Discover what the cost-plus pricing method in a company is and when it is usually used. Know the formula for it and learn how to compute it through given examples.
Cost Plus Pricing | Strategy, Formula & Examples
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Frequently Asked Questions
What is an example of cost-plus pricing?
An example of cost-plus pricing would be a military procurement contract where the firm accepts the contract at cost-plus a pre-determined fixed fee amount. This setup discourages firms from inflating costs to increase revenue, as can happen with cost-plus percentage of cost contracts.
When would you use cost-plus pricing?
Cost-plus pricing is one of the most commonly used pricing models and applies to many situations. It would be beneficial to price a good or service with no historical precedent or competition, and the value to the customer is prohibitively difficult to ascertain.
What is the cost-plus pricing formula?
The cost-plus pricing formula adds a company's desired profit to the break-even price. The formula state that the cost-plus pricing = break-even price * profit margin goal.
Table of Contents
ShowA firm's pricing strategy is one of the most critical elements of its success as a business. There are many ways a company can strategically price its products or services. The most frequently used pricing strategies are:
- Value-based pricing - The price is based on its value to the customer with little focus on cost.
- Competitor-based pricing - The price is based on the price of similar items produced by competitors.
- Cost-plus pricing - The price is at cost plus a markup for profit.
An example of the cost-plus pricing strategy is the retailer Costco, whose pricing strategy is to mark up prices by 15%. If a product costs $100.00, they will set the price at cost + (Cost * 15%), which would be $115.00.
Within the cost-plus system, there are different types of pricing strategies. However, because cost-plus is very popular in government contracting, the government allows only three types of cost-plus contracts. These are:
- Award-fee contracts - These contracts award a fee based on the product's end result.
- Incentive fee contracts - These contracts incent firms by awarding a bigger profit (as an incentive fee) when the firm meets or exceeds pre-established performance targets.
- Fixed-fee contracts - These contracts provide a pre-negotiated fee to the firm on top of its cost. There is no incentive for performance or cost-efficiency. On the flip side, there is also no incentive to have cost overruns, as with the cost-plus percentage of cost contracts.
Another popular cost-plus pricing model is the cost-plus percentage of cost strategy. However, this strategy is forbidden in federal government contracting because it not only discourages efficiency but also actively encourages waste by increasing a firm's total revenue when costs increase. Nevertheless, for some firms, this model is a simple and transparent mechanism of pricing their products that produce outstanding value for the firm and its customers, as in the Cosco example above.
Uses of Cost-Plus Strategy
The cost-plus pricing strategy is popular because of its simplicity and, if done correctly, ability to guarantee the firm will make a profit on its products or services. It is best used in situations where competitive and market research are prohibitively expensive or not possible due to the product's unique nature.
The cost-plus system does not require market or competitor research, making it straightforward and easy to implement. For example, if a law firm provides legal services to a corporation and its cost for providing the services is $250 per hour (factoring in employee expenses and overhead), the firm may decide it would like a profit of 30%, so it will bill the client $250 + ($250 * .30) = $325 per billable hour.
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The most direct way of explaining cost plus pricing is through the cost-plus pricing formula. This formula is:
Cost-Plus Pricing = Break-Even Price * Profit Margin Goal
Where:
- Break-Even Price is the total cost to the firm of producing the product or service.
- Profit Margin Goal is the firm's desired/expected profit level.
- Cost-Plus Price is the price the firm will charge based on its expected profit level for its products and services.
Cost-Plus Pricing Example
Example 1: Firm A produces widgets with a variable cost of $1.50 per widget and $500,000 in monthly overhead costs. It can produce ten million widgets per month and usually operates at 70% capacity. For April, it will produce seven million widgets at a total variable cost of:
$1.50(7,000,000) = $10,500,000
This makes the break-even point $10,500,000 + $500,000 = $11,000,000.
If the firm expects to make a 34.91% profit on the production of widgets, then it must use the cost-plus formula to arrive at its final price:
$11,000,000 + ($11,000,000 * .3491) = $14,840,100
The firm must make $14,840,100 for April to achieve its profit goals. To do so, the firm must charge $14,840,100 divided by 7,000,000, which is approximately $2.12 per widget.
Example 2: Firm B provides auditing and accounting services to public companies. It hires a team of 250 highly experienced CPAs to do this. The total compensation cost per CPA is $74.30 per hour. The firm's monthly overhead cost is $150,000. Each CPA agrees to work 35 hours per week, for a total of 8750 potentially billable hours per month. However, the firm seldom operates at full capacity outside of tax season. As a result, it usually has about 8000 realized billable hours per month.
