Editing Cost-plus pricing

{{Short description|Strategy of setting prices based on a fixed markup percentage}}
'''Cost-plus pricing''' is a [[pricing strategies|pricing strategy]] by which the selling price of a product is determined by adding a specific fixed percentage (a "[[markup (business)|markup]]") to the product's [[unit cost]]. Essentially, the markup percentage is a method of generating a particular desired rate of return.<ref name=":1">{{Cite web|last=Kenton|first=Will|title=How Variable Cost-Plus Pricing Works|url=https://www.investopedia.com/terms/v/variable-cost-plus-pricing.asp|access-date=2021-04-26|website=Investopedia|language=en}}</ref><ref name=":0">{{Cite web|last=Carlson|first=Rosemary|title=Defining and Calculating Cost-Plus Pricing|url=https://www.thebalancesmb.com/cost-plus-pricing-393274|access-date=2021-04-26|website=The Balance Small Business|language=en}}</ref> An alternative pricing method is [[value-based pricing]].<ref name="SudhirJain_ME_2009">{{cite book | last=Jain | first=Sudhir | title=Managerial Economics | year=2006 | publisher= Pearson Education | isbn=978-81-7758-386-1}}</ref>  

Cost-plus pricing has often been used for [[government contracts]] ([[cost-plus contract]]s), and has been criticized for reducing incentive for suppliers to control [[direct cost]]s, [[indirect cost]]s and [[fixed cost]]s whether related to the production and sale of the product or service or not. 

Companies using this strategy need to record their costs in detail to ensure they have a comprehensive understanding of their overall costs.<ref name=":0" /> 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 for military procurement.

==Mechanics==
The three stages of computing the selling price are computing the total cost, computing the unit cost, and then adding a markup to generate a selling price (refer to Fig 1). 
[[File:Cost-plus pricing steps.png|thumb|440x440px|'''Fig 1:''' ''Cost-plus pricing steps''|none]]

'''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.<ref name="SudhirJain_ME_2009" />

'''Step 3b: Calculating Selling Price (SP)'''

''Selling Price = unit cost + markup price''

== Example ==
A shop 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

''Sales Price = unit cost + markup price'' 

Sales Price= $450 + $54

Sales Price = $504

Ultimately, the $54 markup price is the shop's margin of profit.

Cost-plus pricing is common and there are many examples where the margin is transparent to buyers.<ref>{{Cite news |last=Dholakia |first=Utpal M. |date=2018-07-12 |title=When Cost-Plus Pricing Is a Good Idea |url=https://hbr.org/2018/07/when-cost-plus-pricing-is-a-good-idea |access-date=2025-03-18 |work=[[Harvard Business Review]] |language=en |issn=0017-8012}}</ref> Costco reportedly created rules to limit product markups to 15% with an average markup of 11% across all products sold.<ref>{{Cite web |last=Gabler |first=Neal |date=2016-12-03 |title=Inside Costco: The Magic in the Warehouse |url=https://fortune.com/longform/costco-wholesale-shopping/ |access-date=2025-03-18 |website=[[Fortune (magazine)|Fortune]] |language=en}}</ref>

== Rationale ==

Buyers may perceive that cost-plus pricing is reasonable. In some cases, the markup is mutually agreed upon by buyer and seller. For markets that feature relatively similar production costs, companies do not have a dominant strategy.<ref>{{Cite web|last=Park|first=Anna|date=2010|title=Price-setting behaviour: Insights from Australian firms|url=https://www.rba.gov.au/publications/bulletin/2010/jun/2.html|url-status=live|access-date=|website=RBA|archive-url=https://web.archive.org/web/20100808051054/http://www.rba.gov.au:80/publications/bulletin/2010/jun/2.html |archive-date=2010-08-08 }}</ref> Therefore, cost-plus pricing can offer competitive stability, decreasing the risk of price competition (such as price wars), if all companies 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.<ref name=":2">{{Cite web|title=Cost plus pricing definition|url=https://www.accountingtools.com/articles/2017/5/16/cost-plus-pricing|access-date=2021-04-26|website=AccountingTools|language=en-US}}</ref> When there is little market intelligence, the use of a cost-plus pricing strategy compensates for the lack of information by setting prices based on actual costs.<ref>{{Cite web|title=Pricing - cost-plus strategies {{!}} Learn economics|url=https://www.learn-economics.co.uk/Cost-plus-pricing.html|access-date=2021-04-26|website=www.learn-economics.co.uk}}</ref> This method is generally adopted by retail companies such as grocery or clothing stores.<ref name=":2" />

