Introduction
This essay aims to explore the cost-plus pricing approach, specifically when underpinned by total absorption costing, within the field of accounting. Cost-plus pricing is a strategy where a business determines the selling price of a product by adding a markup to the total cost of production. Total absorption costing, as a method, allocates all manufacturing costs—both fixed and variable—to the product, providing a comprehensive cost base for pricing decisions. This discussion will evaluate the key advantages of this approach, such as simplicity and cost recovery, alongside notable problems, including potential inefficiencies and market disconnection. By critically analysing these aspects with support from academic literature, the essay seeks to offer a balanced understanding of the implications for businesses adopting this pricing strategy.
Advantages of Cost-Plus Pricing with Total Absorption Costing
One primary advantage of cost-plus pricing using total absorption costing is its simplicity and ease of application. By calculating the total cost of production, including direct materials, labour, and both variable and fixed overheads, businesses can establish a clear cost base to which a markup is added. This straightforward method requires minimal complexity in calculation, making it accessible for small businesses or those with limited accounting resources. As Drury (2018) notes, such an approach ensures that all costs are systematically accounted for, reducing the risk of underpricing products.
Moreover, this method guarantees full cost recovery, provided that sales volumes are sufficient. Since total absorption costing incorporates all production costs into the unit price, businesses can be confident that each sale contributes to covering both variable and fixed expenses. This is particularly beneficial in industries with high overheads, such as manufacturing, where failing to recover fixed costs can lead to financial strain. Indeed, Horngren et al. (2015) argue that this approach provides a safety net for firms operating in stable markets with predictable demand, ensuring long-term sustainability.
Problems of Cost-Plus Pricing with Total Absorption Costing
Despite its merits, this pricing strategy is not without significant challenges. A critical issue is its potential to encourage inefficiency within the organisation. Since the pricing model is based on costs, there is little incentive for managers to control or reduce expenditure, as higher costs simply translate into higher prices. This can perpetuate wasteful practices, as noted by Kaplan and Atkinson (2015), who suggest that cost-plus pricing may deter cost-cutting innovations, ultimately harming competitiveness.
Additionally, cost-plus pricing using total absorption costing often disregards market dynamics and customer willingness to pay. By focusing solely on internal costs, businesses risk setting prices that are either too high, alienating customers, or too low, missing out on potential profits. For instance, in a competitive market, a firm may struggle to sell products if prices exceed those of rivals, regardless of cost justification. Drury (2018) highlights that this inward-looking approach can disconnect firms from external realities, leading to suboptimal pricing decisions.
Another concern is the arbitrary nature of the markup percentage. Determining an appropriate markup often lacks a scientific basis and can be influenced by subjective judgement, which may not reflect market conditions or strategic goals. This subjectivity, as Horngren et al. (2015) point out, can undermine the reliability of the pricing strategy, especially in volatile economic environments where adaptability is crucial.
Conclusion
In summary, the adoption of cost-plus pricing with total absorption costing offers notable advantages, including simplicity in implementation and the assurance of full cost recovery, which are particularly valuable for businesses seeking financial stability. However, the approach also presents significant drawbacks, such as fostering inefficiency, ignoring market dynamics, and relying on subjective markup decisions. These limitations suggest that while this method may suit stable, less competitive environments, it requires cautious application in dynamic markets where customer demand and competitor actions play a critical role. Arguably, businesses should complement this approach with market-based strategies to balance internal cost recovery with external responsiveness, ensuring both profitability and competitiveness in the long term.
References
- Drury, C. (2018) Management and Cost Accounting. 10th ed. Cengage Learning.
- Horngren, C.T., Datar, S.M. and Rajan, M.V. (2015) Cost Accounting: A Managerial Emphasis. 15th ed. Pearson Education.
- Kaplan, R.S. and Atkinson, A.A. (2015) Advanced Management Accounting. 3rd ed. Pearson Education.
