Full Cost Pricing and the Illusion of Satisficing

Abstract

Most large manufacturing companies report setting prices by marking up some version of full cost. The rationale is that full cost pricing provides a "satisfactory profit." This paper shows that a full cost markup rule imposes a constraint which may prevent the company from achieving satisfactory profits even when satisfactory profits are feasible. We demonstrate that for any given cost structure and allocation basis, there always exist well-behaved demand curves such that satisfactory profits cannot be realized using a full cost pricing strategy even though satisfactory profits could be realized with a better pricing strategy. Thus, there is no guarantee that setting prices via a full cost pricing strategy will yield a satisfactory profit even in an intrinsically profitable company. In general, the more critical a pricing decision is, the less likely that a full cost pricing rule will be satisfactory.

JEL Classification: D40