1) Why do many firms use cost-plus pricing for supply contracts
The cos-plus approach to pricing is an alternative approach by using a general formula for setting a price adds a mark-up to the cost base. Cost-plus prising approach is calculated by the average of total cost (variable and fixed costs), which is a cost base, and the mark-up. One of the methods to calculate the mark-up is to set a target rate on return on investments. The mark-up on full product costs are much lower than on variable manufacturing costs. The reason for that is that when you calculate mark-up based on variable costs you assume that you should generate profit and to recoup fixed costs and other costs, such as R&D, distribution and marketing. The mark-up on full costs is lower because these costs are already include all costs incurred to sell the product ( Bhimani A. Horngren C.T, Datar S.M, Rajan M.V 2012, chapter 12, ‘Management and Cost Accounting’, p386). Because this technique calculate average full costs, the cost base includes a fixed costs and there are some advantages of including fixed costs per unit for pricing decisions. Three main advantages are: full product cost recovery, price stability and simplicity. The logical reason of using cost-plus pricing is that if you charge a full cost plus mark up as a selling price you will break even and because companies are tend to produce a percentage increase in wealth it seems logical (Peter Atrill, Eddie McLaney, 2007, Management Accounting for Decision Makers). Another reason for using cost-plus prising method is that it makes calculations easier and provides clear and objective formula for the calculations. Because of the simplicity of the calculations, it is easy to justify price with the changes in cost (increase of labour costs in our example). Last reason for applying this method is that according to the market structure and the competitions, managers of the company can set target return and the target sales volume. Is the market closed and not competitive, they can set higher prices and earn more.
2) What potential problems do you envision with cost-plus pricing?
In a book The Strategy and Tactics of Pricing: a guide to profitable decision making by T.Nagel 1994 author’s define following problem of cost-plus pricing: ‘The problem with cost-plus pricing is fundamental. In most industries it is impossible to determine a product’s unit cost before determining its price. Because unit costs change with volume. This costs change occurs because a significant portion of costs are ‘fixed’ must somehow be allocated to determine the full unit cost. Unfortunately, since there allocation depend on volume, which changes in price, unit cost is a moving target. ’ Another problem of this strategy is that market not always agrees with the price. Cost-plus price model is not taking to account a price sensitivity of customer and ignore the demand for the product. This model is not taking to account the marked demand function and it could lead to reduction in sales, because market will not buy at the price, which was set by the cost-plus price. This model may work only if the company is a prise maker, not a price take. In other case, if company is a price taker it could lead to zero sales. It is important to remember, that non-cost factors are relevant in price setting and this model is not taking them into account. Another problem is that because this pricing model is very simple and consist only of cost factor and mark-up, this model is not focused on reducing firm costs and it leads to an increase in price, which consumers will pay ( in our case an increase of 3$ according to increase of labour costs).
3) Should Gina contest the price increase? Explain.
According to the given information and taking into account that Rich Manufacturing Company and Bhagat have signed the contract, it means that Gina could not argue with the contract. We know…