4.5 Pricing Decisions

Cost-Plus and Markup Pricing

Cost-plus pricing sets price by adding a markup to a cost base:

Price = Cost base × (1 + markup percentage)

The cost base may be variable cost, full absorption cost, or total cost. The markup must cover any costs not in the base plus a profit target.

Example

Full cost per unit is $80; the firm wants a 25% markup on full cost. Price = $80 × 1.25 = $100. Cost-plus is simple and ensures cost recovery, but its weakness is that it ignores customer demand and competitors — it can price above what the market will bear or leave money on the table.

Target Costing

Target costing reverses the logic and starts in the market:

Target cost = Target (market) price − Required profit margin

The firm first determines the price customers will pay and the profit it must earn, then engineers the product and process to hit the resulting allowable cost.

Example

Market will bear $90; the firm requires a 30% return on sales = $27 profit. Target cost = $90 − $27 = $63. If current cost is $70, designers must remove $7 through value engineering. Target costing is most powerful early in design, when most cost is still committable, and it forces a customer-first discipline.

Value-Based Pricing and Strategy

Value-based pricing sets price according to the customer's perceived value of the product's benefits rather than its cost. It captures more margin when a product is differentiated or solves a high-stakes problem.

New-product launch strategies:

• Price skimming — launch at a high price to capture price-insensitive early adopters, then lower it. Best for innovative, hard-to-imitate products with inelastic early demand.
• Penetration pricing — launch at a low price to win market share fast and deter entrants; relies on elastic demand and economies of scale. Skimming maximizes early margin; penetration maximizes volume and share.

Transfer Pricing Methods

A transfer price is the internal charge when one division sells to another. Three common methods:

• Market-based: use the external market price. Best when a competitive outside market exists; promotes goal congruence and fair divisional performance.
• Cost-based: use variable cost, full cost, or cost-plus. Simple, but actual costs can pass along inefficiency and distort performance.
• Negotiated: divisions bargain. Preserves autonomy but can be time-consuming and reflect bargaining power rather than economics.

A poorly set transfer price causes suboptimal decisions — a buying division may source outside even when internal supply is better for the firm overall.

The General Transfer-Pricing Rule

The minimum price the selling division should accept:

Minimum transfer price = Variable cost per unit + Opportunity cost per unit

• If the seller has idle capacity, opportunity cost is $0, so the floor is just variable cost.
• If the seller is at capacity, the opportunity cost equals the lost contribution margin on outside sales, so the floor rises to the market price.

Example

Division A's variable cost is $18; it can sell all output externally at $30 (so CM = $12). At full capacity, minimum transfer price = $18 + $12 = $30. With idle capacity, the floor is just $18. The maximum the buyer will pay is the lowest outside price available to it.

Price Elasticity of Demand

Price elasticity of demand measures how responsive quantity is to price:

Elasticity = (% change in quantity demanded) ÷ (% change in price)

• Elastic (|E| > 1): quantity is very responsive; a price increase reduces total revenue, and a price cut raises it.
• Inelastic (|E| < 1): quantity barely moves; a price increase raises total revenue.
• Unit elastic (|E| = 1): revenue is unchanged.

Example

A 10% price cut raises quantity 18%. Elasticity = 18% ÷ −10% = −1.8, so |E| = 1.8 (elastic). Because demand is elastic, the cut increases total revenue. Necessities and products with few substitutes tend to be inelastic; luxuries and items with close substitutes tend to be elastic.

Markup on Cost vs. Markup on Price

A recurring exam trap is confusing a markup expressed on cost with a margin expressed on selling price. They are not the same percentage.

• Markup on cost: Price = Cost × (1 + markup). A $60 cost with a 50% markup on cost → $60 × 1.50 = $90.
• Margin on price: Price = Cost ÷ (1 − margin). A $60 cost at a 40% margin on price → $60 ÷ 0.60 = $100.

To convert, note that a 50% markup on cost equals a 33.3% margin on price (the $30 markup is one-third of the $90 price). Always check which base the problem uses; a single wrong base flips the answer choice. The same care applies to whether the cost base is variable, full manufacturing, or total cost — the markup must then cover everything excluded from that base plus target profit.

Choosing a Pricing Approach

No single method dominates; the right approach depends on the market and the product's stage.

Cost-plus guarantees recovery but ignores demand. Target costing imposes market discipline at design, where most cost is still controllable. Value-based pricing captures the most margin but requires knowing what the buyer will pay. Firms often combine them — value or market pricing sets the ceiling, cost analysis confirms a profitable floor.