Cost-based pricing is a way to induce a seller to accept a contract the costs of which represent a large fraction of the seller's revenues, or for which costs are uncertain at contract signing, as for example for research and development.

==Economic theory==

Cost-plus pricing is not common in markets that are (nearly) [[perfect competition|perfectly competitive]], for which prices and output are such that [[marginal cost]] (the cost of producing an additional unit) equals [[marginal revenue]]. In the long run, marginal and average costs (as for cost-plus) tend to converge, reducing the difference between the two strategies. It works well when a business is in need of short-term finance.

==Elasticity considerations==
Although this method of pricing has limited application as mentioned above, it is used commonly for the purpose of ensuring a business covers its costs by "breaking even" and not operating at a loss whilst generating at least a minimum rate of profit.<ref>{{Cite web |last=Marn |first=Michael V. |last2=Roegner |first2=Eric V. |last3=Zawada |first3=Craig C. |date=2003-08-01 |title=Pricing new products |url=https://www.mckinsey.com/capabilities/growth-marketing-and-sales/our-insights/pricing-new-products |access-date=2025-03-18 |website=[[McKinsey Quarterly]]}} </ref> In spite of its ubiquity, economists rightly point out that it has serious flaws. Specifically, the strategy requires little market research hence it does not account for external factors such as consumer [[demand]] and competitor's prices when determining an appropriate selling price.<ref name=":1" /> There is no way in advance of determining if potential customers will purchase the [[product (business)|product]] at the calculated price. Regardless of which pricing strategy a company chooses, [[Price elasticity of demand|price elasticity]] (sensitivity of demand to price) is a vital component to examine.<ref>{{Cite web|date=2014-12-16|title=Pricing Strategies & Elasticity|url=https://julieaskewblog.wordpress.com/marketing-principles/pricing-strategies-elasticity/|access-date=2021-04-26|website=Fundamentals of Marketing|language=en}}</ref> To compensate for this, some economists have tried to apply the principles of [[price elasticity of demand|price elasticity]] to cost-plus pricing.<ref>[https://www.talkcosts.co.uk/ Talkcosts - Cost Guides]</ref>

We know that:<blockquote>MR = P + ((dP / dQ) * Q)</blockquote>
where: <blockquote>
MR = marginal revenue<BR>
P = price<br />
(dP / dQ) = the derivative of price with respect to quantity<BR>
Q = quantity</blockquote>

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:<blockquote>MC = P + ((dP / dQ) * Q)</blockquote>

Dividing by P and rearranging yields:<blockquote>MC / P = 1 +((dP / dQ) * (Q / P))</blockquote>

And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:<blockquote>(P / MC) = (1 / (1 – (1/E)))</blockquote> where:<blockquote>(P / MC) = markup on marginal costs<BR>E = price elasticity of demand</blockquote>

In the extreme case where elasticity is infinite:<blockquote>(P / MC) = (1 / (1 – (1/999999999999999)))<BR>   (P / MC) = (1 / 1)</blockquote>Price is equal to marginal cost. There is no markup.

At the other extreme, where elasticity is equal to unity:<blockquote>(P /MC) = (1 / (1 – (1/1)))<BR> (P / MC) = (1 / 0) </blockquote>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):<blockquote> (P / AVC) = (1 / (1 – (1/E)))</blockquote> 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.

==See also==
*[[Marketing]]
*[[Markup (business)]]
*[[Microeconomics]]
*[[Outline of industrial organization]]
*[[Price elasticity of demand]]
*[[Pricing]]

==References==
{{reflist}}

[[Category:Pricing]]