Cost-plus pricing is one method used by companies to determine the selling cost of their products. It differs from market-based pricing, which is determined more on the customer's perceived value of the product. While cost-plus pricing may provide more stability, since it is not dictated by market trends, this pricing method presents some disadvantages.
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To determine a price using cost-plus pricing, calculate the estimated cost. Divide the fixed cost by the estimated sales, then add the variable cost per unit, which is based on the cost of items such as raw materials or labour which can change as production increases or decreases. For example, if your fixed cost to produce an item is £6,500, your variable costs are £1,300, and your estimated unit sales are 6,000, add the two cost figures together and get £7,800. Divide £7,800 by 6,000 units, which means your cost would be £1.30 per unit. If your desired profit margin is 20 per cent, you would take £1.30 times .20 and get 40 cents, meaning your final unit cost would be £1.50.
A major problem with cost-plus pricing is that it requires high accuracy when determining costs. If businesses are not able to do this, there could be a large discrepancy between actual and estimated costs, which means that may not be able to recover their costs, thus lowering profitability.
Another potential disadvantage of this method is that it depends a great deal on assumption. Two components of the formula are variable costs and estimated sales, so if the actual results of one or both of these figures turn out to be far different, then the whole cost structure could prove to be inaccurate.
Since the formula dictates that profits rise as costs rise, there may be less incentive for companies to keep costs under control, resulting in customers paying inflated prices for the product. For example, in the above example, if variable costs actually turn out to be £1,950, the unit cost would be £1.40 instead of £1.30, meaning the final unit cost would be £1.50.
Conversely, if the customer places a higher value on the product and would be willing to pay more than what the cost-plus pricing formula dictates, the business could be losing out on additional profits. This type or pricing also does little to account for competition pricing and actual demand.
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