Cost markup pricing is a widespread pricing technique that organizations use. It implies the approach in which a price of a product is directly associated with the costs necessary for its production. First, a company calculates the average production costs. Second, the predetermined percentage of a markup (profit margin) is added to make up the final price of the product. If the strategy is successful, it usually ensures a fixed amount of profit per a sold item.
It is important to understand that the specific nature of markup pricing will depend on the environment of a market. However, on the one hand, items that are produced in high volumes and are readily available will have low markups. On the other hand, unique and low-volume items will have higher markups. In an ideal scenario, a company will aim to maximize its profit margin when attempting the cost markup pricing technique. To estimate the markup percentage on a selling price, the following formula is used:
Markup % on selling price = Dollar markup/Selling price*100%
In terms of the accuracy of the results, cost markup pricing does not take into account the effects of different levels of pricing on the patterns of consumer demand. Also, it does not consider the conditions in the market as well as the pricing strategies that competitors use. Because of this, companies that use cost markup pricing as their main approach to establishing pricing on products may limit their long-term profitability.
Another issue associated with accuracy relates to the difficulties in calculating the costs, especially the element of indirect costs. Companies have issues with determining the costs that should be included in the estimation of markup as well as how much of each indirect cost should be allocated.
The approach of cost markup pricing is the most appropriate to use in circumstances when companies are risk-averse. For instance, the gas (petrol) industry usually establishes prices based on this approach because the costs of producing the product vary significantly throughout short periods, and companies usually adapt their prices based on the predetermined markup and the fluctuating costs for sourcing, producing, and marketing gas to consumers.
There are instances in which the target profit margin of a business may not be high enough for reflecting the typical price in the desired market. An example of this is the segment of luxury items such as shoes, handbags, and other accessories. Designers operating in this market usually sell their products for prices that are marked up much higher compared to their costs of production. In this case, the company intentionally increases its markup of the luxury item to participate in the market that has certain rules and standards.
To conclude, cost markup pricing is a strategy that high-risk companies use to ensure that they gain a certain amount of profit for the products they sell. Although this approach has such limitations as the lack of consideration for the market demand, investments, and prices set by competitors, it still holds some ground due to the need for companies to guarantee some level of profit when they market their products. Most organizations ranging from retailers to manufacturers use cost markup pricing because it is a simple method that has a certain level of impartiality and establishes a uniformity of prices in the industry.