Definition
Cost Plus Pricing is a pricing strategy used by companies where they add a specific markup to the cost of the product to determine its selling price. This markup is typically a set percentage of the cost, intended to ensure a profit margin. This strategy makes it easy for the company to calculate their prices, but doesn’t take into consideration market demand or competition.
Key Takeaways
- Cost Plus Pricing is a pricing strategy in which the selling price of a product is determined by adding a specific amount markup to a product’s unit cost. It guarantees that a company receives a certain profit margin.
- While it’s a popular method due to its simplicity, this strategy doesn’t take into account customers’ perceived value of the product or market competition, which could potentially lead to overpricing or underpricing products.
- This strategy is best suited for industries with little product differentiation and where businesses share similar cost structures. However, it would be less effective in highly competitive markets or in cases of unique or premium products.
Importance
Cost Plus Pricing is a crucial concept in finance as it directly impacts profitability and competitiveness of a business. It involves setting the price of a product by determining the total cost of production and adding a profit margin.
This method ensures all costs are covered, and a consistent profit margin is achieved, thereby securing a steady revenue stream. Not only does it streamline pricing decisions, but also simplifies financial forecasting.
However, setting the profitability per product offers flexibility in facing market variations. Despite seeming straightforward, businesses need to apply this method carefully to not overprice their products, thereby maintaining their competitiveness in the market.
Explanation
Cost Plus Pricing serves a significant purpose in various business models by ensuring that all costs involved in the production or sourcing of a product or service are covered, along with a predetermined profit margin. This pricing strategy is a safeguard against potential losses as it ensures the recovery of production costs, while securing a profit.
It’s a favored strategy, particularly among manufacturers and retailers, as it simplifies the pricing process. By adding a standard markup to the total production or purchase cost, businesses can price products or services in a manner that guarantees profitability.
Often, Cost Plus Pricing is employed in contractual agreements, especially in circumstances where production costs are uncertain such as with government contracts, the construction industry, or in custom-made products. It’s also commonly used in retail, where a standard markup percentage is applied across various products.
Its simplicity and transparency make it effective in these areas. However, it’s worth noting that it doesn’t factor in market conditions, competition, customer’s perceived value, or demand elasticity, which can also influence optimal pricing strategies.
Examples of Cost Plus Pricing
Retail Industries: Businesses like Walmart and Amazon buy products from manufacturers at a wholesale rate, then add a mark-up to cover overhead costs like rent, salaries, and transportation, along with some profit margin, creating their retail price. For example, if Walmart buys a table fan for $30 they may add a further 30% as mark-up, pricing it at $39 in their store.
Construction Industry: A real estate developer building a residential complex would use cost plus pricing. They calculate the total cost of construction, add their desired profit margin on top, and divide by the number of apartments to find out the selling price per unit. For instance, if the total cost is $1 million for a 10 unit building, and they wish to make 20% profit, then they would charge ($1 million x
20) /10 = $120,000 per apartment.
Food and Beverages Industry: Restaurants and cafes also use cost plus pricing. They calculate the cost of the ingredients and labor to create a dish, then add on a profit margin to find the final selling price. For example, if a coffee shop spends $1 to make a latte, they might charge $
50 for it, adding in costs for overheads and a profit margin.
FAQ: Cost Plus Pricing
1. What is cost plus pricing?
Cost plus pricing is a pricing strategy where the selling price of a product is determined by adding a specific markup to unit cost. The markup covers the overhead costs and generates a required level of profit.
2. How is cost plus pricing calculated?
To calculate cost plus pricing, you add the cost of the product to the markup. The formula is: Cost Plus Price = Cost of the Product (manufacturing cost, materials, etc) + Desired Profit Margin or Markup.
3. What are the advantages of cost plus pricing?
The main advantages of cost plus pricing are simplicity, predictability, and covering all costs, including indirect costs. It assures profit if the marketer accurately anticipates the market demand and competition.
4. What are the disadvantages of cost plus pricing?
The main drawbacks include lack of consideration for market and competition, overpricing or underpricing risk due to demand fluctuations, and it might not contribute towards achieving the optimal profit.
5. In which industries is cost plus pricing commonly used?
Cost plus pricing is commonly used in retail industries, service companies, and the public sector, such as utilities and healthcare. It’s also used often in contractual work.
Related Entrepreneurship Terms
- Mark-up
- Break-even point
- Profit margin
- Value-added tax (VAT)
- Overhead costs
Sources for More Information
- Investopedia: This is an internationally-recognized platform that provides a vast range of finance terms including Cost Plus Pricing.
- Accounting Tools: This is a trusted platform that provides education on many accounting and business concepts, including details on Cost Plus Pricing.
- Entrepreneur: This platform provides articles about Cost Plus Pricing that are written with the aim of explaining it to business owners and startups.
- Coursera: Coursera provides online courses on many subjects, including finance and pricing strategies such as Cost Plus Pricing.
