Cost-plus Pricing

Cost-plus pricing is the method which selling price is calculated by adding a profit margin to the full cost of the product. It adds a markup to the total cost of goods or services to get the selling price. The total cost includes direct material, direct labor, and overhead cost. Profit margin arrives from multiplying the full cost with the percentage of profit margin. It also is known as markup pricing.

The company wants to ensure profitability, so they sell the product at full cost plus the required profit. The required profit or profit margin is the percentage that the owner or board of directors sets for the management to implement. They want to ensure that the capital is used to generate a proper rate of return.

The objective of this method is to maximize profit without any impact on the sell quantity. Management is required to calculate the correct total cost, otherwise, this method will not work. If we set the price incorrectly, it will be a problem. If the price is too high, it will reduce the sales quantity, so the profit will be lower as well. If the price is set too low, we will lose the opportunity to maximize our profit.

 The cost-plus pricing can be used in reimbursement contracts which supplier will reimburse from client based on actual expenses plus a profit margin. We use this contract when the costs fluctuate and both parties want to avoid the risk. The total cost included direct material, direct labor, and overhead.  

This method will guarantee profit for the company. It does not matter when the cost increase or decreases. However, we have to ensure that the calculation of the total cost is correct otherwise we will not receive the expected return. 

Cost-plus Pricing Formula 

Selling price = Total cost per unit * ( 1 + % of profit margin) 

Total cost = Variable cost per unit + fixed cost per unit

Profit Margin = It is the percentage of profit over the selling price. This percentage usually set by the top management or board the director.

Example

 The company plan to manufacture a new product which has the following cost:

• Direct material: $ 20
• Direct labor: $ 12
• Overhead: $ 10

 The profit margin, which is decided by the top management, is 15% over the total cost.

Please calculate the selling price by using the cost plus pricing method.

Calculate the selling price. 

 The total cost can be calculated as below:

 $ 20 + $12 + $10 = $ 42

The profit margin is 15%, it means the company requires to make a profit 15% over the total cost. Profit margin = 15% * $ 42 = $ 6.3 per unit.

 The selling price will be $ 48.3 (42 + 6.3). In order to make a profit $ 6.3 per unit, company needs to sell at $ 48.3 per unit.

 What are the advantages of cost-plus pricing?

Advantages of cost-plus pricing
Simple	This method is very simple and easy to understand. It is straightforward to calculate, and almost everyone can do it.
Guarantee profit	By including all the costs, we will be able to ensure that the profit is the same as the expectation. There will be no unexpected loss. The company will be able to make a profit base on its plan if there is nothing wrong with cost calculation.
Clear basic	This basic is fair and transparent to our internal team as well as the external parties. The sales department may want to reduce the selling price to increase sale, with this calculation, it will be strong enough to convince them to follow the rule.  We also can negotiate the price with the customer when we want to increase price when cost increase.
For the market with less information	This method will help us to set a price when we lack information about customers willing to pay. The market price may be not available for us as it is a new product. The product customization makes it hard to justify the price with the competitor.
Easy for management to do the budgeting	This pricing strategy will help the management to prepare the annual budget as they know the profit margin. They will be able to calculate the total sale and target profit.  We will receive a consistent profit under the control of the management.
Best for some service	This pricing strategy works well with services such as consultants, lawyers, or audits when the actual work will vary due to customer requirements or scope of work. It is tough to set a fixed price.

What are disadvantages of cost-plus pricing?

Disadvantages of cost-plus pricing
Ignore competitor	With this method, we completely ignore the market price; we set the price solely based on our internal cost and the prefer margin. As a result, the selling price can be lower or higher than the competitor. It may be too low compared to the market price, and we will lose the profit due to consumer surplus. A competitor may not have the advantage of bulk purchase or labor efficiency, so they charge much higher than us.
Not encourage efficiently	This method only considers the cost of prior practice. It does not encourage the management to cut costs or improve internal control such as wastage or idle time. The competitors will keep improving their process and cost control, so they will be able to low their selling prices in the future.
The cost can be too high	Due to the less efficient work, our cost can be too high compared to others. It will lead to a decrease of the total sale and loss the key customers.
Error in cost calculation	If the cost calculation is not done correctly, it will impact our pricing. The total cost may be challenging to calculate, especially the overhead cost.
Focus on historical cost only	The cost per unit is based on the cost of raw material, direct labor, and overhead, which has already been incurred in the past. We do not take a look at the recent price change of these items. We may miss a chance to increase the price; on the other hand, we may lose the customer due to a high price.
Not reflected with the change in demand quantity	The total cost calculates based on the estimate of production quantity, which impacts total sales. However, if the total sales change, the cost per unit will increase and the price will reduce.