Average cost pricing is also is also known as “make-up Pricing” or “Cost plus pricing” .
Average cost pricing is the most common method of pricing used by the manufacturing firms . The general practice under this method is to add a “fair” percentage of profit margin to the average variable cost ( AVC ) . The formula for setting the price is given as :- P = AVC + AVC ( m ) Where AVC = average variable cost; m = make up percentage and AVC ( m ) = gross profit margin ( GPM )
The make-up percentage (m) is fixed so as to cover average Fixed cost ( AFC ) and net profit margin ( NPM ) . Thus , AVC ( m ) = AFC + NPM
The procedure for arriving at AVC and price fixation may be summarized as follows :-
Step-1 :- Estimate the average variable cost . For this , the firm as to ascertain the volume of its output for a given period of time ,usually one accounting or fixed period . To ascertain the output the firm uses figures of its “Planned” or “Budgeted” output or take into account its normal level of production . If the firm is in a position to compute its optimum level of output or the capacity output , the same is used as standard output in computing the average cost .
Step-2 :- is to complete total variable cost ( TVC ) of the “Standard output” . The TVC includes direct cost i.e.. the cost of labor and raw material ,and other variable costs . These costs added together give the total variable cost . The average variable cost ( AVC ) is then obtained by dividing the total variable cost ( TVC ) by the standard output ( Q ) i.e.. AVC = TVC / Q
After AVC is obtained ,a ‘make-up’ of some percentage of AVC is added to it as profit margin and the price is fixed . While determining the make-up , firms always take into account ‘ what the market will bear ’ and the competition in the market .