The firm's break-even cost is:
(8,750 * $74.30) = $650,125 + $150,000 of overhead = $800,125.
If the firm intends to make a profit of 35%, then the cost-plus pricing formula is:
$800,125 + ($800,125*.35) = $1,080,168.75
Because the realized billable hours are usually 8000 and not 8750, the firm must charge $1,080,168.75 divided by 8,000, which equals $135.02 per billable hour, to achieve its desired 35% level of profitability.
If the firm took the break-even cost of $1,080,168.75 and divided it by the potential billable hours of 8,750, it would only charge $123.45 per billable hour. By doing so, at the end of an average month, its revenue would be 8000 multiplied by $123.45, giving a total of $987,600. Since the break-even cost of $800,125 would remain the same, the profit margin for this model would be roughly 23.43%, a full 11.57% lower than its desired level of profitability. Organizations must factor all relevant elements into the pricing strategy to achieve the desired goal.
Advantages and Disadvantages of Cost-Plus Pricing
Like most things, the cost-plus pricing model has advantages and disadvantages. The cost-plus pricing model is often evaluated against competitive and value-based pricing models to determine its desirability over other available options. The cost-plus pricing model received much criticism for its perceived downsides. Below is a list of the advantages and disadvantages of cost-plus pricing.
| ADVANTAGES | DISADVANTAGES |
| Simple | Not competitive |
| Straightforward | Does not account for value |
| Profitable | Not optimal |
| Non-discriminatory | Can discourage cost efficiency |
| Transparent & fair | Can encourage waste |
Advantages
Simple and straightforward, the cost-plus pricing strategy, when calculated correctly, can ensure a company's viability by guaranteeing products produce a profit. The model is an excellent method to use in a market where there is no competition for a product or service that has no precedent. In this situation, arriving at a competitive pricing model would be impossible, and estimating the value for the customers might be prohibitively difficult. This method makes it possible for a new inventor with a new concept but little business acumen to ensure the price charged produces a reasonable profit rather than a loss.
The cost-plus pricing method is transparent, non-discriminatory, and fairer than other options. When published to the public, it instills a sense of trust in the customer that the company is not discriminating against them by charging more when the customer needs the product. Additionally, a company may discriminate against a customer by using their personal information to determine how much the product is worth to them and exploit that knowledge. Because the price is the same for anyone who wants to buy the product, customers believe the price is fair.
Disadvantages
Ironically, precisely this advantage of cost-plus pricing is also its disadvantage. Failure to do market research that can provide insight into the product's value for the customers, or the many different types of customers, can result in less-than-optimal profits. The firm may have a nearly guaranteed 25% profit, but perhaps it could have realized 40% or 60% profit if it had strategically priced its products and services by factoring in the product's value to the customer. For example, it may only cost a firm $3.00 to produce a lavender soap in Provence, but if it packages and markets the soap in the right way, the right customer may buy it for $24.00, a 700% markup. Would it be wise to price that bar of soap at a "reasonable" 30% markup without studying the marketplace? From a business standpoint, it would not. For this reason, critics of the cost-plus pricing strategy often point out that it is less than optimal for maximizing profitability.
Other criticisms are that the cost-plus system does not factor in competitors' prices. If competitors charge significantly more, the firm may leave a lot of profits on the table because of its oversimplified strategy. Conversely, suppose the competitors charge substantially less for a very similar product. In that case, the firm may be unable to sell its products because customers will choose the least expensive product when there is no perceived difference in quality.
Another disadvantage, usually directed at government cost-plus contracts, is that the strategy discourages efficiency because the contractor does not need to worry about the cost: the contract will pay for the cost, whatever it is, plus a profit. There is no incentive to manage costs because the firm will still receive the same profit. Additionally, the contract might encourage inefficiency and waste. If a firm signs a cost-plus percentage of cost contract, it will benefit from higher costs. For example, in a contract to produce 1000 widgets, if the cost is $10.00 per widget and the percentage is 20%, then the firm's profit will be $2,000. If the cost is $100.00 per widget, the firm's profit shoots up to $20,000. The profit margin is the same, but the results are vastly different. For this reason, the cost-plus percentage of cost contract is no longer allowed in government contracting at the federal level. Nevertheless, the strategy is still in use in other places, and when implemented correctly, it can produce a good result.
Cost-plus pricing is the pricing of a product by adding a desired profit to the break-even price. Some benefits of cost-plus pricing are that it is simple, straightforward, profitable, non-discriminatory, transparent, and fair. Some drawbacks are that it is neither competitive nor based on the product's value to the customer. The cost-plus pricing model doesn't consider what competitors charge for similar products or the value the customer places on that particular product, which may be significantly more than its cost-plus profit margin. As a result, it is less than optimal at maximizing profits. It also can discourage cost efficiency and encourage waste.
