Cost-plus pricing
Cost-plus pricing is a common pricing method used by a large number of firms operating in different sectors of an economy. As early as the 1930s, cost-plus pricing seemed to be the dominant pricing strategy pursued by actual firms1. This contrasted with the accepted theory at the time - namely, that price would be determined by both demand and supply (cost) considerations. Cost-plus pricing is a pricing method which only takes into account production costs, and not demand factors, or the price charged by competitors.
Cost-plus pricing starts with the costs of production (per unit) and then adds a fixed amount (or fixed percentage) mark-up to generate a required level of profit from each unit sold. For this reason cost-plus pricing is also called 'mark-up pricing'.
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 .
The advantages of cost-plus pricing
- 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.
- It allows for costs to be covered, and guarantees a profit.
- 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 absence 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.
- 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.
- As a result of this, the price set ignores the true ‘value’ of a product to the customer.
- While it does guarantee a profit, it does not guarantee that profits are maximised.
- 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.
- 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.
1. Hall, R. L., and C. J. Hitch. “Price Theory and Business Behaviour.” Oxford Economic Papers, no. 2, 1939, pp. 12–45. JSTOR, www.jstor.org/stable/2663449. Accessed 14 Mar. 2021.
