Standard Cost Pricing

A development of the cost-plus approach to setting prices is to use cost 'standards' based on management accounting systems. Variable costs of production (materials, labour, bought-in components, etc.) are added up and divided by the number of units intended to be produced to give a variable cost per unit. Similarly running costs of the organization (rent, rates, energy, maintenance, together with management and administrative costs) are totalled and divided by the number of units to be sold to provide the fixed cost per unit. Finally the profit required is added in on a per unit basis.

Adding together the variable cost, fixed cost and profit per unit gives the selling price. This approach is much used by companies producing a large range of products because it allows a complex situation to be subjected to disciplined control using standard accounting methods.

Despite the fact that it is a simple way of calculating price, it is an inferior method of setting prices. The first problem is that it assumes that costs are the thing which cause people to buy. But the market is not the least bit interested in cost. It is interested in getting what it wants at a competitive price.

Using the standard cost system, full cost accounting, full cost pricing, or whatever name is used, in this method fixed costs are treated on a percentage basis. Then if the fixed costs are down then the selling prices go down as well as selling price. In the end the actual profit per unit will go down.

In other words, using costs as a basis for calculating prices needs tempering by consideration of what customers want and what they are prepared to pay if maximum profit is to be achieved.