Cost plus method

The term "Cost plus method" refers to a pricing strategy or a type of contract where the price of a product or service is determined by calculating the total cost of production or service delivery and then adding a specific percentage or fixed amount as profit. It falls under the broader category of pricing strategy within business and management accounting. This method ensures that all direct costs, indirect costs, and overheads are covered, along with a predetermined profit margin.

History and Origin

The cost plus method, particularly in the form of cost-plus contracts, gained prominence and widespread use during periods of national emergency, such as World War I and World War II. During these times, the urgency of production for war materials made traditional competitive bidding impractical, as manufacturers faced unpredictable market conditions and difficulties in accurately estimating costs for large-scale, novel projects. To incentivize companies to produce essential goods quickly and without fear of financial ruin, governments turned to contracts that guaranteed reimbursement of costs plus a profit. For instance, during World War II, many defense contracts were structured this way, allowing companies to focus on production rather than cost optimization, as their expenses were covered, and a profit was assured.⁷, Frank B. Gilbreth, an early pioneer in industrial engineering, also described the "cost-plus-a-fixed sum" method for his building contracting business as early as 1907. The Federal Acquisition Regulation (FAR) still details various types of cost-reimbursement contracts, including those that operate on a cost-plus basis, demonstrating its continued relevance in government procurement.⁶,⁵

Key Takeaways

• The cost plus method calculates a price by adding a markup (either a percentage or fixed amount) to the total cost of a product or service.
• It guarantees coverage of all production costs and a predetermined profit.
• Commonly used in industries with hard-to-estimate costs, such as government contracting, custom projects, and regulated utilities.
• Provides simplicity in pricing but can offer less incentive for economic efficiency or cost control for the seller.
• Can be less competitive in markets where buyers have many alternatives.

Formula and Calculation

The basic formula for the cost plus method is straightforward:

Where:

• Total Cost: This includes all expenses associated with producing a good or service. This can comprise direct costs (like raw materials and labor directly involved in production), indirect costs, fixed costs (like rent), variable costs (like electricity for production), and overhead costs (administrative and selling expenses).
• Markup: This is the profit component, which can be expressed as a fixed monetary amount or, more commonly, as a percentage of the total cost. If it's a percentage, the formula can be written as:

For example, if the total cost to produce an item is $100 and the desired markup percentage is 20%, the selling price would be:
Price = $100 * (1 + 0.20) = $100 * 1.20 = $120.

Interpreting the Cost Plus Method

Interpreting the cost plus method primarily involves understanding its implications for profitability and cost management. For businesses employing this method, a higher total cost directly translates to a higher selling price, assuming the markup percentage remains constant. This means that controlling costs is crucial for maintaining competitive pricing while still achieving the desired profit margin.

From a buyer's perspective, a cost-plus arrangement often means transparency regarding the seller's expenses, as the costs are usually detailed to justify the final price. However, it can also mean that the buyer bears the risk of cost overruns if the seller has little incentive to minimize expenses. The method is often favored when the scope of work is uncertain, or when unique, custom projects are undertaken, making upfront fixed-price agreements difficult or risky for the seller.

Hypothetical Example

Imagine "TechSolutions Inc." is developing custom software for a government agency. Due to the unique requirements and potential for unforeseen challenges in project management, they agree to a cost plus contract.

1. Calculate Direct Costs: TechSolutions estimates direct labor (programmers' salaries for the project), software licenses specific to the project, and server usage costs.

   • Direct Labor: $500,000
   • Software Licenses: $50,000
   • Server Usage: $20,000
   • Total Direct Costs: $570,000

2. Calculate Indirect Costs/Overhead: They allocate a portion of their general administrative expenses, office rent, and utility costs to the project.

   • Allocated Overhead: $80,000

3. Determine Total Cost:

   • Total Cost = Direct Costs + Overhead = $570,000 + $80,000 = $650,000

4. Apply Markup: The contract specifies a 15% markup on total costs for profit.

   • Markup Amount = $650,000 * 0.15 = $97,500

5. Calculate Final Price:

   • Final Price = Total Cost + Markup Amount = $650,000 + $97,500 = $747,500

In this scenario, the government agency would pay TechSolutions Inc. $747,500. If actual costs were higher, the final price would also increase, ensuring TechSolutions' 15% profit on the incurred expenses.

