By Martin Hahn.
Most people, whether beginners in the study of marketing or senior businessmen, when asked how prices are arrived at, will start from the cost of manufacture. The most common approach is ‘cost-plus’, or calculating the basic production cost and adding on a margin for profit.
Cost and profit margin may not be the sole keys to arriving at the ‘right’ price although they are important elements. At worst, if costs are not recovered, the firm cannot survive. Similarly, if a ‘reasonable’ profit is not obtained, in the long run again the firm cannot survive.
The cost-plus approach, therefore, contains some all-important elements and also has the merit, in principle, of simplicity. In practice, however, things are not so simple, because we need to know (a) what the cost is, and (b) what a reasonable profit is.
The problem with determining the cost is that usually cost per unit depends on the quantity being produced. This is because there are certain fixed costs – rent, rates, capital charges or rental on machinery and equipment, some wages and salaries – which are incurred whatever the level of production. As the quantity produced increases, the fixed cost per unit decreases. In addition, there are variable costs incurred as each unit is produced, for raw materials, power, and some wages. It is the total of fixed costs and variable costs divided by the number of units produced that gives us the total cost per unit.
This means that the cost of production is not the simple and immutable figure that it is sometimes assumed to be. Worse still, the number of units produced will depend on demand, and demand is influenced by price. So now we have the situation where we are trying to arrive at price with cost as the main determinant, yet cost is itself determined by price.
It must be remembered too that it is total cost we must work with (including marketing and distribution costs) not the simple ‘Factory gate’ cost of manufacture alone.
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