Role of Cost in Markup Pricing

Although a variety of cost concepts are employed in markup pricing, most firms use a standard, or fully allocated, cost concept. Fully allocated costs are determined by first estimating direct costs per unit, then allocating the firm's expected indirect expenses, or overhead, assuming a standard or normal output level. Price is then based on standard costs per unit, irrespective of short-term variations in actual unit costs.

Unfortunately, use of the standard cost concept can create several problems. Sometimes, firms fail to adjust historical costs to reflect recent or expected price changes. Also, accounting costs may not reflect true economic costs. For example, fully allocated costs can be appropriate when a firm is operating at full capacity. During peak periods, when facilities are fully utilized, expansion is required to increase production. Under such conditions, an increase in production requires an increase in all plant, equipment, labor, materials, and other expenditures. However, if a firm has excess capacity, as during off-peak periods, only those costs that actually rise with production—the incremental costs per unit—should form a basis for setting prices.

Successful firms that employ markup pricing use fully allocated costs under normal conditions but offer price discounts or accept lower margins during off-peak periods when excess capacity is available. In some instances, output produced during off-peak periods is much cheaper than output produced during peak periods. When fixed costs represent a substantial share of total production costs, discounts of 30 percent to 50 percent for output produced during off-peak periods can often be justified on the basis of lower costs.

"Early bird" or afternoon matinee discounts at movie theaters provide an interesting example. Except for cleaning expenses, which vary according to the number of customers, most movie theater expenses are fixed. As a result, the revenue generated by adding customers during off-peak periods can significantly increase the theater's profit contribution. When off-peak customers buy regularly priced candy, popcorn, and soda, even lower afternoon ticket prices can be justified. Conversely, on Friday and Saturday nights when movie theaters operate at peak capacity, a small increase in the number of customers would require a costly expansion of facilities. Ticket prices during these peak periods reflect fully allocated costs. Similarly, McDonald's, Burger King, Arby's, and other fast-food outlets have increased their profitability substantially by introducing breakfast menus. If fixed restaurant expenses are covered by lunch and dinner business, even promotionally priced breakfast items can make a notable contribution to profits.

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