Practical Applications

The cost plus method finds its most common applications in specific industries and contract types where estimating exact costs upfront is challenging, or where transparency and risk-sharing are paramount.

• Government Contracts: Governments, particularly in defense and infrastructure, frequently use cost-plus contracts for complex projects like developing new weapons systems or building large public works. This is because the scope, materials, and labor required can be highly uncertain at the outset, and this method reduces the risk for contractors, encouraging them to undertake essential projects. The Federal Acquisition Regulation (FAR) outlines various forms of cost-reimbursement contracts, including cost-plus-fixed-fee, cost-plus-incentive-fee, and cost-plus-award-fee contracts.⁴,³
• Regulated Monopolies/Utilities: In industries like electricity, water, and natural gas, where services are often provided by regulated monopolies, pricing is often set using a cost-plus model. Regulators allow the utility companies to recover their operating costs and earn a "fair rate of return" (profit margin) on their investments. This approach aims to ensure the utility can maintain and upgrade infrastructure while providing essential services. However, it also raises questions about the incentive for utilities to control costs.²
• Custom Manufacturing and Contract Costing: For highly customized products, specialized equipment, or unique services where each project is distinct, the cost plus method can be used. It's prevalent in sectors like construction, aerospace, and bespoke software development, where precise cost estimation before starting the work is difficult.
• Research and Development (R&D): Companies undertaking R&D projects for external clients may use a cost-plus approach due to the inherent uncertainties of research. This allows the research firm to cover its expenses and earn a profit, even if the project's exact path or duration is unknown.

Limitations and Criticisms

While the cost plus method offers simplicity and guaranteed revenue for the seller, it is not without significant limitations and criticisms.

One of the primary drawbacks is the diminished incentive for the seller to control costs. Since the profit is tied to a percentage of the costs, there is little motivation to minimize expenses; in fact, higher costs can lead to higher absolute profits. This can result in inefficiencies, inflated expenses, and a lack of innovation. For example, government contracts structured on a cost-plus basis have frequently been criticized for leading to significant cost overruns, as contractors may have little reason to seek the most economical solutions.¹

Another criticism is that this method does not consider market dynamics or customer perception of value. The price is solely determined by internal costs and a desired markup, potentially leading to prices that are either too high for the market to bear or too low, leaving potential profits on the table. It can also make a company less competitive against rivals who employ more aggressive pricing strategy models or have more efficient operations.

Furthermore, the determination of "costs" can be complex and contentious, particularly for overhead costs and shared resources. Disputes can arise between parties regarding what constitutes an "allowable" or "reasonable" cost, necessitating extensive audits and administrative oversight. This can add complexity and administrative burden to what initially appears to be a simple pricing approach.

Cost Plus Method vs. Value-Based Pricing

The cost plus method and value-based pricing represent fundamentally different philosophies in setting prices.

While the cost plus method is simpler to implement and provides a guaranteed profit margin for the seller, it risks ignoring market demand and competitive pressures. Value-based pricing, on the other hand, aims to align the price with the customer's perceived benefit, potentially leading to higher prices and greater profitability in competitive markets, but it requires deep market understanding and effective communication of value.

FAQs

What is the main advantage of using the cost plus method?

The main advantage is its simplicity and the guarantee that all costs will be covered, ensuring a predetermined profit margin. This reduces financial risk for the seller, especially in projects with uncertain costs.

In what situations is the cost plus method most commonly used?

It is commonly used in government contract costing, custom manufacturing, professional services, and industries with regulated prices like utilities. These are typically situations where cost estimation is difficult upfront or where the buyer prioritizes project completion over strict cost minimization.

Does the cost plus method encourage efficiency?

Generally, no. Since profit is often tied to a percentage of costs, there is less incentive for the seller to minimize expenses. In fact, higher costs can lead to higher absolute profits, potentially leading to inefficiencies.

How does the cost plus method relate to government contracts?

Many government contracts, particularly for complex or uncertain projects (like defense procurement), are structured as cost-plus. This allows contractors to be reimbursed for their allowable costs and receive an additional fee, reducing the financial risk for the contractor and encouraging them to undertake critical work.

Can a business lose money using the cost plus method?

While the method aims to guarantee profit, a business could still lose money if it miscalculates its total costs, if the agreed-upon costs are not fully reimbursable, or if significant unforeseen expenses arise that are not covered by the contract terms or exceed the defined cost ceiling.