What is Cost Plus Pricing?
Definition of Cost Plus Pricing
In cost plus pricing, businesses calculate their costs for producing a good or delivering a service, then add a markup percentage on top of that cost to arrive at their selling price.
All costs would be considered in this calculation – direct material cost, direct labour cost and overheads costs.
The markup percentage added to the total costs are determined by the company’s desired profit margin. For example, if a company wishes to achieve a 20% profit margin, and the total costs are £100, they would use a 20% markup, resulting in a selling price of £120.
Cost plus pricing can be used for both one-time purchases and recurring orders. For example, business that sell products and services could both use cost plus pricing to determine the selling price. In either instance, the aim is to cover all costs while also ensuring that a profit is made.
Cost Plus Pricing Formula
Calculating cost plus pricing uses a very simple formula.
Firstly, all total and fixed costs would be considered, then a markup percentage is added.
Cost Plus Pricing Methods
There are typically three stages in calculating cost plus pricing for a product or service:
Step 1 – Determine the Total Cost
The first step to using the cost plus pricing method is to establish the total cost of the product or service. This is the sum of all fixed/variable and direct/indirect costs.
Variable costs vary with the number of units, whereas fixed costs do not. As cost plus pricing requires a unit cost, the total fixed costs must be divided by the number of units to ascertain the unit cost.
Direct costs are the costs that are directly associated with producing the product or service. Indirect costs are the overhead costs of running the business, such as rent, utilities, and administrative expenses.
Step 2 – Apply the Markup
Once you have a clear understanding of all your costs, the markup percentage would need to be decided and applied.
The markup is effectively the profit per unit.
For example, a 25% markup would essentially be a 25% profit margin on the product or service.
Step 3 – Adjust Price as Required
Once the costs have been determined and the markup applied, it’s important for a business to monitor how well the prices are working. If sales are slow, it may be necessary to lower the prices in order to attract more customers. On the other hand, if demand is high and the product/service is constantly selling out, it may be time to raise prices in order to maximize profits. By regularly reviewing the prices, this ensures that cost plus pricing is being used in the most effective way to grow business performance.
Cost Plus Pricing Examples
Service Business
If a cleaning business is looking to determine the selling price of servicing a customer’s office using cost plus pricing. They are looking to achieve a 40% profit, the calculation would be as follows:
Labour | £12.50 x 2 hours | £25 |
Materials | £2.50 general cleaning supplies | £2.50 |
Mileage | 45p per mile x 10 miles | £4.50 |
TOTAL |
| £32 |
TOTAL COSTS + MARKUP % = SELLING PRICE
£32 + (40% x £32)
£32 + £12.8 = £44.80
Product Business
An independent fashion store is looking to calculate the pricing for a summer dress using cost plus pricing. The cost of manufacturing the dress includes:
Material: £5
Direct labour: £20
Postage: £5
Marketing £5
Overhead: £5
Using cost plus pricing, they want to make 50% profit on the sale of the summer dresses, as the weather forecast is predicting a long heatwave, and they wish to capitalise on the expected high demand.
TOTAL COSTS + MARKUP % = SELLING PRICE
£40 + (50% x £40)
£40 + £20 = £60
Cost Plus Pricing Advantages
There are several benefits to using cost plus pricing:
Simplicity
Calculating cost plus pricing is a relatively simple calculation, as it only involves a business’s costs and desired markup percentage.
Profitable
Any business using cost plus pricing would be inclined to accept this pricing method for a contractual agreement with a customer, since there is a guarantee that their costs will be reimbursed, and that they will make a profit. However, the most important aspect of being profitable, it that all of the costs incurred have been recognised and included in the calculation.
Flexibility
Cost plus pricing gives businesses the flexibility to adjust their prices up or down as needed, based on changes in their costs or desired profit margins. For example, if the price of wood increases, then a furniture manufacturer would need to increase their prices to ensure their costs are covered.
Familiarity
Most customers are generally familiar with this pricing method, so they may be more likely to accept these prices when they understand how they’re calculated. In situations where the supplier is looking to persuade the customer of the need for a price increase, the supplier can point to an increase in its costs as the reason for the increase.
Cost Plus Pricing Disadvantages
There are also several drawbacks to using cost plus pricing:
Ignores Competition
Cost plus pricing only looks at internal factors, and doesn’t consider what competitors are charging for their products. This can lead to prices that are too high or too low relative to what customers are actually willing to pay. Consequently, this would lead to lost sales if the price is too high, and lost profit if the price is too low.
Unforeseen Costs
Businesses might be able to theoretically approximate their costs for a product or service, but this would not take into account any unforeseen costs that arise unexpectedly. For example, when using cost plus pricing for a product, the business may agree a price with a customer, only for supply chain issues to occur, which means using a different supplier at a higher cost.
Accurate Costing Difficulty
Total costs, including indirect costs, can be difficult to estimate. Many businesses find it difficult to accurately estimate all of their indirect costs (e.g., overhead expenses), which can lead to problems when trying to use cost plus pricing effectively as any costs not captured would reduce the profit made from the sale.
Uses Historic Costs
Cost plus pricing is based on historical costs, which might not accurately reflect the current or future costs of production. For example, over time, costs can vary due to multiple factors such as inflation, changes in the price of raw materials, labour costs and energy costs.
If a business uses historic costs that have become outdated, it may either underprice or overprice its products, leading to potential profit losses or reduced competitiveness.
No Incentive to Operate Efficiently
Using cost plus pricing, the price of the product or service is determined by adding a markup on to the costs. Therefore, the company is guaranteed a fixed profit margin, regardless of what those total costs are.
As a result, there is likely to be less focus on trying to reduce those costs, or improving operational efficiencies to again save further costs.
If a competitor does focus on these cost savings and efficiencies, they may be able to offer the same quality product for a lower price, and take away customers and revenue.
Not Suitable for All Industries
In highly competitive industries where price sensitivity is high, cost plus pricing may not be the most suitable strategy as customers are more likely to compare prices across different businesses and choose the most affordable option.
If a business solely relies on cost plus pricing, it might struggle to offer competitive prices and therefore lose market share to competitors who can provide similar products or services at lower prices. Industries such as retail, e-commerce, and consumer electronics tend to fall into this category.