For a firm to be a commercial success, its sales price for a product should reflect the costs of production while tacking on a profit margin. A basic approach to pricing is the cost-plus method in which an entrepreneur calculates her total cost for producing and distributing a good. She then divides the total cost by the number of units she produces to arrive at the cost per unit. This is known as the break-even point. She adds a profit margin to the total cost to arrive at the price at which she sells to customers. The profit margin must not be exceed what customers are willing to pay.
Easy to Calculate
A major benefit of cost-plus pricing approach is that it is easy to calculate the cost of production. The entrepreneur has the information handy and can refer to it. He knows what inputs went into producing a good and the costs of each. He also knows the profit margin he is seeking and can add this markup to the cost to arrive at a price.
Reflects Cost Changes
During times when costs are rising, cost-plus pricing helps fight the effects of inflation. When costs are declining, this too will be reflected in a cost-plus pricing approach. Suppose a firm is producing sweaters and finds that the cost of wool has risen. The firm using cost-plus pricing will be able to reflect this additional cost in its price. Similarly, if the cost of wool drops, the production cost declines. The firm’s price will go down
Compared with other more sophisticated pricing strategies, cost-plus is a basic approach. The business using this approach assumes that it can pass on all the costs of production to its consumers and make a profit. It is an easy concept to put into practice in the case of everyday products. There are other strategies that account for more complex real-world situations. For instance, a firm could employ a strategy in which its price may not reflect all its costs of production while it tries to gain market share in a competitive market. Or a firm that wants to gain market share in a competitive market could come up with a price tag and then work backward to control its costs. In another scenario, a firm that produces a premium good could charge a premium price that reflects more than just the cost of production and a profit margin.