of the base cost to be used in the formula, under different cost assumptions. Example 2 Cost-plus pricing Pricer Ltd is to begin the manufacture of a new product, X, and must calculate a base cost, to which will be added a mark-up in order to arrive at a selling price. The following direct costs have been established, although they will probably be subject to an error margin of ‡ 10 per cent under full production conditions: It is estimated that 10,000 units of X could be produced within the existing manufacturing capacity, but the spare 2,500 machine hours currently available (of a total of 25,000 available hours) could alternatively be used to increase the production of Y, which shows a contribution of £30 per machine hour. However, additional advertising expenditure of £11,000 would be required to stimulate the additional demand for Y. Current fixed costs are £120,000 for the production facilities, £80,000 for selling and distribution and £60,000 for administration. These are likely to increase to £100,000 for selling and distribution, and £70,000 for administration, again with an error margin of ‡10 per cent for any increase. Pricer has spent £150,000 on developing X, and working capital of £70,000 will be required to support its successful manufacture. The company's cost of capital is 10 per cent. Variation 1, using conventional absorption costing principles, building in the conservative error margin but ignoring opportunity considerations reasonably be expected to fu suate aroyd the "target, some higher and some lower, averaged bout in sumpan ay, it is to be hoped, that the overal target return required by the company is ultimately achieved.