Cost Plus Price
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ScribdTranslationsCost Plus Price
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ScribdTranslationsCost-plus pricing is a strategy that is used to determine the retail and/or wholesale price of
goods and services offered for consumption. Businesses of all sizes tend to use this
simplistic pricing model as a guideline for arriving at sale prices that will allow the
company to cover all costs associated with the production and sale of the products, and still
make a reasonable profit from the effort. The basic formula for cost-plus pricing works as
Well, for calculating pricing goods such as the cost of a meal in a café as it does for pricing.
services such as utilities or courier services.
The ultimate goal of cost-plus pricing is to allow the originator of a good or service to price
goods and services in a manner that helps to ensure all costs associated with the effort are
covered. At the same time, cost-plus pricing helps to promote the creation of a situation
where the originator makes a profit and remains competitive with companies that offer
similar goods and services. Fortunately, only a few simple pieces of information are
required to establish a solid cost-plus pricing model for any business.
The first key component to calculating cost-plus pricing is to establish what it costs to
actually produce the end product or service. This involves considering all expenses that go
into the production process, such as raw materials, labor and production costs, packaging,
transport, and sales and marketing expenses. By dividing the cumulative expenses
associated with producing the products by the number of units produced, it is possible to
arrive at what is sometimes referred to as the unit cost. The unit cost represents the
minimum price that must be charged in order for the producer to recoup his or her
investment into the creation of the unit.
Next, there is the matter of determining the additional price to attach to each unit offered.
for sale. Many companies will use what is known as a percentage allocation to determine
this amount. For example, if the unit cost for a given item comes to Rs.10 in Indian
Rupees, the producer may choose to add Rs.7 to the retail price for each unit, representing
a 70% profit margin. For wholesale situations, the producer may choose to offer something
along the lines of a 40% markup above expenses, thus offering wholesale clients a discount
off the retail price that still allows the producer to earn a reasonable profit from each unit
produced.
Another factor that will influence the percentage markup is local competition. Using the
same example above, a company cannot reasonably expect to make money if the Rs.17
retail price per unit is higher than similar products available in the same market. With that
In mind, the percentage of the markup may be adjusted downward to enhance the chances.
of capturing consumer attention and successfully capturing a section of the consumer
market.
The mechanism of cost plus pricing decision can be well understood from the following
detailed example.
Consider a business with the following costs and volumes for a single product:
Fixed costs:
Factory production costs 750,000
Research and development 250,000
Fixed selling costs 550,000
Administration and other overheads 325,000
Total fixed costs 1,625,000
Variable costs
Variable cost per unit 8.00
Markup
Mark-up % required 35%
Budgeted sale volumes (units) 500,000
What should the selling price be on a cost plus basis?
The total costs of production can be calculated as follows:
Total fixed costs 1,625,000
Total variable costs (8.00 x 500,000 units) 4,000,000
Total costs 5,625,000
Markup required on cost (5,625,000 x 35%) 1,968,750
Total costs (including mark up) 7,593,750
Divided by budgeted production (500,000
units)
Selling price per unit 15.19
The advantages of using cost plus pricing are:
Easy to calculate
Price increases can be justified when costs rise
Price stability may arise if competitors take the same approach (and if they have
similar costs
4. Pricing decisions can be made at a relatively junior level in a business based on
formulas
The main disadvantages of cost plus pricing are often considered to be:
This method ignores the concept of price elasticity of demand - it may be possible
for the business to charge a higher (or lower) price to maximize profits depending
on the responsiveness of customers to a change in price
2. The business has less incentive to cut or control costs - if costs increase, then
selling prices increase. However, this might be making an 'inefficient' business
uncompetitive relative to competitor pricing;
It requires an estimate and apportionment of business overheads. For example, total
factory overheads need to be calculated and then allocated in some way against
individual products. This allocation is always arbitrary.
4. If applied strictly, a cost plus pricing method may leave a business in a vicious
circle. For example, if budgeted costs are over-estimated, selling prices may be set
too high. This in turn may lead to lower demand (if the price is set above the level
that customers will accept), higher costs (e.g. surplus stock) and lower profits.
When the pricing decision is made for the next year, the problem may be
exacerbated and repeated.
Amongst the factors that influence the choice of the mark-up percentage are as follows:
1. Nature of the market - a mark-up should reflect the degree of competition in the
market (what do the close competitors do?)
Bulk discounts - should volume orders attract a lower mark-up than a single order?
3. Pricing strategy - e.g. skimming,
4. Stage of the product in its life cycle; products at the earlier stages of the life cycle
may need a lower mark-up percentage to help establish demand.
