Cost-plus pricing is a pricing strategy in which the selling price, of goods and services, is determined by adding a specific fixed markup percentage to a singular product's unit cost. Essentially, the markup percentage is the company's way to generate a profit margin that reaches their target rate of return and maximises their overall profits. The markup percentage can be derived by using the firm's target rate of return. An alternative pricing method is value-based pricing.
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.
Companies must ensure cost breakdowns are deliberately maintained to ensure they have a comprehensive understanding of their overall costs. This information is necessary to generate accurate cost estimates.
Cost-plus pricing is especially common for utilities and single-buyer products that are manufacture to the buyer's specification such as military procurement.
The three steps in computing the selling price are calculating the total cost, unit cost and then adding a markup to generate a selling price (refer to Fig 1).
Step 1: Calculating total cost
Total cost = fixed costs + variable costs
Fixed costs do not generally depend on the number of units, while variable costs do.
Step 2: Calculating unit cost
Unit cost = (total cost/number of units)
Step 3a: Calculating markup price
Markup price = (unit cost * markup percentage)
The markup is a percentage that is expected to provide an acceptable rate of return to the manufacturer.
Step 3b: Calculating Selling Price (SP)
Selling Price = unit cost + markup price
Kmart selling a vacuum cleaner will be examined since retail stores generally adopt this strategy.
Total cost = $450
Markup percentage = 12%
Markup price = (unit cost * markup percentage)
Markup price = $450 * 0.12
Markup price = $54
SP = unit cost + markup price
SP = $450 + $54
SP = $504
Ultimately, the $54 markup price is Kmart's profit margin.
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 markets that feature relatively similar production costs, companies do not have a dominant strategy. Therefore, cost-plus pricing can offer competitive stability, decreasing the risk of price competition such as price wars, if all firms adopt cost-plus pricing. The strategy enables price changes to goods and services relative to increases or decreases in the product cost which are simple to communicate and justify to customers. When there is little market intelligence issues of information failure arise. The use of the cost-plus pricing strategy allows the lack of information to be filled through setting price on a markup of costs. This method is generally adopted by retail companies such as grocery or clothing stores.
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.
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. In the long run, marginal and average costs (as in cost-plus) tend to converge, reducing the difference between the two strategies. It works very well when a business is in need of short-term finance.
Although this method of pricing has limited application as mentioned above, it is commonly used for the purpose of ensuring a firm covering their costs by "breaking even" and not operating at a loss whilst generating a minimum rate of profit. In spite of its ubiquity, economists rightly point out that it has serious methodological flaws. Specifically, the strategy requires little market research hence, why it does not account for external factors such as consumer demand and competitor's prices when determining an appropriate selling price. There is no way of determining if potential customers will purchase the product at the calculated price. Regardless of which pricing strategy a company chooses, price elasticity is a vital component to examine. To compensate for this, some economists have tried to apply the principles of price elasticity to cost-plus pricing.
We know that:
MR = P + ((dP / dQ) * Q)
MR = marginal revenue
P = price
(dP / dQ) = the derivative of price with respect to quantity
Q = quantity
Since we know that a profit maximizer, sets quantity at the point that marginal revenue is equal to marginal cost (MR = MC), the formula can be written as:
MC = P + ((dP / dQ) * Q)
Dividing by P and rearranging yields:
MC / P = 1 +((dP / dQ) * (Q / P))
And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:
(P / MC) = (1 / (1 – (1/E)))
(P / MC) = markup on marginal costs
E = price elasticity of demand
In the extreme case where elasticity is infinite:
(P / MC) = (1 / (1 – (1/999999999999999)))
(P / MC) = (1 / 1)
Price is equal to marginal cost. There is no markup. At the other extreme, where elasticity is equal to unity:
(P /MC) = (1 / (1 – (1/1)))
(P / MC) = (1 / 0)
The markup is infinite. Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):
(P / AVC) = (1 / (1 – (1/E)))
Technically, AVC is a valid substitute for MC only in situations of constant returns to scale (LVC = LAC = LMC).
When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be, and often are, considering the price elasticity of demand, whether consciously or not.
- Markup (business)
- Outline of industrial organization
- Price elasticity of demand
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