What is Cost Plus Pricing?
Cost plus pricing is a distinct pricing strategy involving adding a specific markup to the overall cost of goods and services for the sake of arriving at an optimal selling price. Determining the plus pricing strategy relies upon the introduction of several key factors, including labor cost, direct material cost or cost to produce, and overhead costs for a particular product or a service. The evidence indicates that cost plus pricing is one of the simplest approaches to determine the selling price, which represents the foundational idea of how business functions.
Many companies use a plus pricing strategy at the moment of releasing products. In the process, firms calculate the costs to produce or the total cost and anticipate the desired rate of return. Later, the businesses merely put two numbers together and have their distinct pricing method.
The Cost Plus Calculation
There are several distinct stages for cost plus pricing calculation. In order to get the proper selling price and determine a distinct pricing method, it is crucial to follow three steps:
- The first phase includes determining the total cost of the particular product or service. To receive the number one, one needs to get the sum of both fixed and variable costs, including labor costs, overhead costs, and markup percentage. The pricing strategy within the stage includes the factors of cost variability.
- The second phase includes dividing the total cost by the number of existing units of a product to determine the cost of a single unit. Based on the calculation, it is possible to determine one of the fundamental aspects of pricing strategy and selling price.
- The final phase of cost plus calculation stems from multiplication of the single unit cost by markup percentage to get the selling price.
The process mentioned above builds the foundation for cost plus pricing as a pricing strategy translating the information concerning labor costs and overhead costs to determine the proper rate of return.
To illustrate how the cost plus calculation works. For instance, a company is designing a product that includes the direct material cost of $10, labor costs of $20, and overhead costs of $5. The firm applies a 10 percent markup percentage to its products. When employing a cost plus pricing approach, the company arrives at the total cost of $35 and multiplies it by the markup percentage of 10 percent to get the product price of $38.5.
Advantages of Cost Plus Pricing
While determining cost plus pricing is an easy-to-use pricing method, there are advantages and disadvantages of the pricing strategy.
- Cost plus pricing is simple to use. The pricing method can be easily applied to derive the product cost.
- The approach offers assured contract profits. Based on the contractual agreement with a client, a contractor can be sure that costs will be reimbursed and profits will be created.
- One key incentive to use the pricing strategy stems from its justifiability. The strategy is applicable when the supplier intends to persuade consumers that there is a particular need to increase a price.
These are the primary advantages of cost plus pricing, which allow a good selling price while determining the different markup percentages.
Disadvantages of Cost Plus Pricing
While there are particular benefits of cost plus pricing, it is also important to consider the disadvantages of the approach.
- Cost plus pricing ignores the competition. While the firm sets a price based on internal factors, it does not consider competitors' prices.
- Another disadvantage of the method stems from product cost overruns. It means that designing the product does not include adapting the product to the target audience.
- The practice ignores replacement costs. Essentially, the method does not consider the constant cost changes.
The Bottom Line
Cost plus pricing is a viable and easy method to use. However, one should consider both advantages and disadvantages of the approach. Companies can benefit from the strategy. Yet, they need to consider risks brought by competition, potential replacement costs, and the product's design to meet the target audience's desires.
What is cost-plus pricing?
Cost plus pricing is a distinct pricing strategy involving adding a specific markup to the overall cost of goods and services for the sake of arriving at an optimal selling price.
What are the advantages of cost-plus pricing?
Cost-plus pricing is an easy-to-use pricing approach and it doesn’t require any specific skills or knowledge from the pricing manager. Simplicity is the reason why this approach is used by many retailers at the start of their pricing journey.