What Is Cost plus pricing?
Cost plus pricing is a fundamental pricing strategy where a company determines the selling price of a product or service by adding a specific markup percentage to its total production cost. This method falls under the broader financial category of pricing strategy, focusing on internal costs rather than external market factors or competitor prices. Cost plus pricing ensures that all direct costs and overhead costs are covered, with an additional amount for profit margin.
History and Origin
The concept of covering costs and adding a profit has ancient roots, but modern cost plus pricing gained significant traction with the rise of industrial manufacturing and large-scale procurement. Its formal adoption as a widespread practice was notably influenced by government contracts during wartime. For instance, the U.S. government widely utilized cost-plus contracts during World War I to incentivize rapid production of war materials, ensuring contractors were reimbursed for all associated costs plus a guaranteed profit.6 This approach facilitated timely delivery despite unpredictable market conditions and challenges in cost estimation. Early forms of cost-plus contracts, particularly those with a percentage-of-cost fee, were later restricted in government procurement due to concerns about inflated costs and lack of incentive for efficiency.
Key Takeaways
- Cost plus pricing sets prices by adding a markup to total costs.
- It is straightforward to calculate and ensures cost recovery.
- This strategy offers predictable profit margins for businesses.
- It is widely used in industries with stable cost structures or in government contracting.
- A key limitation is that it does not consider market demand or competitor pricing.
Formula and Calculation
The formula for cost plus pricing is straightforward:
Alternatively, it can be expressed as:
Where:
- Total Cost refers to the sum of all costs incurred in producing a product or service. This typically includes direct costs (like materials and labor directly attributable to the product) and overhead costs (such as rent, utilities, and administrative salaries).
- Markup Percentage is the desired profit margin expressed as a percentage of the total cost.
This calculation is a core concept in cost accounting, allowing businesses to set prices that ensure profitability.
Interpreting the Cost plus pricing
Interpreting cost plus pricing involves understanding that the resulting price is primarily a function of internal efficiencies and desired profitability, rather than external market dynamics. A higher markup percentage translates to a larger profit margin per unit, assuming the product sells at that price. Conversely, a lower markup might lead to increased sales volume if the market is price elasticity, but it reduces the profit per unit. Businesses use cost plus pricing to ensure that they at least cover their variable costs and fixed costs to reach their break-even point and beyond.
Hypothetical Example
Consider "Alpha Manufacturing," a company producing specialized electronic components. Alpha's accountants calculate the total cost to produce one component:
- Direct materials: $15.00
- Direct labor: $10.00
- Allocated overhead costs per unit: $5.00
Therefore, the total cost per unit is $15.00 + $10.00 + $5.00 = $30.00.
Alpha Manufacturing decides to use a 25% markup on its costs to achieve its desired profit margin.
Using the cost plus pricing formula:
Selling Price = Total Cost × (1 + Markup Percentage)
Selling Price = $30.00 × (1 + 0.25)
Selling Price = $30.00 × 1.25
Selling Price = $37.50
So, Alpha Manufacturing would price each electronic component at $37.50 using cost plus pricing.
Practical Applications
Cost plus pricing is prevalent in several industries and scenarios where accurately determining costs and ensuring a predictable profit margin are paramount. It is commonly observed in:
- Government Contracts: Agencies often use cost-reimbursement contracts, which are a form of cost-plus, especially for complex projects with uncertain scopes like research and development, where precise costs are hard to estimate upfront. An example is a Cost-Plus-Fixed-Fee (CPFF) contract, where the contractor is reimbursed for allowable costs and receives a pre-determined fee.
- 5 Construction Projects: Builders often quote projects based on the estimated costs of materials, labor, and subcontractors, plus a predetermined percentage for profit. This method can offer transparency and flexibility when project scope changes.
- Manufacturing: Companies producing customized goods or operating in industries with economies of scale may rely on cost plus pricing to ensure they cover their production expenses and achieve target profitability on each unit.
- Service Industries: Professional services, such as consulting or accounting, sometimes use a cost-plus approach by calculating the cost of employee time and resources, then adding a markup.
This strategy ensures that the company's revenue covers expenses and contributes to profitability.
Limitations and Criticisms
While straightforward, cost plus pricing has notable limitations and faces criticism. One primary drawback is its inward-looking nature; it largely ignores external market factors such as supply and demand or what competitors are charging. This can lead to suboptimal pricing decisions, potentially leaving money on the table if customers are willing to pay more, or losing market share if the calculated price is too high for the market.
A4 significant criticism, especially in government contracting, arises from cost-plus-percentage-of-cost (CPPC) contracts, which were often prohibited due to creating a perverse incentive for contractors to increase costs to maximize their percentage-based fee. Th3is can lead to inefficiency and lack of cost control within the organization, as the focus remains on passing costs to the customer rather than minimizing them. Ad2ditionally, determining the "true" total cost can be complex, especially with fluctuating variable costs or difficulties in allocating fixed costs accurately.
Cost plus pricing vs. Value-based pricing
Cost plus pricing and value-based pricing represent fundamentally different philosophies in setting prices. Cost plus pricing is internally focused, deriving prices directly from the costs of production and a desired profit margin. It offers simplicity and ensures that all expenses are covered.
In contrast, value-based pricing is externally focused, setting prices based on the perceived value of a product or service to the customer. This method considers customer willingness to pay, benefits offered, and competitive alternatives, often leading to higher prices and potentially greater revenue if the perceived value is high. While cost plus pricing is easier to implement and provides predictable margins, it often overlooks what customers are willing to pay, potentially leaving revenue opportunities untapped. [C1ompetitive pricing](https://diversification.com/term/competitive-pricing) strategies often fall somewhere between these two extremes, considering both internal costs and external market conditions.
FAQs
Is cost plus pricing always the best strategy?
No, cost plus pricing is not always the best strategy. While simple and ensuring cost recovery, it can lead to missed opportunities if it underprices a product with high perceived value or overprices a product in a highly competitive pricing environment where competitors offer lower prices.
What industries commonly use cost plus pricing?
Industries with predictable or easily measurable costs, such as manufacturing, construction, and government contracting, frequently use cost plus pricing. It is also found in regulated industries where profit margins might be fixed. It helps ensure that all fixed costs and variable costs are covered.
How does cost plus pricing account for profit?
Cost plus pricing accounts for profit by adding a predetermined "markup percentage" to the total cost of producing a good or service. This markup directly translates into the desired profit margin for the company on each unit sold.
Can cost plus pricing be used for services?
Yes, cost plus pricing can be applied to services. Service providers calculate their total costs, including labor, materials, and overhead costs associated with delivering the service, and then add a markup to determine the client fee. This is common in consulting, legal, and other professional service fields.