Cost plus pricing is a cost-based method for setting the prices of goods and services. Under this approach, you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to it a markup percentage (to create a profit margin) in order to derive the price of the product. Cost plus pricing can also be used within a customer contract, where the customer reimburses the seller for all costs incurred and also pays a negotiated profit in addition to the costs incurred.
The Cost Plus Calculation
As an example, ABC International has designed a product that contains the following costs:
- Direct material costs = $20.00
- Direct labor costs = $5.50
- Allocated overhead = $8.25
The company applies a standard 30% markup to all of its products. To derive the price of this product, ABC adds together the stated costs to arrive at a total cost of $33.75, and then multiplies this amount by (1 + 0.30) to arrive at the product price of $43.88.
Advantages of Cost Plus Pricing
The following are advantages to using the cost plus pricing method:
- Simple. It is quite easy to derive a product price using this method, though you should define the overhead allocation method in order to be consistent in calculating the prices of multiple products.
- Assured contract profits. Any contractor is willing to accept this method for a contractual agreement with a customer, since it is assured of having its costs reimbursed and of making a profit. There is no risk of loss on such a contract.
- Justifiable. In cases where the supplier must persuade its customers of the need for a price increase, the supplier can point to an increase in its costs as the reason for the increase.
Disadvantages of Cost Plus Pricing
- Ignores competition. A company may set a product price based on the cost plus formula and then be surprised when it finds that competitors are charging substantially different prices. This has a huge impact on the market share and profits that a company can expect to achieve. The company either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues.
- Product cost overruns. Under this method, the engineering department has no incentive to prudently design a product that has the appropriate feature set and design characteristics for its target market. Instead, the department simply designs what it wants and launches the product.
- Contract cost overruns. From the perspective of any government entity that hires a supplier under a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures – on the contrary, it will likely include as many costs as possible in the contract so that it can be reimbursed. Thus, a contractual arrangement should include cost-reduction incentives for the supplier.
- Ignores replacement costs. The method is based on historical costs, which may have changed. The most immediate replacement cost is more representative of the costs incurred by the entity.
Evaluation of Cost Plus Pricing
This method is not acceptable for deriving the price of a product that is to be sold in a competitive market, primarily because it does not factor in the prices charged by competitors. Thus, this method is likely to result in a seriously overpriced product. Further, prices should be set based on what the market is willing to pay – which could result in a substantially different margin than the standard margin typically assigned using this pricing method.
Cost plus pricing is a more valuable tool in a contractual situation, since the supplier has no downside risk. However, be sure to review which costs are allowable for reimbursement under the contract; it is possible that the terms of the contract are so restrictive that the supplier must exclude many costs from reimbursement, and so can potentially incur a loss.