What’s it: Cost-plus pricing is a pricing strategy in which the company adds up the profit margin (markup) to the cost of making the product. This is the most basic and simplest method because it uses cost as the basis of calculation.
Another term for cost-plus pricing is markup pricing.
Cost-plus pricing is in contrast to market-based pricing. Under the latter approach, companies first consider demand and competition in determining the selling price, rather than the cost.
Why do companies adopt cost-plus pricing
Cost-plus pricing is used primarily by companies who want certainty about costs. Examples of companies that often use cost-plus pricing are retail, construction, and government services.
Retailers usually want to calculate for sure the gross profit margin of each unit sold. Apart from being easy to calculate, the cost-plus pricing approach allows companies to ensure that their costs are covered. This strategy also provides certainty for their suppliers.
The contractor can also use this method to determine the contract price. Cost-plus pricing avoids the uncertainty associated with cost estimates. In the construction industry, customers crave certainty about costs. That way, they can set a more certain selling price.
How to calculate cost-plus pricing
Let’s discuss one by one how cost-plus pricing works. First, we’ll cover the main features of this pricing. Then, we will discuss about the formula and how to calculate it.
The main feature of cost-plus pricing
The two components of price:
- Production cost per unit
- The desired markup or profit
The cost-plus pricing approach takes into account all relevant costs. In the manufacturing industry, it includes direct material costs, overhead costs, and labor costs.
In practice, calculations may vary. Some companies may only consider production costs. After that, the company adds a markup percentage to cover other overhead costs (including administration, sales, and distribution costs).
Meanwhile, other companies calculate all relevant costs, including overhead costs. They estimate the costs of administration, sales, and distribution costs and add them to the total costs. The company then determines the selling price by multiplying it by the profit percentage.
Cost-plus pricing formula and example
The calculation of this approach is relatively easy. First, you need to determine the total cost of the product. You can add up fixed costs and variable costs.
Second, you divide the total cost by the number of units. This is to determine the cost per unit.
Third, multiply the cost per unit by the percentage of profit you want. The greater the profit percentage, the higher the selling price of the product.
The following is the cost-plus pricing formula:
Price = Cost per unit × (1 + Percentage markup)
Let’s take an example.
A clothing company reports its production costs as follows:
- Raw material costs: $10,000
- Direct labor costs:$ 5,000
- Overhead costs: $ 3,000
From this data, the total product cost is $18,000. Say, the total output that the company produces is 180 units. Thus, the cost per unit of output is $ 100.
The company wants the product to have a margin of around 20 percent. From this information, the per unit of clothing sold is $ 100 x (1 + 20%) = $ 120. That means the firm makes a profit of $ 20 per unit of output sold or about 20% of its cost. Easy right?
Specifies the markup percentage
The company can adjust the profit percentage according to the demand conditions. For example, when demand is high, companies may set higher markups. Conversely, when demand falls, they lower the markup so that the product price remains affordable.
Next, the markup percentage may also differ between product lines. Companies set a higher percentage for some products and lower for others. That depends on demand and competition.
Hope you remember. In calculating cost-plus pricing, a company should still consider the demand conditions and competitors’ prices. Both determine the profit margin. For example, when the competition is fierce, the company may set lower margins so that the selling price is not too high. The opposite condition applies when the competitive pressure is lower.
Even though companies consider demand and profit, production costs remain the primary determinant.
If the company has a higher production cost, the selling price will likely be higher. The company will probably take the low percentage of markup. So, the final price is not too expensive.
Back to the calculation example above. Say, a competitor in the market sells a product for $ 100. That’s the same as the company’s production costs.
If the company takes a 20% profit margin, it will not sell the product because it is too expensive. Therefore, the company may only take a lower profit margin, for example, by 5%.
The advantages and disadvantages of cost-plus pricing
Is the cost-plus pricing a good deal?
It depends on the nature of the product and the company’s business. In industries with a small output quantity and involving enormous production costs, cost-plus pricing is more suitable. An example is the construction industry.
In that industry, the cost of building a unit is very high. It will be a significant factor in determining the price. Also, contractors cannot spread costs across multiple outputs (like manufacturing) because they will only work on a few projects.
Advantages of cost-plus pricing
The first advantage of cost-plus pricing is that it is simple and straightforward. The company does not require customer surveys when setting sale prices. Perhaps a more complicated process is in allocating consistent overhead in calculating the prices of some products. Some products may require more promotional costs than others. Therefore, they should have a higher weight.
The second benefit is profit stability. The company can lock profits into the contract, so it is unlikely to change as long as it is in effect. Profit markup will usually take into account potential future risks.
The third is maximizing profits. Companies can assign different profit percentages to other products. Also, they can adapt it to the conditions of demand and competition in the market.
The disadvantages of cost-plus pricing
Although easy, cost-plus pricing does not guarantee demand. This approach is only oriented internally (cost) rather than external (customers and competitors).
Take the example of a new company. They will usually have a higher fee structure than the existing companies. If they use this approach, their product will cost more. Instead of generating sales, buyers are reluctant to buy products.
Well, let’s break down the drawbacks of cost-plus pricing. First, this approach is inflexible. I mean, prices are not responsive to market changes. Although the company can adjust the percentage markup, the selling price ultimately depends on its cost structure.
Say, the company has a high-cost structure. Assume that market prices fall to a level below the firm’s unit cost. If it adopts cost-plus pricing, the company cannot reduce the price below the cost per unit.
That is the minimum limit for determining the selling price. And, at that level (cost per unit), the company doesn’t make a profit. So, the company likely won’t (lower prices even further).
Second, the allocation of overhead costs is more complicated than in theory. If the company has various products, difficulties arise when determining what the overhead will be for each.
For example, in their budget, they might define advertising costs for individual products. However, when negotiating with advertising agencies, they may not be negotiating the advertising costs per product. Apart from being time-consuming, the company cannot take advantage of such a discount for awarding large contracts to agents.
Third, the price may be less competitive. Indeed, companies can adjust their profit margins. However, if competitors’ price is below the firm’s unit cost, it cannot keep up. As I said earlier, the threshold price is the cost per unit. Even at that level, the company does not make a profit.
So, if it sticks to this approach, the company could lose sales and market share by being uncompetitive.
Fourth, it is difficult for companies to adjust prices if they are already in the contract. It can cause losses if the company considers the only historical cost. Costs are currently rising, and the company is unable to revise the agreement.
Fifth, the product may be less attractive to customers. Under this method, the company has no incentive to design a product with a suite of features and design characteristics that match market needs and wants.