Cost-plus pricing
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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. It is a way for companies to calculate how much profit they will make. 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
- Easy to calculate
- Minimal information requirements
- Easy to administer
- Tends to stabilize markets - insulated from demand variations and competitive factors
- Insures seller against unpredictable, or unexpected later costs
- Ethical advantages (see: just price)
- Simplicity
- It is readily available
- Price increases can be justified in terms of cost increases
Disadvantages of cost-plus pricing
- Provides incentive for inefficiency
- Tends to ignore the role of consumers
- Tends to ignore the role of competitors
- Uses historical rather than replacement value
- Uses “normal” or “standard” output level to allocate fixed costs
- Includes sunk costs rather than just using incremental costs
- Ignores opportunity costs