Cost-plus pricing, also known as markup pricing, is a practice that companies use to determine the cost of a product to the company and then add a percentage above that cost to set the selling price for the customer.
The Concept of Cost-plus Pricing in Pricing Strategy
Cost-plus pricing is a very straightforward strategy for determining prices of goods and services. In cost-plus pricing, you first add up the cost of direct materials, direct labor, and overhead to determine the cost of providing the product or service to the company. A percentage is then added to the total cost to set the selling price. This percentage is the profit. Therefore, you need to start with a strong and accurate understanding of the costs of doing business and the source of those costs.
3 Steps to Calculate Cost-plus Pricing
There are three steps to calculating cost-plus pricing for a product:
Step 1: Determine the total cost of the product or service, which is the sum of fixed costs and variable costs (fixed costs do not change with the number of units, whereas variable costs do change).
Step 2: Divide the total cost by the number of units to determine the cost per unit.
Step 3: Multiply the cost per unit by the markup percentage to arrive at the selling price and profit margin for the product.
An Example of Cost-plus Pricing
Suppose a company sells a product for $1, and that dollar includes all costs associated with making and marketing the product. The company can then add a percentage above that dollar as the “markup” in cost-plus pricing. This portion of the price is the company’s profit.
Depending on the company, the markup percentage may also include a factor that reflects current market conditions or economic circumstances. If demand is slow, the markup percentage may be lower to attract 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 command a higher price for its product.
Advantages and Disadvantages
In some cases, like a contractual sales agreement, it makes sense to use cost-plus pricing, while it can cause significant financial problems if used in other pricing scenarios. Here are some positives of using this type of pricing method:
Building the selling price for the product: It is straightforward using this method, with one caveat. You need to have a consistent way to allocate infrastructure costs in each future accounting period to maintain the integrity of cost building.
Securing revenue with a contract: Any supplier would want to have a cost-plus pricing contract because it essentially guarantees sales at a certain profit margin and covers all production costs without any risk of loss.
A way for suppliers to justify and explain price increases: With cost-plus pricing, it’s easy to implement price increases because companies can simply inform customers that the costs of producing the product have gone up.
Cost-plus pricing comes with its share of drawbacks, including the following:
Pricing does not take competition into account: The product can be priced too high, costing the company lost sales and market share. Pricing can also be below competitors, resulting in missed profit opportunities from not charging market price for their goods.
Suppliers have little incentive to control or reduce costs: When they enter into a cost-plus pricing agreement, companies end up producing what they want, regardless of production costs or how it sells in the market.
Higher costs from cost-based suppliers: Suppliers have an incentive to include every possible cost in the cost contract rather than looking for ways to reduce and streamline costs.
Does not
Considers the latest replacement costs: Cost-based pricing relies on historical costs and does not take into account any recent changes in the amount of costs incurred.
Considerations
A major issue with cost-based pricing is that it does not consider any measurement of the demand for the product or service. The formula is unaware of whether potential customers will purchase the product at the specified price. To compensate for this, some business owners have attempted to apply principles of price elasticity to cost-based pricing. Some may simply look at competitive offers, trends, and business acumen to determine the price that the market can 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, rather than its cost of production. If your company offers specialized or unique products with high-value features, you may be well positioned to take advantage of value-based pricing, which typically generates a higher profit margin.
Source: https://www.thebalancemoney.com/cost-plus-pricing-393274
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