What Is Cost-Plus Pricing Strategy?

by Scott Shpak; Updated November 06, 2018

Cost-plus is a marketing strategy used for pricing goods and services.

Cost-plus pricing is, perhaps, the most common way of establishing a profitable selling price for
a product or service, since it ensures that a company sells a product for more than it had cost
the company to make the product, provided that the cost calculations are accurate. Usually,
pricing on the cost-plus model adds a fixed percentage on top of unit cost. This may be
established by the company, and sometimes, it's a negotiating point with re-sellers who want to
gain a competitive edge.

Establishing Unit Cost

Central to the cost-plus strategy is the accurate definition of unit cost, since undervaluing the
true cost of providing a product or service means that the cost-plus price doesn't produce the
intended profit. For a company following generally accepted accounting principles, calculating
unit cost is generally straight forward.

Unit cost is calculated by adding direct material costs, direct labor costs and an allocation of the
company's overhead expenses. For example, if a company makes only one product, 100
percent of overhead expenses, or fixed costs, would be added to the unit cost price. If the
company adds a second product, perhaps 50 percent of fixed costs would be attributed to each
product, unless the new product represented a different proportion of the company's sales. The
point is to account for all of the company's fixed costs through unit cost allocation, so that unit
cost calculations present accurate break-even pricing, as the basis for its cost-plus strategy.

Creating a Cost-Plus Model

The cost-plus calculation itself is simple. Once the accurate unit costs are calculated, the
cost-plus value is simply added to unit cost. This doesn't include all market factors or influences,
however. There are costs such as return of unsold goods, for example, that may not be
accountable at the time of cost-plus pricing, except on a past-performance or projection basis.
Client contracts may also influence cost-plus pricing. For instance, a client who negotiates a
guaranteed maximum price contract could limit the cost-plus value, tying the producing
company to terms of the contract, even if production costs increase after the contract goes into
effect.

The Pros and Cons of Cost-Plus Pricing

The simplicity of the cost-plus strategy is perhaps its most attractive advantage. Establishing a
profitable sales price is easy, if you know the unit cost and the cost-plus amount. For example,
in a sales negotiation, a company representative can quickly calculate new pricing, if a potential
buyer increases an offer to purchase. If the representative knows that the cost-plus amount is
30 percent over unit cost, the representative could offer percentage incentives of, say, 10 to 15
percent for certain volume purchases, without accidentally pricing a product at a loss. Cost-plus
pricing ensures profitability and also provides a way of ensuring profit margins even as
production costs increase.

The primary drawback of cost-plus pricing is the assumption that unit cost is competitive.
Consider a company that manufactures a toaster for a $20.00 unit cost, to which it adds a 30
percent cost-plus amount for a retail price of $26.00. A competing company that makes a similar
toaster for $10.00 unit cost has a remarkable advantage. Pricing competitively, the other
company makes $16.00 of profit per sale, and they could even impact the more expensive
company by selling their toaster at half-price while maintaining 30 percent profitability.

Cost-plus strategy also removes some incentive for streamlining production efficiencies. Since
the cost-plus margin is assured regardless of production costs, a company may not seek to
lower its costs to either gain market advantage or increase profit margins. In fact, as sometimes
happens with government procurement contracts issued on a cost-plus basis, a disreputable
business may pad its costs or alter overhead allocations to create artificially inflated selling
prices.

In practice, cost-plus pricing may be part of a more flexible pricing strategy, one that factors in
categories such as market competition and pricing, rather than concerning itself with generating
fixed percentages of profit that are vulnerable to market conditions.

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