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Calculating Cost-Plus Prices

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Cost-plus pricing, also known as markup pricing, is a company's practice of determining the cost of the product for the company and then adding a percentage on top of that price to determine the sales price to the customer.

Cost-plus pricing is a very simple, cost-based pricing strategy for determining the prices of goods and services. With cost-plus pricing you first add the direct material costs, the direct labor costs and overhead to determine what the company costs to offer the product or service. A markup percentage is added to the total costs to determine the selling price. This marking percentage is profit. You must therefore start with a thorough and accurate understanding of all operating costs and where these costs come from.

In certain cases, the percentage of the layout is agreed by both the buyer and the seller. This percentage can also serve as a negotiating tip during the sale.

3 steps to calculate cost-plus prices

Three steps are needed to calculate costs plus plus rates for a product:

  • Step 1: Determine the total costs of the product or service, which is the sum of fixed and variable costs (fixed costs don't vary with the number of units, while variable costs do).
  • Step 2: divide the total costs by the number of units to determine the unit costs.
  • Step 3: multiply the unit costs by the formatting percentage to arrive at the selling costs and the profit margin of the product.

A cost-based price example

Suppose a company sells a product for $ 1, and that $ 1 includes all costs necessary to make and market the product. The company can then add a percentage on top of that $ 1 as the 'plus' part of the cost-plus pricing. That part of the price is the profit of the company.

Depending on the company, the marking percentage may also include a factor that reflects the current market or economic conditions. If demand is slow, the market rate may be lower to lure customers. On the other hand, if the demand for the product is high and the economic conditions are good, the market rate may be higher if the company believes it can demand a higher price for its product.

Pros and cons

In certain situations, such as a contracted sales agreement, it makes sense to use a cost-pricing method, while in other price scenarios this can lead to major financial problems. Below are some of the benefits of using this type of pricing method:

  • Structure of the selling price of a product: It's easy to use this method, with a warning. You must have a consistent method for allocating overhead costs per accounting period to maintain integrity with cost structure.
  • Locking the income with a contract: Every supplier wants a contract with cost-plus pricing, because it mainly guarantees a turnover with a certain profit percentage and covers all production costs without risk of loss.
  • One way for suppliers to justify and explain a price increase: Cost-plus pricing makes it easier to roll out price increases because companies can easily inform customers that production costs have increased.

The cost plus model has a number of disadvantages, including the following:

  • Prices don't take the competition into account: The product could be over priced, which would cost the company in terms of lost sales and market share. Prices could also be lower than those of the competition, causing the company to lose potential profits because the market price for its goods is not calculated.
  • Suppliers have little reason to control or reduce costs: When they have entered into a cost-plus price arrangement, companies ultimately produce what they want, regardless of what it costs to produce or how it sells in the market.
  • Runaway costs from suppliers hired on a cost plus basis: Suppliers tend to include all possible costs in a cost plus contract, rather than looking for ways to save and streamline costs.
  • Does not take into account the most recent replacement costs. The cost plus method is based on historical costs and doesn't take into account recent changes in the amount of costs incurred.

Considerations

A major problem with cost-plus pricing is that it doesn't take into consideration any measure of demand for the product or service. The formula doesn't take into account whether potential customers will actually purchase the product at the stated price. To compensate for this, some entrepreneurs have tried to apply the principles of price elasticity to cost plus prices. Others can easily look at competitive offers, trends and business insight to determine what price the market will bear.

An alternative is Value Based Price, which is the process of determining the selling price of a product or service based on the benefits it offers buyers, not what it costs to produce. If your company offers special or unique products with very valuable features, you may be well positioned to take advantage of value-based prices, which generally generate a higher rate of return.

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