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Cost-plus pricing

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Cost-plus pricing is a pricing strategy by which the selling price of a product is determined by adding a
specific fixed percentage (a "markup") to the product's unit cost. Essentially, the markup percentage is a
method of generating a particular desired rate of return.[1][2] An alternative pricing method is value-
based pricing.[3]

Cost-plus pricing has often been used for government contracts (cost-plus contracts), and has been
criticized for reducing incentive for suppliers to control direct costs, indirect costs and fixed costs
whether related to the production and sale of the product or service or not.

Companies using this strategy need to record their costs in detail to ensure they have a comprehensive
understanding of their overall costs.[2] This information is necessary to generate accurate cost
estimates.

Cost-plus pricing is especially common for utilities and single-buyer products that are manufactured to
the buyer's specification, such as for military procurement.

Mechanics Edit

The three parts of computing the selling price are computing the total cost, computing the unit cost, and
then adding a markup to generate a selling price (refer to Fig 1).
Fig 1: Cost-plus pricing steps

Step 1: Calculating total cost

Total cost = fixed costs + variable costs

Fixed costs do not generally depend on the number of units, while variable costs do.

Step 2: Calculating unit cost

Unit cost = (total cost/number of units)

Step 3a: Calculating markup price

Markup price = (unit cost * markup percentage)

The markup is a percentage that is expected to provide an acceptable rate of return to the
manufacturer.[1]

Step 3b: Calculating Selling Price (SP)

Selling Price = unit cost + markup price

Example Edit

A shop selling a vacuum cleaner will be examined since retail stores generally adopt this strategy.
Total cost = $450

Markup percentage = 12%

Markup price = (unit cost * markup percentage)

Markup price = $450 * 0.12

Markup price = $54

SP = unit cost + markup price

SP = $450 + $54

SP = $504

Ultimately, the $54 markup price is the shop's margin of profit.

Rationale Edit

Buyers may perceive that cost-plus pricing is reasonable. In some cases, the markup is mutually agreed
upon by buyer and seller. For markets that feature relatively similar production costs, companies do not
have a dominant strategy.[4] Therefore, cost-plus pricing can offer competitive stability, decreasing the
risk of price competition (such as price wars), if all companies adopt cost-plus pricing. The strategy
enables price changes to goods and services relative to increases or decreases in the product cost which
are simple to communicate and justify to customers.[5] When there is little market intelligence, the use
of a cost-plus pricing strategy compensates for the lack of information by setting prices based on actual
costs.[6] This method is generally adopted by retail companies such as grocery or clothing stores.[5]
Cost-based pricing is a way to induce a seller to accept a contract the costs of which represent a large
fraction of the seller's revenues, or for which costs are uncertain at contract signing, as for example for
research and development.

Economic theory Edit

Cost-plus pricing is not common in markets that are (nearly) perfectly competitive, for which prices and
output are such that marginal cost (the cost of producing an additional unit) equals marginal revenue. In
the long run, marginal and average costs (as for cost-plus) tend to converge, reducing the difference
between the two strategies. It works well when a business is in need of short-term finance.

Elasticity considerations

See also

References Edit

Kenton, Will. "How Variable Cost-Plus Pricing Works". Investopedia. Retrieved 2021-04-26.

Carlson, Rosemary. "Defining and Calculating Cost-Plus Pricing". The Balance Small Business. Retrieved
2021-04-26.

Jain, Sudhir (2006). Managerial Economics. Pearson Education. ISBN 978-81-7758-386-1.

Park, Anna (2010). "Price-setting behaviour: Insights from Australian firms". RBA.

"Cost plus pricing definition". AccountingTools. Retrieved 2021-04-26.

"Pricing - cost-plus strategies | Learn economics". www.learn-economics.co.uk. Retrieved 2021-04-26.

[1], McKinsey Quarterly, August 2003

"Pricing Strategies & Elasticity". Fundamentals of Marketing. 2014-12-16. Retrieved 2021-04-26.

Last edited 23 days ago by 2604:2000:2FC0:F:81D9:9D27:E036:57C9

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