Cost-plus pricing is a type of pricing strategy where a business establishes the price for its goods and services in relation to its production cost.
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Table of Contents
What Is Cost-Plus Pricing
Cost-plus pricing is a pricing strategy where a company will calculate the cost of producing its goods and services and determines a markup to that cost.
In other words, you set the price for your goods and services in relation to your cost per unit.
For example, if a company has a cost of goods sold of $50 per unit, it can use the cost-plus pricing strategy to mark it up by 50% and sell it for $75 per unit.
This means that no matter how much it costs the company to produce its goods, it will sell them with a 50% markup.
Benefits of Cost-Plus Pricing
There are a few key benefits to using a cost-plus pricing strategy.
The first benefit is that it’s simple to calculate your price.
What you need to do is to look at internal records to calculate your cost per unit and use that figure to set your selling price.
Another benefit of this strategy is that you know that you can generate a consistent profit or return on your goods and services.
Another more subjective reason that this pricing strategy is useful is that it’s easy to explain to a client and the rationale is simple to understand.
Drawbacks of Cost-Plus Pricing
Although cost-plus pricing has several key benefits, it’s important that you also consider its drawbacks.
The most important drawback with cost-plus pricing is that it’s a pricing strategy that only looks at your company’s internal figures without assessing the market or the competitor rates.
If you set your price purely based on how much it costs you to produce each unit, you may price yourself too high or too low compared to the market rates.
Another disadvantage of cost-plus pricing is that it does not promote efficiency and innovation.
Since the price for the goods and services is always marked up, the company is assured of its profits and therefore may not be inclined to innovate as rapidly or resolve operational inefficiencies.
A third important drawback is that this type of pricing strategy may not yield the expected profits if there are cost overruns or shifts in market rates in such a way that the company cannot quickly adjust its prices accordingly.
For so long as the company has not adjusted its sales price, any cost overruns or extra expenses will chip away at the company’s profit margin.
When To Use Cost-Plus Pricing Strategy
The cost-plus pricing strategy is typically used in industries where there’s a steady and consistent demand for the products and services and organizations can sell high volumes.
For example, the grocery business is one type of business where the retailer will use a cost plus pricing strategy for items sold on its shelves.
Also, the price needs to be set at what the market is willing to pay.
If consumers or clients are not willing to pay a high markup, then setting a high markup will produce the opposite effect of lowering sales.
Cost-plus pricing should not be used in competitive markets as competitors may not be using a pricing strategy in line with their cost.
For example, if you are producing smartphones, you may be losing significant sums of money if you set your price based on your cost.
Rather, the market may be willing to pay a significant premium to purchase the latest smartphone.
Takeaways
So there you have it folks!
What is cost plus pricing?
In a nutshell, cost plus pricing is a type of pricing strategy where a company sets the prices for its goods and services by adding a fixed percentage on top of its cost per unit.
This extra percentage is generally called the “markup”.
The cost plus pricing is a pricing method where you strictly rely on internal information to set your prices as it’s a function of your cost per unit sold.
You’ll need to be careful as to when you use this type of strategy and provide contractual protections allowing you to adjust your prices in case there are cost overruns or rapid changes in the market.
If you need any legal advice with regard to your commercial contracts with your clients, suppliers, or vendors, our business law firm can provide you with the necessary support.
