Defining and Calculating Cost-Plus Pricing
Determining Your Profit Margin
Cost-plus pricing, also called markup pricing, is the practice by a company of determining the cost of the product to the company and then adding a percentage on top of that price to determine the selling price to the customer.
Cost-plus pricing is a very simple cost-based pricing strategy for setting the prices of goods and services. With cost-plus pricing you first add the direct material cost, the direct labor cost, and overhead to determine what it costs the company to offer the product or service. A markup percentage is added to the total cost to determine the selling price. This markup percentage is profit. Thus, you need to start out with a solid and accurate understanding of all the business' costs and where those costs are coming from.
In certain cases, the markup percentage is agreed upon by both buyer and seller. This percentage can also serve as a bargaining chip during the sale.
3 Steps to Computing Cost-Plus Pricing
There are three steps involved in computing cost-plus pricing for a product:
- Step 1: Determine the total cost of the product or service, which is the sum of fixed and variable cost (fixed costs do not vary by the number of units, while variable costs do).
- Step 2: Divide the total cost by the number of units to determine the unit cost.
- Step 3: Multiply the unit cost by the markup percentage to arrive at the selling cost and the profit margin of the product.
A Cost-Based Pricing Example
Suppose that a company sells a product for $1, and that $1 includes all the costs that go into making and marketing the product. The company may then add a percentage on top of that $1 as the "plus" part of cost-plus pricing. That portion of the price is the company's profit.
Depending on the company, the percentage of markup may also include some factor reflecting the current market or economic conditions. If demand is slow, then the markup percentage may be lower in order to lure in customers. On the other hand, if demand for the product is high and economic conditions are good, the markup percentage may be higher as the company feels it can demand a higher price for its product.
Advantages and Disadvantages
In certain situations, such as a contracted sales agreement, it makes sense to use a cost-plus pricing method, while it could cause big financial problems if used in other pricing scenarios. Following are some of the positives of using this type of pricing method:
- Building up the selling price of a product: It's simple using this method, with one caveat. You need to have a consistent method for allocating overhead costs each accounting period going forward to maintain integrity with the cost buildup.
- Locking revenues in with a contract: Any supplier would like to have a contract with cost-plus pricing because it essentially guarantees sales with a certain profit percentage and coverage of all production costs with no risk of having a loss.
- A way for suppliers to justify and explain a price increase: With cost-plus pricing, price increases are easier to roll out because companies can simply inform clients that the costs to produce the product have risen.
The cost-plus model comes with its share of disadvantages, including the following:
- Pricing doesn't consider the competition: The product could be priced too high, which would cost the company in terms of lost sales and market share. The pricing could also be lower than the competition's, causing the company to lose potential profits because of not charging the market rate for its goods.
- Suppliers have little incentive to control or reduce costs: When they've entered into a cost-plus pricing arrangement, companies end up producing what they want, regardless of what it costs to produce or how it sells in the market.
- Runaway costs from suppliers hired on a cost-plus basis: Suppliers have the incentive to include every possible cost in a cost-plus contract, rather than looking for ways to cut costs and streamline.
- Doesn't consider most recent replacement costs. The cost-plus method is based on historical costs and doesn't factor in any recent changes in the amount of costs incurred.
A significant issue with cost-plus pricing is that it doesn't consider any measure of demand for the product or service. The formula is unmindful of whether potential customers will actually purchase the product at the indicated price. To compensate, some business owners have tried to apply the principles of price elasticity to cost-plus pricing. Others may simply look at competitive offers, trends, and business acumen to determine what price the market will bear.
An alternative is value-based pricing, which is the process of determining the selling price of a product or service based on the benefits it provides to buyers, not what it costs to produce. If your business offers specialty or unique products with highly valuable features, you may be well positioned to take advantage of value-based pricing, which typically generates a higher profit percentage.