Cost-plus pricing

Pricing method whereby a standard markup is added to the estimated cost of the product. The cost-plus price is computed by dividing the fixed costs of a product by the estimated number of units to be sold and then adding the variable cost per unit, or by adding the total variable costs and fixed costs and then dividing by the total number of units to be produced. This will determine the true unit cost. Once the true unit cost has been determined, that cost is divided by 1 minus the desired return on sales (a percentage) to determine the cost-plus price.

For example, the fixed costs to produce an item are $300,000, the variable costs add up to $100,000, and the estimated number of units to be produced is 50,000. Add 100,000 to 300,000, divide by 50,000, and the true unit cost equals $8. If the desired return on sales is 20%, divide $8 by 1 minus .20, and the cost-plus price for this item will be $10.

Clear and convenient way to establish a selling price. This method may be used in determining a contract price by a supplier seeking to avoid the uncertainty associated with predicting costs. Cost plus pricing may be found in developmental contracts for new products. Federal agencies deal with cost plus fixed fee contracts. In cost plus pricing, an item is priced at its cost (including direct material, direct labor, and factory overhead) plus some fixed fee or profit markup. For example, if the total cost of a contract is $325,000 and the fixed fee is $100,000, the contract price would be $425,000. If a profit markup is used, it should be based on the nature of the product and corporate considerations (e.g., marketing aspects). For example, if cost is $200,000 and a profit markup on cost of 30% is desired, the contract price is $260,000.

When cost plus pricing is used to determine a transfer price for an internal transfer of a product within the organization, it closely approximates an outside market price. Thus, the resulting synthetic market price is considered a good practical substitute.

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Cost-plus pricing is a pricing method used by companies. 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 that one first calculates the cost of the product, then includes an additional amount to represent profit. Cost-plus pricing is often used on government contracts, and has been criticized as promoting wasteful expenditures.

The method determines the price of a product or service that uses direct costs, indirect costs, and fixed costs whether related to the production and sale of the product or service or not. These costs are converted to per unit costs for the product and then a predetermined percentage of these costs is added to provide a profit margin.

Advantages of cost-plus pricing

1. Easy to calculate
2. Minimal information requirements
3. Easy to administer
4. Tends to stabilize markets - insulated from demand variations and competitive factors
5. Insures seller against unpredictable, or unexpected later costs
6. Ethical advantages (see: just price)

Simplicity

Disadvantages of cost-plus pricing

1. provides no incentive for efficiency
2. tends to ignore the role of consumers
3. tends to ignore the role of competitors
4. use of historical accounting costs rather than replacement value
5. use of “normal” or “standard” output level to allocate fixed costs
6. inclusion of sunk costs rather than just using incremental costs
7. ignores opportunity costs
8. contractors may not focus on performance because the cost is always covered by the client

See also

• Cost-plus contract

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