Cost-plus pricing

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Cost-plus pricing is a pricing strategy in which the selling price is determined by adding a percentage markup to a product's unit cost. An alternative pricing method is value-based pricing.[1]

Cost-plus pricing is often used on government contracts (cost-plus contracts), and was criticized for reducing pressure on suppliers to control direct costs, indirect costs and fixed costs whether related to the production and sale of the product or service or not.

Cost breakdowns must be deliberately maintained. This information is necessary to generate accurate cost estimates.

Cost-plus pricing is especially common for utilities and single-buyer products that are manufactured to the buyer's specification such as military procurement.

Mechanics[edit]

The two steps in computing the price are to compute the unit cost and to add a markup. The unit cost is the total cost divided by the number of units. The total cost is the sum of fixed and variable costs. Fixed costs do not generally depend on the number of units, while variable costs do. The markup is a percentage that is expected to provide an acceptable rate of return to the manufacturer.[1]

Rationale[edit]

Buyers may perceive that cost-plus pricing is a reasonable approach. In some cases, the markup is mutually agreed upon by buyer and seller.

In product areas that feature relatively similar production costs, cost plus pricing can offer competitive stability if all firms adopt cost-plus pricing.

Cost-based pricing is a way to induce a seller to accept a contract whose total costs represent a large fraction of the seller's revenues, or in which costs are uncertain at contract signing.

Economic theory[edit]

Cost-plus pricing is not common in markets that are (nearly) perfectly competitive, in which prices and output are driven to the point at which marginal cost equals marginal revenue. The economic theory of profit maximization does not apply in the absence of perfect competition. However, in the long run, marginal and average costs (as in cost-plus) tend to converge, reducing the difference between the two strategies. It works great when a business is in need of short term finance.

References[edit]

  1. ^ a b Jain, Sudhir (2006). Managerial Economics. Pearson Education. ISBN 978-81-7758-386-1.