Markup Pricing

The most elementary pricing method is to add a standard markup to the product's cost. Construction companies do this when they submit job bids by estimating the total project cost and adding a standard markup for profit. Similarly, lawyers and accountants typically price by adding a standard markup on their time and costs.

Suppose a toaster manufacturer has the following costs and sales expectations:

Variable cost per unit $ 10 Fixed cost 300,000

Expected unit sales 50,000

Figure 4-11 The Three Cs Model for Price Setting

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The manufacturer's unit cost is given by:

Unit cost = variable cost + fixed cosls = $10 + $3rP,0,,0,0/0 = $16

unit sales 50,000

If the manufacturer wants to earn a 20 percent markup on sales, its markup price is given by:

" " (1 — desired return on sales) 1 — 0.2

Here, the manufacturer charges dealers $20 per toaster and makes a profit of $4 per unit. If the dealers want to earn 50 percent on their selling price, they will mark up the toaster to $40. This is equivalent to a cost markup of 100 percent.

Does the use of standard markups make logical sense? Generally, no. Any pricing method that ignores current demand, perceived value, and competition is not likely to lead to the optimal price. Markup pricing works only if the marked-up price actually brings in the expected level of sales.

Companies that introduce a new product often price it high, hoping to recover their costs as rapidly as possible. But a high-markup strategy could be fatal if a competitor is pricing low. This happened to Philips, the Dutch electronics manufacturer, in pricing its videodisc players. Philips wanted to make a profit on each videodisc player. Meanwhile, Japanese competitors priced low and succeeded in building their market share rapidly, which in turn pushed down their costs substantially.

Markup pricing remains popular for a number of reasons. First, sellers can determine costs much more easily than they can estimate demand. By tying the price to cost, sellers simplify the pricing task. Second, when all firms in the industry use this pricing method, prices tend to be similar, which minimizes price competition. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers: Sellers do not take advantage of buyers when demand becomes acute, and sellers earn a fair return on investment.

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