Cost Plus PricingDefined with Examples & How to Calculate

Written By:
Lisa Borga

Cost-plus pricing is a method of determining the price of a product by finding the cost of producing the good or service and then adding a markup.

This is a simple approach to pricing that simply requires a company to find the direct material and labor costs and add them to the overhead before adding a markup percentage to find the selling price of a product.

The markup percentage that is added is actually the business’s profit.

This makes it essential to begin with a thorough knowledge of all of the costs a business has as well as where those costs originated.

What is Cost Plus Pricing?

Cost-plus pricing is one of the simplest and most easily understood methods of pricing.

Correspondingly, it is also a very commonly used pricing strategy.

Cost-plus pricing combines its variable and fixed costs and combines them to arrive at the company’s total costs incurred in manufacturing a product.

A markup percentage or premium is then added to arrive at the final product price.

Often this markup price is based on the desired level of profit decided upon by the seller; however, in other circumstances, it may be negotiated by both parties in a transaction.

How To Use Cost-Plus Pricing

There are a few steps to follow in using cost pricing to come to a sales price for a product.

These are:

1. It is important to find all of the costs associated with producing a product or service. This is the total of all fixed and variable costs such as direct materials and labor as well as overhead.
2. Once all costs have been totaled, this number is then divided by the number of units to be sold in order to find the unit cost.
3. This unit cost is then multiplied by the markup percentage in order to find the final selling price for the product.

There is no normal markup, and the percentage a business chooses may vary enormously, although some industries will possess a norm.

In some cases, a company may base its markup percentage at least in part upon the current state of the market or economy.

In times when demand is low, they may choose to lower it, and in times of high demand and good economic conditions, they may choose to raise it in order to receive a higher return on their product.

Pros and Cons of Cost Plus Pricing

Pros of Cost Plus Pricing

The pros of cost-plus pricing include its simplicity to implement for a variety of products.

However, whether or not cost-plus pricing is advisable to implement depends upon the nature of the industry in which a company is in.

For companies that typically use fixed-price contracts, cost-plus pricing can be advantageous because it virtually guarantees that a certain level of profit is earned off of each sale, and it is easy to justify a rise in price before the next contract simply by explaining that the cost of production has increased.

It is also efficient for industries that manufacture goods with an extremely high production cost, such as in building construction.

In this case, the company cannot easily be spread between different projects, and the cost will inherently play a major role in the pricing of any project.

Cons Cost-Plus Pricing

One disadvantage with cost-plus pricing is that it is easy to price the product wrong since this method does not take into account the competition.

A manager could price products or services too high, which could cause the business to lose sales or market share.

Or, products could be priced too low, in which case the business might lose profits as a result of charging less than the market rate.

There is also little reason for suppliers to control costs.

If a business enters a cost-plus pricing agreement with a supplier, the supplier tends to produce whatever they desire no matter what the cost of production is or how well the product will sell.

Suppliers may charge high prices when hired under a cost-plus pricing agreement because they have every reason to add all the costs they can rather than trying to cut costs.

Additionally, cost-plus pricing does not take into account current replacement costs.

Historical costs are used in the cost-plus pricing method, and these costs do not account for recent changes in the costs a business incurs.

Special Circumstances

One problem cost-plus pricing has is the fact that it does not take into account the amount of demand for a service or product.

The formula fails to consider whether or not a customer really buys the service or product at the designated price.

To make up for this, some managers attempt to use the principles of price elasticity along with cost-plus pricing.

Whereas other managers and owners just keep an eye on what is happening in the market with other similar businesses and products to determine their prices.

One alternative to cost-plus pricing is value-based pricing, which involves deciding on a product’s selling price by considering the benefits a buyer receives from the service or product rather than the cost of producing the product.

Value-based pricing works especially well for businesses that sell specialty products or particularly unique products that have very valuable attributes. This type of pricing generally provides a higher percentage of profit.