A manufacturer’s selling prices should not be based on costs alone. One reason is that the actual cost of each product is not known with precision. At best, each product’s cost is an average that resulted from allocations of the indirect manufacturing costs. In addition, there are selling, general and administrative expenses that are even more difficult to associate with individual products.
A more compelling reason that selling prices should not be based solely on costs is the market for a product. If a product is unique, protected by a patent and trademark, and the demand for the product is high, customers may accept a selling price that is unusually high. In other words, the value of the product is much greater than the costs identified with the product plus a normal profit or markup.
At other times the market will include competitors offering a similar product at lower selling prices because of efficiencies, lower costs, or inaccurate cost calculations. Perhaps another competitor will sell a similar product at a lower selling price in hopes of attracting customers who will buy additional, more profitable products. These situations will likely prevent the manufacturer from achieving significant sales at selling prices that are based on costs plus a desired profit.
Given the complexity of a manufacturer’s operations and the competition in the market place, it is rare for a manufacturer to have selling prices based on its true costs plus a uniform rate of profit.
