Andrew’s Full Cost Pricing Theory

The full-cost pricing theory was also propounded by Prof. Andrews. He emphasized on full cost principle of price fixation by businessmen.

According to Andrews, the costing margin is defined as an addition to the constant average direct cost and will normally tend to cover the cost of the indirect factors of production and provide a normal level of net profit.

Andrews used the concept of average direct variable cost rather than the kinked demand curve as used by Hall and Hitch. Andrews visualizes the relevant range of output where the average direct variable cost remains constant.

According to him, The price that is fixed by the business firms is such that it is equal to the estimated average direct cost of production plus a costing margin, i.e. the price is equal to the ‘full cost per unit of output’.

Andrews, based on his empirical investigation assumed that the average variable cost (or average direct cost) remains constant over a large range of output provided the prices of variable factors remain constant. Thus, the average variable cost is a horizontal straight line over a large range of output if the prices of variable factors remain constant.

According to Andrews, the costing margin is defined as an addition to the constant average direct cost and will normally tend to cover the cost of the indirect factors of production and provide a normal level of net profit. Once we fixed the costing margin, it will remain constant irrespective of the level of output. But the costing margin varies as a result of changes in the price of fixed factors of production and in response to competitive and market forces.

Andrews also assumed that given the prices of fixed factors of production, the price of the product will remain the same irrespective of the level of output. Once the prices are set as per the full cost rule, the firm can sell whatever amount demanded by the buyers at this full cost price.

The Andrews theory of full-cost pricing is shown in the above figure. In the figure, price and cost are measured on Y-axis, and output is measured on X-axis. AC is the average direct cost curve faced by the firm, which is saucer-shaped. The average direct cost curve initially falls, then remain constant for a large range of output and then eventually rises as the level of output increases.

Corresponding to this average direct cost, MC is the marginal cost curve. The marginal cost curve initially falls and lies below average direct cost, then it coincides with the average direct cost curve and eventually, MC lies above average direct cost as the level of output increases.

Firms before fixing the prices have to calculate the average direct cost, total indirect cost as well as the amount of profit they wish to earn. The sum of total indirect cost and the number of profits planned will yield a fixed sum of money which remains constant for fixation of price in the short run.

According to Andrews, the costing margin is calculated from this fixed sum of money by diving it with the chosen level of output. The chosen output that is used for the purpose of estimating the costing margin can be determined in three ways-

First, it may be determined on the basis of expected sales in a future period for which output is being produced.

Secondly, it may be determined on the basis of sales of products made in the preceding production period or average sales achieved over a number of previous production periods.

Thirdly, it may be determined on the basis of the capacity output of the given plant, where capacity output is the maximum output that can be produced with the given plant.

If a new firm wishes to set the price of its product, then output is determined on the basis of capacity output and expected sales in a future period and not on the basis of sales of a product made in the preceding production period.

Under these circumstances, where a new firm wishes to set the price, then only the second and third method is used to determine the chosen output for the costing margin, and the first method is completely ruled out.

In the figure, let us assume that firms have chosen the OM level of output for estimating the costing margin and for fixing the price of the product. We have read that the fixed sum of money is the sum of the total overhead, indirect cost and the normal level of profits.

Now at OM level of profit, if the fixed sum of money, firms have chosen OM level of output for estimating the costing margin and for fixing the price of the product. We have read that the fixed sum of money is the sum of the total overhead, indirect cost and the normal level of profits.

Now at OM level of profit, if a fixed sum of money is divided by the chosen level of output OM, it yields SR amount of costing margin to be added to the average direct cost for determining the price of the product. At the OM level of output, the average direct cost is SM. If we add this average direct cost SM to the costing margin SR we get full cost which is equal to RM. The price of the product is fixed at OP, which is equal to the full cost of RM.

The price of the product OP which is determined on the basis of full cost RM will remain unchanged irrespective of the amount demanded and the actual output produced in the given period.

DD is the negatively sloped demand curve faced by the firm. At price OP, OQ units of output will be produced and demanded by the buyers. Now with any increase or decrease in demand for the product, the price would remain unchanged at OP provided that the amount demanded lies within the range where average direct cost remains constant, i.e. within the horizontal straight line portion. It is also provided that the costing margin remains unaltered.

Thus, according to Andrew’s full cost pricing theory price of the product will change due to changes in direct and indirect production costs and not as a result of changes in demand.

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