What is Cost-Plus Pricing and why it is a good Pricing Strategy?

Cost-plus pricing keeps the price of products and services in such a manner that it covers the cost of production and provides sufficient profit margin for the firm to reach its target rate of return. In other words, the company decides the margins that it wants from the product, and then adds the margin on top of the cost to come to a selling value. Thus, the mark up pricing or cost-plus pricing method can provide the company with an overview on how much profit they are going to have.

Calculation of Cost-plus pricing

The calculation or computing of the cost-plus pricing takes into consideration the average variable and average fixed costs as well as the quantity, which is assumed based on an evaluation of the firm’s production capacity.

Therefore, we have the average cost derived from the multiplication of average variable cost and average fixed cost. The average variable cost is calculated by dividing the total variable cost by quantity. This is the initial phase in computing the cost-plus pricing.

AVC= TVC/Q
AFC= TFC/Q

AC= AVC+AFC

Where – AC is Average cost.
AVC is average variable cost
AFC is average fixedcost
TVC is total variable cost
TFC is total fixed cost
Q is total quantity

The following and last step consists in identifying the mark-up over costs. Here we introduce a target rate of return, which is a ratio of the respective share of total profit. If the target rate of return is x, then the equation of the unit of output would be:

Unit of output = X/Q

Where – X is rate of return and Q is total quantity.

The final price through the cost-plus pricing strategy will be:

P= AVC+AFC+X/Q.

This pricing has been considered the most rational approach to maximizing profits due to the ease of its calculation and lack of need to any additional information. Therefore, compared to competitive pricing, the cost up pricing strategy tends to ignore the competitors completely when establishing the price.

At the same time, it also ignores the consumers which is its drawback. In order to determine the profit margin it is essential to take into consideration also the management perception, the demand elasticity as well as the competitive conditions. After all, the main interest of managers is to focus on emphasizing the product’s maximum value.

Application of Cost-plus pricing for Business

This strategy can be applied in markets where there is a lack of information in uncertain markets. As it is hard to gain a certainty on how your demand curve is going to fluctuate, the strategy offers a general price.

Moreover, as it is working for uncertain markets, for the managers is easier to know more and be sure about production costs rather than consumers and competitors behaviors. The simplicity and availability of this strategy is what makes it quite popular among companies.

Dating back to medieval times, the present strategy is being used in USA as well as China and India.

However, the strategy can offer wrong perspectives. If we were to take for example a piece of furniture produced in China, the way to calculate the price through the cost-plus pricing strategy is to identify the cost of production and add the profit margin you wish to achieve.

But it depends on the sales target as if the sales are low than you have expected than you might result in losses. Another thing is that if the Chinese company tries to sell its furniture in China but also on international markets, such as France, the success of the company depends highly on customers’ behaviors and perceptions, as French people will believe that the Chinese products are of poor quality if the prices are set lower than their expectations.

Advantages of Cost-Plus Pricing strategy

This pricing strategy takes the cost of manufacturing a product, or providing a service into consideration. A profit markup is added on top of the cost and the customer is given the final price which is cost + profit. There are several reasons that we think Cost-plus pricing is the best pricing strategy today.

1. Pricing can become your core competency

If pricing is your advantage, and you are giving the best pricing in the market, than it becomes very difficult to imitate you. If your pricing is already cost-plus, and there is only so much margin you can have, than you become almost impossible to imitate. As a result, you get one of the strongest core competency any company can have – Price. Examples include Walmart and other retail chains which fight the market on the basis of price.

2. Competition is very smart

Competition is very smart and it can imitate the same features that you are offering. However, adding features comes at a price. When your competition is adding same features as yours, the competition price will likely increase. When it comes down to price war, your pricing will be better. Thus, you are one up on the competition due to the cost-plus strategy.

3. Digital price checking

Today, most customers check for the price of the product online. Because cost-plus pricing gives you a pricing edge over competition, it is natural that you will be chosen more frequently, when people are taking online decisions. This is because you are better priced than the competition. This fact is assuming that your product is equally good as well.

4. Budget buying

Many people prefer budget buying. Imagine situations such as an economic downturn, or in general negative feelings in the market. In such times, people prefer budget buying. Similarly, customers of the SEC B and SEC C segment will always prefer budget buying. All these customers can easily purchase your products thereby giving you more segments to tap.

5. Challenges for Cost-plus pricing

The challenge is to keep the cost down. Without keeping the cost down, the pricing strategy fails. This is because if your cost is already high, and plus you are adding profit on it, than your price becomes very high for the market. And you probably lose market share.

Conclusion on Cost plus

Thus this pricing can become the best pricing strategy for your product or your service provided that you maintain and prune the costing such that it is below the industry standard.