Cost-plus pricing is a description of several types of pricing methods used by companies that require relatively little information. In cost-plus pricing, you calculate the cost of the product and then an additional amount is included to represent the profit percentage. Government contracts often feature cost-plus pricing, despite accusations that it promotes wasteful spending. Cost-plus pricing is in contrast to demand-based pricing, which is when firms try to use the economics of supply and demand to set the profit-maximizing price.
The method uses the direct, indirect and fixed costs of the production of a product or service, although one of the failures of the model is that it includes all costs, whether related to the actual production, marketing or sale of the product or not. The method also requires that the firm select a desirable markup percentage, which will then be applied to costs. In the United States, cost-plus contracts can be audited by the government by the Defense Contract Audit Agency, because specific rules govern on how cost-plus pricing should be applied, what items are included in pricing and how calculations are to be made.
One equation used to come up with cost-plus prices is: P = (AVC +FC%)* (1+ MK%), where P = price, AVC = average variable cost, FC = percentage apportionment of fixed costs, and MK% = percentage markup. Variable costs are those that vary as the output level varies, and fixed costs are costs that do not vary with the level of output. Fixed costs include costs such as property, equipment and labor. AVC or average variable cost is variable cost divided by level of output.
Calculations are easy using cost-plus methods, as evidence by the following example using a small retail bicycle firm as a model. If the variable cost of obtaining a new bicycle from suppliers is, on average, $100/bike (AVC = $100), and you have to cover a fixed cost of $10,000/ month to keep your business solvent (which includes rent, employee pay, utilities and other costs of doing business). If you estimate selling about 1,000 bikes in a month, this makes your percentage apportionment of fixed costs on each bike $10,000/1,000, or $10/bike (FC% = $10). If the bike firm is interested in a markup percentage of 30 percent (MK% = 30), the formula would yield P = (100+10)*(1+.30) = $143/bike. This means that on average, when the bike store sells a bike for $143 they will earn an average of $33 dollars on the sale.
There are a few variations of cost-plus pricing. First of all, using different equations to apply the percentage markup is common practice, and leads to different results. For example, our formula adds the markup percentage of total costs on top of total costs to get selling price. If the equation is changed to P = (AVC +FC%)/(1-MK%), total costs will be 1-MK% of the selling price, and will yield different results. Turnkey pricing is a variant of cost-plus pricing, and refers to applying a fixed amount of profit to the cost of a good, sometimes ignoring everything but purchase price of the goods from suppliers, and is popular with franchises and retailers. Activity-based pricing is another variant of cost-plus pricing, and involves matching up activities with the costs associated with that activity, and aggregating costs to try to determine price.
Cost-plus pricing has several benefits, but drawbacks include times when demand-based pricing methods would be more successful. Cost-plus pricing systems are easy to administer and calculate, and require only minimal information while preventing runaway or unexpected costs. Problems include a lack of incentive for efficiency in resource consumption, and a lack of consideration for both consumers and competition. Further, sunk costs (expenditure that has been made and cannot be recovered) and opportunity costs (costs associated with opportunities that are forgone when a firm's resources are put to their best alternative use) are not differentiated in cost-based pricing from other forms of cost, probably leading to inefficient outcomes. Finally, the use of cost-plus pricing in government contracts is debated because it does not provide incentives to cut costs (costs are always covered by the client).