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What is cost plus pricing?
How does it work in simple terms?
In this article, I will break down the meaning of Cost Plus Pricing so you know all there is to know about it!
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What Is Cost Plus Pricing
Cost plus pricing is a pricing method where you set your prices at a fixed percentage over your cost per unit.
In other words, you take your “cost” and you “plus” your profits.
For instance, if a product costs you $100 per unit to produce, you may set your price at $150, representing 50% on top of your unit cost.
This type of pricing strategy may not be suitable for all types of businesses and all types of products.
For example, companies selling software products may not be able to use a cost plus pricing as they will price their software significantly under its true value.
Typically, companies looking to achieve cost-leadership will opt for this type of pricing, so consumers know they will always pay a certain percentage point above the company’s cost.
Cost Plus Pricing Formula
You can use the cost plus pricing formula to establish the price for your products and services by taking its cost per unit and marking it up.
Here is the cost plus pricing formula:
Price Per Unit = Cost Per Unit X (1 + Markup Percentage)
For instance, if your cost per unit is $50, you may choose to mark it up by 20% thus selling it at $60 per unit.
The markup percentage is essentially the percentage that you use to add a value to the cost per unit so you can reach your selling price.
Cost Plus Pricing Advantages
Using a cost plus pricing can have several key advantages.
The first advantage is that it’s a highly simple pricing strategy.
Companies will internally have all the data they need to use cost plus pricing as all you need is the total cost per unit.
Once you add up all your production cost and divide it by the total number of units sold, you get your cost per unit.
The second advantage is that it’s a type of pricing strategy that is easily explainable to end customers.
When a company uses a cost plus pricing, customers can easily understand that the company is setting prices above its production cost at all time.
Another advantage of using this strategy is that the company knows that it will always generate the same return per unit whether or not the cost per unit fluctuates.
If a company is selling at a 10% markup, it will always generate 10% whether the cost per unit stays stable or goes up.
Cost Plus Pricing Disadvantages
Although cost plus pricing has key advantages, there are several disadvantages you should be mindful of.
The first disadvantage is that cost plus pricing does not consider any variables other than the company’s internal cost per unit.
In other words, the price that competitors set for the goods is not taken into account.
As a result, a company may set a price that is much higher than that of its competitors leading to a decrease in sales.
Another disadvantage is that a company may not adequately set its markup and end up generating less returns than it thought it could generate.
If the cost per unit goes up and the company cannot adjust its sales price, its profit margin will quickly chip away.
The third disadvantage is that when companies know that they can always fix their prices above cost and have a stable return, they may no longer focus on efficiency and competitiveness.
As a result, the company may slowly lose its edge in the market and end up seeing competitors produce more and lower costs per unit.
Cost Plus Pricing Example
Let’s look at an example of how cost plus pricing works in practice.
Let’s assume that a company produces canned soup.
Here are the costs that the company has to assume for producing and distributing its canned soups to grocery stores and retailers:
- Cost of goods sold: $2.00 per unit
- Labor cost: $0.15 per unit
- Overhead costs: $0.15 per unit
- Distribution costs: $0.50 per unit
The total cost to the company is $2.80 per unit of canned soup.
The company can choose to sell the canned soup at $3.08 representing a 10% markup over its cost.
You take $2.80 cost per unit X 10% = $0.28.
You add $0.28 markup to your unit cost and get $3.08 per unit.
Cost Plus Pricing FAQ
What is a cost plus pricing strategy?
A cost plus pricing strategy involves setting a sales price by adding a markup to the production cost for every unit.
With this strategy, you add up all your costs such as material costs, labor costs, overhead costs, and all other direct costs, and add a markup percentage.
For instance, if your cost per unit is $20, you may choose to mark it up by 25%.
Based on that, you’ll sell each unit at $25.
Who should use cost plus pricing?
For many businesses, setting prices strictly on a cost plus pricing method may not be ideal.
In some industries, if the production costs are relatively stable over time and a company has predictable sales volume, it can be justified to use this strategy.
However, most companies will consider other pricing strategies that consider the competitors, supply and demand, along with the market rates.
What is the difference between cost plus pricing and value based pricing?
When you set your prices based on a “cost plus pricing” strategy, you are looking at your costs per unit and you are marking it up.
On the other hand, when you are using “value-based pricing”, you are looking at the customers’ perceived value and set your price according to that.
For example, a software product may be priced based on the value obtained by the client instead of the company’s development cost.
How do you calculate cost plus pricing?
Calculating your sales price by using cost plus pricing is quite easy.
First, you should calculate your total cost for producing your goods or offering your services.
Then, you divide your total cost by the total number of units you have produced.
Then, you use that cost per unit and multiply it by a markup percentage to get your selling price.
So there you have it folks!
What is cost plus pricing?
In a nutshell, cost plus pricing is a simple pricing method where a company sets the price for its goods and services based on a fixed rate over and above its cost per unit.
Every company tracks its production cost per unit to calculate its profitability.
If a company wants to have a stable profit margin, it can consistently sell its goods based on a markup over its costs.
This type of strategy is easy to use as the company internally has all the data it needs to set its prices.
On the other hand, this pricing strategy does not consider any other variables like competitor’s prices, market conditions, and so on.
Now that you know what cost plus pricing is and how it works, good luck with your research!
I hope you enjoyed this article on Cost Plus Pricing! Be sure to check out more articles on my blog. Enjoy!
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