Markup percentages are an important part of business. Using the right markup on products and services ensures that companies earn enough profits to remain in business. The cost-plus markup is widely used because it's simple and easily applied to a variety of business situations. Although easy to calculate, it has some significant advantages and disadvantages.
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Cost-plus pricing is a retail markup used by many companies when pricing products and services on contracts. Cost-plus pricing is fairly simple; sometimes the hardest part is ensuring that an accurate cost is used when calculating the markup. After determining the proper cost of a product or service, the cost-plus formula is applied to calculate the price.
Two basic forms of cost-plus formulas are used by businesses. The first one is a standard retail formula, the second a more detailed manufacturing formula.
Price = Cost + (Markup percentage x Cost)
Price = (AVC x FC%) x (1 + Markup %) AVC = average variable cost FC% = percentage of fixed costs allocated to each product
The second formula is subject to changes based on how manufacturing costs are allocated by the accounting department.
Cost-plus pricing has several benefits: ease of calculation, limited, predictable costs applied to contracts and fair pricing. These benefits work hand-in-hand for companies using cost-plus pricing on customer contracts. The first two benefits are easy for field reps and accounting to calculate, because limited information is needed for the formula. The last two benefits ensure that clients know the amount they're paying for each service or product. Additionally, the more they purchase, the more they can expect to pay.
Some disadvantages occur when using cost-plus pricing--such as no efficiency standards, lack of competitive pricing, and using standard output for allocating fixed costs. Similar to the benefits, the disadvantages can work when pricing client contracts. Because the price is based on product cost, costs may escalate due to inefficient production--and the inefficiency is passed along to the client. This may allow a competitor to price the products lower than the original company and take away the business opportunity. Allocating fixed costs is also important, because an improper allocation can raise the selling price of goods.
Cost-plus pricing is very popular on government contracts because of its simplistic calculation process. However, many cost-plus contracts accepted by the government are subject to several audits to ensure against inflated costs. The Defense Contract Audit Agency (DCAA) is one example of a government audit agency; the DCAA reviews and audits defence contracts for improper costs that are passed on to the government. Other government agencies exist to audit contracts with different sectors of the private market.
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