What is Cost Plus Pricing?
Cost-plus pricing is a methodology in which the selling price of a product is determined, based on unit costing, by adding a certain mark-up or profit premium to the cost of the product.
In simple words, it is a strategy of pricing a product in the market by adding a specific margin to the cost of that product. This margin, or better known as mark-upMark-upThe percentage of profits derived over the cost price of the product sold is known as markup. It is determined by dividing the company's total profit by the cost price of the product and multiplying the result by 100.read more, is the entrepreneur’s profit.
Or
Thus, a stepwise approach is:
Step #1: Obtain details of all costs and units/resources involved in the production.
Step #2: Segregate them into groups, say fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more, labor costLabor CostCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more, direct costDirect CostDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc.read more, direct material costDirect Material CostDirect Material Cost is the total cost incurred by the company in purchasing the raw material along with the cost of other components including packaging, freight and storage costs, taxes, etc. that are related directly to the manufacturing and production of various products of the company.read more.
Step #3: Calculate unit cost based on the number of units involved in the production.
Step #4: Either determine the total unit cost of production and multiply it by mark-up or premium percentage or determine the total cost by multiplying unit costUnit CostUnit cost is the total cost (fixed and variable) incurred to produce, store and sell one unit of a product or service. It is calculated by adding fixed and variable expense and dividing it by the total number of units produced.read more and the number of units of each cost type.
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For eg:
Source: Cost Plus Pricing (wallstreetmojo.com)
How Does it Work?
- The most commonly used method is variable cost-plus pricing. In this, the mark-up or profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more is added to the variable costs of the product. Thus, the selling price equals the sum of variable costs and desired mark-up. Another method to determine price through cost-plus strategy is target costing where the selling price is fixed, and costs are worked upon to increase efficiency in the system, thereby increasing profit margin.
- Thus, profit equals the fixed selling price, minus the total of all costs. There are different variable costs associated with the manufacturing of a product. Direct labor, selling and marketing expenses, material and packaging costs, etc. are some of them. It should be noted that different cost-plus pricing strategies are applicable to different scenarios. Take, for example, the one described above – variable cost-plus pricing. This strategy is used when markets are competitive, and market producers are capable of lowering variable costs in order to gain profits.
- This strategy can also be used for contract bidding where the specifics of a product are based on the variable costs, and thus, the lowest bidder is the beneficiary. A key demerit is that this strategy of pricing excludes opportunity costs. Opportunity cost is determined by the next best use of an asset or resource. If management can put to use its resources in a more profitable manner, it should include such assumptions and facts in its worksheet. Reliance on cost-plus pricing for such inclusions can be delusional.
Example of Cost Plus Pricing
Let’s take an example.
Suppose a power generation plant in a small city of Florida supplies electricity to the state electricity grid. The manager of this plant has agreed to be paid a 12% premium on the unit cost of electricity. He has employed a 1,000-strong workforce for his power plant. The items above are based on monthly costing, and for convenience of calculation, 1,000 units are assumed to be produced per month. How should the manager go about deciding the price of per unit of electricity generated in his plant?
The manager lays out the unit cost of each of the expenses that his plant incurs and tabulates it as follows:
Solution:
- All figures in US$ except units;
- The manager calculated the total unit cost to be the sum of fixed and variable costs and found it to be $5100.
- The selling price can be determined either based on unit cost since the schedule here is activity-based costing. Or else, the manager can use the total cost price to determine his profit.
Note that in both scenarios, his profit and profit margin will be the same.
Profits are:
Selling Price = 12% Premium on Unit Cost Price of $5100 – Cost Price Itself = $612
- Hence his total profit will be $612 times units sold = $612,000.
- The profit margin will be 612/5100 or simply 12%, which was his premium on the cost price.
Now, it is the efficient operation and management of the plant that can lead to cost reductions, in either fixed costs or variable costs or both, thereby increasing the profit and profit margin for the manager.
Advantages of Cost Plus Pricing
- Helpful in competitive markets to participate in price wars.
- Easy to apply in situations where the unit product is specific and non-uniform.
- Helpful in measuring accounting profits and working on ways to improve efficiencies.
Disadvantages
- Difficulty in applying the strategy in most situations due to lack of efficiency;
- Cost-plus pricing may not encourage management to strategize consistently to keep up with the pace of competition because it always acknowledges price with profit and does not give incentives to reduce costs.
- The method is unjustifiable when a business deals with innovation and design. In such cases, the incentives to improve are overridden as market demand, and customer satisfaction takes priority.
Conclusion
Cost-plus pricing is one of the most used as well as the simplest pricing strategies in businesses. The method has its advantages and disadvantages. For example, it often becomes difficult for the manufacturing businesses to equate production and demand such that the production schedule is profitable.
The primary disadvantage of this pricing strategy is that it ignores the competitor’s profit margins and takes into account only the mark-up that the business/company/manufacturer focuses on. To tackle such situations, costing departments should always include competition and various aspects of sustainability and profitability in the mark-up or premium above cost price. Nevertheless, cost-plus pricing can help take deeper insights into businesses and develop consistencies and profits.
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