PRODUCTION MANAGEMENT - COST PLUS

PRODUCTION MANAGEMENT

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Question:

Why do you think cost-plus and target rate of return pricing are so prominent in Nigerian business? Does the use of these policies negate the validity of economic models based on the assumptions of profit maximization or sales revenue maximization? Explain

Answer:

 One of the most important objectives of a firm is to set price in order to achieve a target rate of return on investment.  In order to accomplish this objective, the firm will try to establish a price such that on the average, the return to the capital employed in producing the particular product will equal the predetermined level.  Capital for this purpose includes net worth Plus long term debt.  One method of accomplishing the above objective is using the cost-plus pricing mechanism.

COST-PLUS PRICING:  Cost-Plus Pricing is one of the most common methods of pricing used in the business world today especially in Nigeria.  This approach seems very simple.  In this method, the firm needs only to determine the cost of producing a unit of output and then to price it at that cost plus some mark-up. With this method, the firm must decide what costs should be included, at what volume of output should those costs be determined and how large a mark-up is appropriate.    As stated above that cost-plus pricing is the most widely used method of price determination in Nigeria, this is owing to reasons as enumerated below:

First, cost-plus pricing leads to a relatively stable price. For example, in industries whose output is used by others as a material input, price stability may be very important.  In negotiating contracts, many corporate buyers prefer a stable price since this reduces the time and expense they must exert in trying to get the best buy.

Second, cost – plus pricing may make price increase more acceptable to consumers.  If the consumers can be convinced that an increase in price is simply a reflection of increased costs, they are less likely to develop feelings of ill-will towards the seller. 

Third, cost-plus pricing is very compatible with the objective of many firms to achieve a specified rate on investment. 

Finally, once the methods to be used in determining the relevant costs and the mark-up are established, this pricing strategy becomes fairly simple.  It is possible to combine cost-plus pricing with the economic model of profit maximization and thereby account for demand factors.  We know that, for profit maximization, marginal revenue should equal marginal cost.