Cost-plus pricing
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Cost-plus pricing is a pricing method commonly used by firms. It is used primarily because it is easy to calculate and requires little information. There are several varieties, but the common thread in all of them is you first calculate the cost of the product, then include an additional amount to represent profit. Cost-plus pricing is often used on government contracts, and has been criticized as promoting wasteful expenditures.
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Calculating price using the cost-plus method
There are several ways of determining cost, and the profit can be added as either a percentage markup or an absolute amount. One example is:
- P = (AVC + FC%) * (1 + MK%)
where:
- P = price
- AVC = average variable cost
- FC% = percentage allocation of fixed costs
- MK% = percentage markup
For example: If variable costs are 30 yen, the allocation to cover fixed costs is 10 yen, and you feel you need a 50% markup then you would charge a price of 60 yen:
- P = (30 + 10) · (1 + 0.50)
- P = 40 · 1.5
- P = 60
An alternative way of doing the same calculation is:
- P = (AVC + FC%) / (1 − MK%)
To make things simpler, some firms, particularly retailers, ignore fixed costs and just use the purchase price paid to their suppliers as the cost term. They indirectly incorporate the fixed cost allocation into the markup percentage. To simplify things even further, sometimes a fixed amount is applied rather than a percentage. This fixed amount is usually determined by head-office to make it easy for franchisees and store managers. This is sometimes referred to as turnkey pricing.
Another variant of cost plus pricing is activity based pricing. This involves being more careful in determining costs. Instead of using arbitrary expense categories when allocating overhead, every activity is linked to the resources it uses.
Cost will need to be recalculated and the percentage markup will likely need to be adjusted as the product goes through its life cycle. This is sometimes referred to as product life cycle pricing, although it is seldom done deliberately or in a planned and organized manner. Price skimming and penetration pricing are also types of product life cycle pricing but they are demand based pricing methods rather cost based.
Advantages of cost-plus pricing
- easy to calculate
- minimal information requirements
- easy to administer
- tends to stabilize markets - insulated from demand variations and competitive factors
- ethical advantages (see: just price)
Disadvantages of cost-plus pricing
- tends to ignore the role of consumers
- tends to ignore the role of competitors
- use of historical accounting costs rather than replacement value
- use of “normal” or “standard” output level to allocate fixed costs
- inclusion of sunk costs rather than just using incremental costs
- ignores opportunity costs