In practice cost is the most important influence on price. Many firms base price on simple cost-plus rules (costs are estimated and then a profit margin is added in order to set the price) a study by Lancelot gave a number of reasons for the predominance of this method.
Planning and use of scarce capital resources are easier.
Assessment of divisional performance is easier
It emulates the practice of successful large companies.
Organizations fear government action against 'excessive' profits.
There is a tradition of production rather than of marketing in many organizations.
There is sometimes tacit collusion in industry to avoid competition.
Adequate profits for shareholders are already made, giving no incentive to maximize profits.
Cost-based pricing strategies based on internal data are easier to administer.
Over time, cost-based pricing produces stability of pricing, production and employment.
Full cost -plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark- up for profit. The full cost' may be a fully absorbed production cost only, or it may include some absorbed administration, selling and distribution overhead.
A business might have an idea of the percentage profit margin it would like to earn. And so might decide on an average profit mark-up as a general guideline for pricing decisions
This would be particularly useful for businesses that carry out a large amount of contract work or jobbing work, for which individual job or contract prices must be quoted regularly to prospective customers. However, the percentage profit mark-up dose not have to be rigid and fixed, but can be varied to suit the circumstances. In particular, the percentage mark-up can be varied to suit demand conditions in the market.
Problems with and advantages of full cost-plus pricing.
There are several serious problems with relying on a full cost approach to pricing.
It fails to recognize that since demand may be determining price, there will be a profit-maximizing combination of price and demand.
There may be a need to adjust prices to market and demand conditions
Budgeted output volume needs to be established. Output volume is a key factor in the overhead absorption rate.
A suitable basis for overhead absorption must be selected, especially where a business produces more than one product.