Monday, January 18, 2010

Cost-plus pricing

Pricing method whereby a standard markup is added to the estimated cost of the product. The cost-plus price is computed by dividing the fixed costs of a product by the estimated number of units to be sold and then adding the variable cost per unit, or by adding the total variable costs and fixed costs and then dividing by the total number of units to be produced. This will determine the true unit cost. Once the true unit cost has been determined, that cost is divided by 1 minus the desired return on sales to determine the cost-plus price.

The method determines the price of a product or service that uses direct costs, indirect costs, and fixed costs whether related to the production and sale of the product or service or not. These costs are converted to per unit costs for the product and then a predetermined percentage of these costs is added to provide a profit margin.

Advantages of cost-plus pricing

1. Easy to calculate
2. Minimal information requirements
3. Easy to administer
4. Tends to stabilize markets - insulated from demand variations and competitive factors
5. Insures seller against unpredictable, or unexpected later costs

Disadvantages of cost-plus pricing

1. Provides no incentive for efficiency
2. Tends to ignore the role of consumers
3. Tends to ignore the role of competitors
4. Uses historical accounting costs rather than replacement value
5. Uses “normal” or “standard” output level to allocate fixed costs