Defining and Calculating Cost-Plus Pricing
Determining Your Profit Margin
Cost-plus pricing, also called mark-up pricing or markup pricing is the practice by a company of determining the cost of their product to them 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, it is really important to have 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, and/or is a bargaining chip in getting the sale.
3 Steps to Computing Cost-Plus Pricing
There are 3 steps to computing cost-plus pricing.
Step 1 is 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 is to divide the total cost by the number of units to determine the unit cost
Step 3 is to multiply the unit cost by the markup percentage to arrive at the selling cost, and the profit margin of the product.
An Example of Cost-Based Pricing
For example, if a company sells a product for $1.00, and that $1.00 includes all the costs that go into making and marketing the product, then it may add a percentage on top of that $1.00 as the "plus" part of cost-plus pricing. That portion of the price is their profit.
Depending on the company, the percentage of markup may also include some estimate of market or economic conditions. If demand is slow, then the mark-up 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, then the mark-up percentage may be higher as the company feels they can get the higher price for their product.
Cost-plus pricing has an achille's heel - it does not consider any measure of demand for the product or service. The formula is unmindful if potential customers will purchase the product at the marked-up 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 the market will bear" in pricing.
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, unique or products with highly valuable features you may be well positioned to take advantage of value-based pricing, which typically generates a higher percentage of profit.