The organization must know the break-even point and desired profit margin to calculate cost-plus pricing. A simple formula is cost-plus pricing = break-even price * profit margin goal. Break-even price is the total cost to the firm of producing the product or service. Profit margin goal is the firm's desired/expected profit level. Multiply the cost to provide a service by the desired profit margin. However, the formula can be trickier than it appears, and the firm must keep an eye on all elements that factor into the cost to be effective at producing the desired result.
Video Transcript
What Is Cost-Plus Pricing?
Your company has been developing a new printer that will streamline many processes for your small business customers. Your job is to determine the price of the printer. After doing some research, you determine that the best method for pricing the printer is the cost-plus method.
Cost-plus pricing is a straightforward and simple way to arrive at a sales price by adding a markup to the cost of a product. In our example of the printer, you first have to determine the break-even price, which is the sum of all of the expenses involved in creating a product, including expenses like supplies, production costs, and marketing costs. When you pull all of the expenses together to determine the cost of each printer, you determine that each one will cost $78 to produce. If you sold the printer at $78 your company would break even, meaning there would be no profit or loss.
However, your company definitely plans to earn money from the sale of the printers. In fact, the goal is to earn 25% on each printer. So, you implement the following formula for cost-plus pricing to arrive at the sales price:
Break-even price * profit margin goal
Examples
Let's walk through the cost-plus pricing formula using our printer example:
- Break-even price: You determined that the total cost of development, production, and marketing of the product is $78
- Profit margin goal: Your company wants to make money on the printers at a margin of 25%
Cost-plus pricing = break-even price * profit margin goal
Cost-plus pricing = $78 * 1.25
Cost-plus pricing = $97.50
Using cost-plus pricing, you determine the price of the printer to be $97.50. This allows the company to recoup the cost of producing the printer, while earning a 25% profit margin on each unit sold.
Cost-plus pricing is not only for products, but for services as well. Many companies that provide consulting services rely on cost-plus pricing. For instance, let's say your company offers a repair service for small businesses who own your printers. The repair personnel earn $10/hour, and there are other additional expenses such as supplies, mileage reimbursement, and the cost of the customer service representative who schedules the repairs. If these fees average $4 per service call and the company wants to earn 30% profit on each hour billed for repair services, you can use the same formula to arrive at the cost-plus pricing for the repair service.
- Break-even price = $10 for repair personnel cost + $4 in supplies, transportation, and customer service = $14
- Profit margin goal: Your company wants to make a margin of 30% on the repair service
Cost-plus pricing = break-even price * profit margin goal
Cost-plus pricing = $14 * 1.3
Cost-Plus Pricing = $18.20
To achieve the 30% profit margin goal, your company must bill clients at $18.20 per hour.
Evaluation of Cost-Plus Pricing
Cost-plus pricing is a simple method to determine the pricing of a product or service, but it comes with some challenges. There are several issues, but there are two significant disadvantages to consider.
- Cost-plus pricing does not take into account what competitors are charging for similar products. For example, if your competitors are selling a similar printer for $92, you may lose sales because their printers are cheaper than yours.
- Cost-plus pricing does not consider what consumers are willing to pay for a product. If consumers are price sensitive and will only pay $85 for a printer, setting your price at $97.50 will likely hurt your sales.
Lesson Summary
Let's review. Cost-plus pricing is a straightforward and simple way to arrive at a sales price by adding a markup to the cost of a product. An effective pricing strategy sets a sales price that is reasonable considering the product being sold, ensures the required profit margin for the company, and recoups all the expenses of producing the item. Cost-plus pricing simply multiplies the break-even price by the profit margin to arrive at the final price.
Cost-plus pricing can also be applied to services by calculating the total cost of providing the service and then multiplying that by the desired profit margin, ensuring that the company earns a specific amount of money as profit. Cost-plus may be a very simple, straightforward way to price a product; however, it does not account for the price competitors are charging nor does it consider the price point consumers find reasonable.
Cost-Plus Pricing Key Terms
 |
- Cost-plus pricing: simple way to determine sales prices by adding markups to the costs of products
- Break-even price: the sum of the expenses required to produce a product
- Profit margin goal: the profit goal percentage as set by the company for each sale of the product
Learning Outcomes
When this lesson ends, students should be able to:
- Define cost-plus savings
- Determine how to calculate for cost-plus savings
- Explain what the break-even price is for a product
- Define profit margin goal
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