a)  Distinguish between cost plus and contribution margin pricing

Cost plus pricing is a management pricing tool where the pricing decision focuses totally on costs, ensuring that a selling price is set that covers the costs of running the business and will be sufficient to provide a profit. The selling price is arrived at by simply adding to costs a profit percentage to get the selling price. It is based on the following formula:

The percentage mark-up will generally be an industry norm and will vary depending on what actual costs (direct costs only or total costs) are taken into account. There are three main approaches to cost plus pricing.

1.  Gross margin pricing; This is where cost (C) represents just the materials cost or cost of sales. In this situation the mark-up percentage is quite high as it must be sufficient to cover both direct labour and direct expenses as well as overhead expenses and provide a profit.

2.   Direct cost pricing: This is where cost (C) represents the total direct costs. In this situation the mark-up percentage must be sufficient to cover both overhead expenses and provide a profit.

3.   Full cost pricing: This is where cost (C) represents total costs of the business. In this situation the mark-up percentage can be quite small as it represents clear profit.

Different business sectors will use different cost based methods. For example, the fast moving consumer goods (FMCG) end of the retail sector tends to use gross margin pricing, whereas other business sectors may use a full costing approach. It all depends on the business sector and the sophistication of the costing system used.

Contribution margin pricing focuses on ensuring that each product or service that a business provides offers a target contribution towards fixed costs and profit. Thus it is important to identify and classify all costs into their fixed and variable components. Contribution margin pricing is based on the premise that prices are set using variable costs as the base and what the market will bear as the ceiling. This ensures that although individual sales may not provide an overall profit, the sum of all sales will provide sufficient contribution to cover fixed costs and provide the required profit. The main focus is on providing a contribution to fixed costs and, should economic conditions and competitive levels be favourable, the contribution can be quite large to ensure the business reaches profitability as early as possible. This method can provide a high discretionary element to price setting and thus can be quite useful for businesses that are sensitive to economic and seasonal factors and have a high fixed cost operating structure, such as hotels and airlines.

b) Outline the major criticisms of cost plus pricing.

·     It only focuses on costs and ignores other factors such as the economic environment, competition, and the marketing and sales strategy of the business.

·     It also does not take into account the required level of profitability based on the level of investment in the business.