When Should Cost Plus be used?

By Indeed Editorial TeamMarch 8, 2022There are many strategies businesses can use to help them determine appropriate pricing for their products and services. Cost-plus pricing is o

When Should Cost Plus be used?

By Indeed Editorial Team

March 8, 2022

There are many strategies businesses can use to help them determine appropriate pricing for their products and services. Cost-plus pricing is one method companies can use to ensure they're meeting their company's needs and considering their own costs in their calculations. In this article, we define what cost-plus pricing is, explain how to calculate it, list the advantages and challenges associated with the method and provide an example to illustrate how cost-plus pricing works.

What is cost-plus pricing?

Cost-plus pricing is a pricing method companies use to arrive at a sale price for their product or service. Cost-plus pricing takes into account the direct material, labor and overhead costs for a product along with a markup percentage. Cost-plus pricing works for products, services and customer contracts, where the customer agrees to reimburse the seller for the price of their labor or service plus a pre-negotiated profit on top of seller costs.

Cost-plus pricing allows companies to sell their products or services for more than it cost them to produce or deliver. While costs can be a straightforward measurement, desired profit margins can differ from company to company. Typically, cost-plus pricing and profit margins won't take into account competitor pricing or market research.

Related: What Is a Pricing Strategy?

How to calculate cost-plus pricing

Heres how to calculate cost-plus pricing::

1. Determine total cost

To determine the total cost of your product or service, add up all the associated fixed and variable costs. Fixed costs won't change with the number of units you produce, whereas variable costs do.

Fixed costs include such expenses as leasing or rental costs, insurance or interest payments. Variable costs include money spent on things like labor, materials or commissions. Adding all the costs associated with producing a product or delivering a service can determine your total cost.

Related: Fixed vs. Variable Costs: Definitions and Examples

2. Divide the total cost by your output

Next, divide the total cost by the number of units you've produced. If you provide a service, you can divide the total cost by the number of hours you worked or some other relevant measurement such as cost per user. This can help you determine how much it costs to produce a single product or deliver a service to your customers. To recover your costs, you would need to charge at least this amount to your customers.

3. Calculate the selling cost

To calculate your selling cost, multiply the unit cost by your markup percentage. To determine your markup percentage, you can divide the cost of your goods or service by your desired profit margin. Consider making your markup percentage higher than the profit margin. For example, a profit margin of 20% might warrant a 25% markup.

Related: How To Calculate Margins and Markups To Enhance Profitability

Benefits of using cost-plus pricing

The following are advantages to using the cost-plus pricing method:

It's simple to use

The cost-plus formula contains relatively few variables. It can allow companies to price their products and services consistently without a lot of market research. It can also be a reliable strategy for small businesses or businesses that don't have a lot of extra time to focus on nuanced pricing strategies. However, take care when defining your desired profit margins and overhead allocations so you can be consistent in your calculations and pricing.

It's reliable

With the cost-plus method, you can ensure you're covering all your costs and generating your desired returns. For example, a contractor who uses cost-plus pricing on agreements with clients can guarantee they receive payment for their services and achieve their profit margin expectations. This eliminates the risk of loss and ensures that, no matter what happens over the course of the contract, customer payment meets the sellers minimum expectations.

As long as businesses accurately calculate their cost per user or cost per item, cost-plus pricing ensures buyers cover every expense with their purchases. Sometimes, however, there are additional costs that companies cannot predict. By increasing your margin, you can compensate for any missed costs and create a buffer against market fluctuations or uncalculated expenses. It can also help you estimate revenue within a specific time frame based on advertising spending, conversion rates and average sales.

It's easy to understand

Another benefit to cost-plus pricing is that it can be simple for customers to understand and accept. Because there are relatively few components involved, explaining how you arrived at your price to customers rarely requires a complicated explanation. If a customer has questions about an increase in price, the supplier can reference an associated rise in a fixed or variable cost that shows the reasoning for the price change.

It requires little research

Cost-plus pricing can be helpful if you have limited information surrounding customer expectations, competitor pricing or market demand. The only data needed for cost-plus pricing are your own costs and desired profit margins. If you don't have a direct competitor or there aren't similar products within the marketplace, the cost-plus method ensures you're pricing your product in a way that satisfies your needs and reflects the costs you incurred to produce your offerings. In these scenarios, cost-plus pricing can provide an effective starting price you can refer to as you grow your knowledge of the market and your customers.

Related: How To Calculate Selling Price

Disadvantages of cost-plus pricing

While there are many benefits to the cost-plus pricing method, there are several challenges associated with this model. Here are some things to consider when using the cost-plus pricing strategy:

It doesn't always correlate to customer value

One potential drawback to the cost-plus method is that customers don't always equate cost to value. Often, customers are most willing to spend when they perceive a product or service to be worth their investment. If something is costly to produce but offers little value to the customer, they may be reluctant to spend money on the offer.

Understanding customer needs and expectations can be important factors to consider when pricing a product and cost-plus pricing can sometimes overlook the customer component. Optimizing your pricing within an existing market can increase the demand for your product.

It can reduce efficiency

Another potential challenge to cost-plus pricing is its potential to interfere with a company's efficiency. Often, companies aim to lower their operating costs and expenses so they're able to increase their profitability. With cost-plus pricing, however, suppliers fix their margins and guarantee return rates so they may be less motivated to reduce costs.

It doesn't take into account the competition

Consumers often choose lower price alternatives if they think a company has priced a product or service too high. Evaluating competitor pricing can help businesses understand how much consumers are willing to pay.

Cost-plus considers only internal factors and so it can sometimes ignore important external factors like competitor offerings. This can create a challenge because if a company prices their product too low, they can sacrifice potential profits. If they price it too high, customers may purchase a competitor's offering instead.

Related: Competitive Pricing: Definition and Tips

Cost-plus pricing example

For example, if a company sells sunglasses and they want to use the cost-plus method to price their product, they might determine:

  • The total cost of production: The company adds their material costs of $220.10, their labor costs of $56.15 and their allocated overhead of $80.75 to determine their total production cost of $357.00.
  • The cost per unit: For the next step, the company divides its total production cost by its output. In this example, they produced 20 sunglasses. $357.00/20 = $17.85.

The selling cost: If the shoe company applies a 30% markup to their products, they can multiply their unit price by 1 x .30 to arrive at $23.21. This number serves as the basis for a final consumer price of $23.50 for a pair of sunglasses.

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