When introducing a product to the market, a company must first figure out how to fairly price the item in order to maximize sales and profits. One method used to calculate pricing is the full-cost technique, which adds in all the expenses associated with making a product and the profit margin a company would like to make on the item.
TL;DR (Too Long; Didn't Read)
Full-cost pricing is a method of price setting that involves adding the costs of making and selling a product along with a markup percentage to determine the price of a product.
What Is Full-Cost Pricing?
Full-cost pricing is one of many ways for a company to determine the selling price of a product. To use this pricing method, you add together all costs of creating and selling the product (including material costs, labor costs, selling and administrative costs and overhead costs) and a markup percentage to allow for a profit margin. You then divide this number, which should include the price of all units produced, by the number of units you expect to sell.
The full-cost calculation is simple. It looks like: (total production costs + selling and administrative costs + markup) ÷ the number of units expected to sell.
An Example Calculation
Consider an example of how the full-cost system works. Tom's Treat Toys is trying to figure out a fair price to charge for their finest fun figures. They decide they want to make a profit margin of 50 percent and sell 50,000 units. The company spends $2 million making all of their products and $600,000 on their total company sales and administration costs. The finest fun figures take up 25 percent of their manufacturing floor and 25 percent of their overall sales and administration costs. That means the total production cost for the finest fun figures is $500,000, and the total sales and administration cost is $150,000.
The total cost of making and selling the product comes out to $650,000, which means that a 50 percent profit margin would be $325,000. When the profit margin is added to the total costs, the total comes out to $975,000. Divide that number by the number of units (50,000), and you'll get the total cost of the product per unit, which comes out to $19.50.
Absorption vs. Full-Cost Pricing
Another common pricing method that is very similar to the full-cost principle is absorption pricing. Whereas full-cost pricing simplifies the numbers by using the same formula to allocate costs to a specific product, absorption pricing is more precise and more complex.
In the example above where the company allocated 25 percent of its factory floor and sales/admin expenses toward the finest fun figures, absorption pricing would treat each cost more precisely. For example, they might allocate 25 percent of the factory rent toward the making of the finest fun figures since they take up that space, but their utility costs may be divided differently if one product takes more water or more electricity to create. Similarly, if a product has a higher marketing budget but lower research and development costs associated with it, these costs will be added in based on how the company allocates these resources rather than just simplifying the overall sales and administrative costs into one number.
When to Use Full-Cost Pricing
Full-cost pricing is not a good technique when determining what to charge for a product sold in a competitive market or a market that already has standardized pricing. That is because it does not take into account the prices charged by competitors, it does not allow management the opportunity to reduce prices in order to grow market share and it does not factor in the value of the product to the consumer. It is also not a good option for a company that produces many products, as the pricing formula can be difficult to use when you have to figure out how many resources are to be allotted to one product out of dozens.
This technique can be very useful when a product or service is based on the requirements of a customer. In these cases, it can be useful for setting long-term prices that will be high enough to guarantee a profit after all expenses. For example, if a company develops a new software package that is unlike anything on the market, the company will need to figure out pricing in a market where there is no competition and the pricing has not yet been established.
Benefits of Full-Cost Pricing
The greatest benefits to full-cost pricing are that it is fair, simple and will likely turn a profit. The pricing is easily justifiable because the prices are based on actual costs. When manufacturing costs go up, it is also easy to justify increasing prices without angering customers. If a product does have competitors and they take the same approach to pricing, this can also result in price stability as long as the competitors have similar costs.
Full-cost pricing is also fairly easy to calculate as long as the company doesn't sell too many products to make figuring out the costs per item impractical. In fact, full-cost pricing can actually allow junior employees to determine the cost of a product since it is based solely on formulas.
Finally, by taking all the expenses of a product into account and figuring in the profit margin a company would like to see, it can guarantee that the product will earn a profit as long as the calculations are correct.
Drawbacks of Full-Cost Pricing
There are some disadvantages to using full-cost pricing, though. As previously stated, for example, this pricing strategy is not good to use in a competitive market because it ignores the prices set by the competition. Similarly, it ignores what buyers are willing to pay, so the price could be too high or too low in comparison to what the company could be charging, resulting in either lost potential profits or lost potential sales.
By allowing for any possible product costs in the calculations, this pricing method also provides no incentive for designers and engineers to create a product in a less-costly manner. If costs increase, then selling prices will also increase accordingly, and employees may have little incentive to reduce costs internally rather than just passing them on to the consumer.
Another major problem with full-cost pricing is that it only takes into account expense estimates and sales volume estimates, both of which could be incorrect. This could result in a completely wrong pricing strategy. For example, if you account for 5,000 units being sold and only 2,000 units are sold, you may lose money on the item depending on the profit margin you set. It can also be difficult to figure out an accurate apportionment of costs if a company sells more than one product.
For many companies, full-cost pricing is too simplistic, failing to take into account the actual costs of all expenses and how they are allocated to one product over another. This is why absorption pricing is sometimes preferable because it further breaks down the cost of all expenses and divides them more accurately by all the products the company sells.