Cost-plus pricing

Cost-plus pricing is a common pricing method used by a large number of firms.

A price based on this method starts with the costs of production and then adds a fixed amount (or fixed percentage) mark-up to generate a required level of profit from each unit sold.

The calculation of cost can be based on all the identified costs of production – called ‘full-cost’ pricing, which considers both fixed and variable costs, or just on the ‘direct’ variable costs of production – called ‘contribution’ or ‘direct cost’ pricing.

Example

Below is a hypothetical cost calculation for a firm producing hand-made wooden cabinets and using a full-cost approach .

Cost plus pricing

The advantages of cost-plus pricing

  1. Cost-plus pricing is very simple to understand and straightforward to implement - the mark-up may become a ‘rule of thumb’ in particular industries and applied across a wide range of products. 
  2. It allows for costs to be covered, and guarantees a profit.
  3. The use of a mark-up allows for negotiation around the percentage (rather than negotiating the final price).
    Cost-plus pricing can help solve the problem of information failure - in the absense of market intelligence setting price based on cost means that the mark-up formula can be seen as a convenient way to fill the information gap.

Disadvantages of cost-plus pricing

Although cost-plus pricing has many advantages, it can be criticised in several ways.

  1. Firstly, it does not take changing market conditions into account. There may be times when demand is buoyant, and increased profits may be justifiable. Prices are not customised and individual variations in how customers value products (and hence how much they are prepared to pay) is not considered. As an example of failing to factor-in market conditions, cost-plus prices make no allowance for price elasticity of demand, or cross elasticity of demand, or to changes in these as market conditions change.
  2. As a result of this, the price set ignores the true ‘value’ of a product to the customer.
  3. While it does guarantee a profit, it does not guarantee that profits are maximised.
  4. Given this, cost-plus pricing can be seen to be anti-competitive if the method (or model) is shared by all competitors in an industry. In this respect many oligopolies fall back on cost-plus pricing as it avoids the risk associated with a price war.
  5. It may encourage firms to inflate production costs . This may be common with the pricing of government contracts. If this case, resources may be used inefficiency and result in higher tax levels.

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