Cost-plus pricing

Cost-plus pricing is one of the most popular used pricing technique and begins with an estimate of the cost of building the product or providing the service, and adds a certain percentage of profit to determine the price. Provided there is no market price for this product, the contractor must propose a price approach that is not based on market prices. When using this pricing technique, remember to determine in advance which costs are to be included in determining the price.

One of the pitfalls of using cost-plus pricing for a buyer is that the seller can cover the costs to establish a large database. Furthermore, some costs, for example overheads, can be difficult to apply. In a period of rapid inflation, this technique of pricing is popular, especially when the producer must use ingredients whose price changes.

Cost-plus pricing formula

During the company's pricing process, price is a function of the cost of a product or service. This means that the typical approach is to use a cost plus valuation. This approach involves establishing a cost base and adding a margin to this cost base to determine the target sales price. This is the sale price of the product, which is to ensure the desired profit when the seller is able to specify any price for the product. The formula is being expressed by calculation as follow:

Cost + (Markup Percentage * Cost) = Target Selling Price

Advantages of cost-plus pricing method

Above all, cost-plus pricing method does not maximize your profits and is very easy to implement. After obtaining the desired margin, it is enough to multiply the variable costs by the margin to get your price. This is especially important and beneficial when you have many products and you do not have the share that was responsible for pricing various products. What's more, it provides a reasonable margin. By applying the same tag to all products, you know you are getting a certain margin.

Companies with more complex pricing mechanisms can sometimes sell products with low margins. Competition pricing costs is predictable. If both you and your competitors have a lot of products, it can be difficult to know how to price relative to competition from all sides. Knowing that your competitors are using a standard tag also allows you to use the standard tag and keep the price constant compared to the competition. In addition, this method of pricing is fair. Many businessmen uncomfortably charge different customers with different prices, and even charge different margins for different products. They think it's fair. Prices plus costs seem extremely fair.

Cost-plus pricing limitations

This pricing method has a tree major limitations which are:

• Ignoring the market’s demand
• This approach requires some assumptions about the future volume before setting costs and calculating the cost plus the selling price, which can lead to an increase in the derived cost plus sales price when demand falls and vice versa
• Is can not be guaranteed that total sales revenues will exceed total costs, even if each product is valued above cost

Different methods of cost-plus pricing

Different cost bases can be used for cost plus pricing. The grounds include direct variable costs, total direct costs, total direct and indirect costs, and total costs based on the allocation of the share of all organizational costs to the product or service. Different percentage profit margins are added depending on the cost base used. If a direct variable cost base is used, a high percentage margin will be added to provide a contribution to cover part of all costs not included in the cost base plus profits. If the total cost base is used as the cost base, a lower percentage margin will be added to provide only a contribution to profits.

Examples of Cost-plus pricing

• Manufacturing: A manufacturer may determine the cost of materials, labor, and overhead, add a certain percentage of profit, and then come up with the price of the product.
• Retail: A retailer may determine the cost of a product from the distributor, add a mark-up to cover overhead costs, and then set the price for the product.
• Professional Services: A professional service provider may estimate the time and cost of completing a project, add a certain percentage of profit, and then set the price for the service.
• Construction: A construction company may estimate the cost of materials, labor, and overhead, add a certain percentage of profit, and then set the price for the project.

Other approaches related to Cost-plus pricing

One other common pricing technique is cost-plus pricing. This approach begins with an estimate of the cost of building the product or providing the service, and adds a certain percentage of profit to determine the price. Other approaches related to cost-plus pricing include:

• Skimming Pricing: Skimming pricing involves setting a high price initially and then gradually reducing the price over time. This approach is often used when a product is new or unique.
• Penetration Pricing: Penetration pricing involves setting a lower price initially to gain market share. This technique is often used when introducing a new product to an established market.
• Value Pricing: Value pricing involves setting a price based on the customer’s perceived value of the product. This approach can be used to differentiate a product from competitors and create high perceived value.
• Bundling Pricing: Bundling pricing involves offering a combination of products or services at a discounted price. This technique is often used to increase sales and attract customers.

In conclusion, cost-plus pricing is one of the most popular pricing techniques, but there are other approaches related to it that can be used to determine the price of a product or service. These include skimming pricing, penetration pricing, value pricing and bundling pricing.

Footnotes

Cost-plus pricing — recommended articles

Cost oriented pricing — Captive pricing — Skimming pricing strategy — Flexible pricing — Product line pricing — Trade discount — Pricing strategy — Price bundling — Discriminatory pricing

References

• Drury C (2004), Management and Cost Accounting , Thomson, London, p. 436-437
• Guerreiro R (2012), Determining The 'Plus’ In Cost-Plus Pricing: A Time-Based Management Approach, "Journal of Applied Management Accounting Research", nr 10, p. 1-16
• Heisinger K (2009), Essentials of Managerial Accounting , Cengage Learning, Mason, p. 327
• Pride W (2017), Marketing Principles with Student Resource Access 12 Months , Cengage AU, Sydney, p. 406
• Stiving M (2011), Impact Pricing: Your Blueprint for Driving Profits , Entrepreneur Press, Irvine, p. 73-74
• Weygandt J (2009), Managerial Accounting: Tools for Business Decision Making , John Wiley & Sons, New Jersey, p. 341

Author: Jakub Stachów