What is Cost-Plus Pricing Strategy?
Cost-Plus Pricing is a pricing strategy wherein a business determines the selling price of its goods and services to meet a target profit margin, with an embedded markup attached.
Under the cost-plus pricing strategy, the selling price of a product is calculated by adding a markup percentage (or premium) to the total cost of producing a product, expressed on a per-unit basis.
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How Does Cost-Plus Pricing Work?
The cost-plus pricing strategy is characterized by establishing the selling price (or sale price) to cover the costs attributable to the production and delivery of the product, with a premium to ensure a predetermined profit margin is met.
The core objective of cost-plus pricing is to ensure that the selling price covers the incurred costs (or “break-even”) with sufficient excess profit earned per unit sale to meet a target profit margin.
The underlying intuition behind cost-plus pricing is that the selling price should, at a bare minimum, cover all costs incurred, first and foremost.
By inserting a markup percentage (“premium”) to the sale price—the company ensures that each customer conversion, or sale, recoups the initial costs incurred, followed by a profit deemed sufficient on each unit sold.
However, the drawback to the cost-plus pricing method is not that implied sale price might not be competitive (i.e. not enough market demand at the price point), or poorly align with the perceived value from the perspective of customers.
To mitigate the risks of cost-plus pricing, companies can “blend” the method in combination with other pricing strategies, such as value-based pricing or competitive pricing, akin to a sanity check.
Therefore, conducting market research on competitor pricing, quantifying the estimated customer willingness to pay (i.e. relationship between price and demand), and analyzing the value proposition of the product relative to competing offerings in the market are each necessary for a company to refine its pricing strategy.
How to Calculate Cost-Plus Pricing
In order to set the price, the company starts off by calculating the total cost per unit, which is inclusive of all direct costs like materials and labor, and indirect costs such as overhead expenses.
The conversion of a company’s direct costs to a per-unit basis is relatively straightforward; however, indirect costs must be allocated across each unit based on the production volume or labor hours.
The markup percentage—which bridges the gap between the breakeven point and representing the target gross profit margin—is added to the total cost to arrive at the selling price thereafter.
The markup amount, expressed in dollar figures, is equal to the total cost per unit multiplied by the sum of one of the markup percentage.
In short, the markup is the premium applied to the sale price for the production and distribution of the product to be economically feasible.
If the total cost incurred to produce and deliver a good or service exceeds the profit earned on a per-unit basis, the negative profit margin is unsustainable over the long-term, exceptions aside (e.g. intentional “loss-leader” to capitalize on upselling or cross-selling opportunities later down the line).
The step-by-step process to calculate the selling price using the cost-plus method are as follows:
- Step 1 ➝ Determine Total Cost Per Unit (Direct Cost per Unit + Indirect Cost per Unit)
- Step 2 ➝ Set the Desired Markup Percentage Based on Target Profit Margin
- Step 3 ➝ Estimate the Selling Price (Multiply the Total Cost Per Unit by 1 + Markup Percentage)
Cost-Plus Pricing Formula
The cost-plus pricing formula can be expressed as the total cost per unit multiplied by the sum of the markup percentage and one.
The formula consists of two key components:
- Total Cost per Unit ➝ The total cost comprises the direct and indirect costs from producing and distributing products, expressed on a per-unit basis.
- Markup Percentage ➝ The markup percentage is set based on the target profit of the company, and is added to the total cost per unit to determine the selling price.
For example, if the total cost per unit is $100 and the desired markup percentage is 25%, the selling price would be calculated as follows:
- Selling Price = $100.00 × (1 + 25%) = $125.00
The markup pricing is added to the total cost per unit, which comes out to a selling price of $125.00 per unit.
Cost-Plus Pricing: What are the Pros and Cons?
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Cost-Plus Pricing Calculation Example
Suppose we’re tasked with establishing the prices of a niche industrial B2B equipment manufacturer that produces specialized machinery.
The company incurs the following costs to manufacture one unit of a new product line introduced to the market.
Machinery Costs (Per Unit)
- Direct Materials and Components = $12,000
- Direct Labor Costs for Assembly = $6,000
- Allocated Overhead Expenses = $7,000
- Total Cost per Unit = $12,000 + $6,000 + $7,000 = $25,000
The management team of the manufacturer has established a standard markup of 60% on cost for this particular product line to achieve its profitability targets for 2024.
Upon inserting our cost assumptions into the formula, we arrive at an estimated selling price of $40k per unit.
- Selling Price = $25,000 × (1 + 60%) = $25,000 × 1.6 = $40,000
Given the implied selling price of $40,000 and a total cost of $25,000, the manufacturer earns a profit of $15,000 per unit sale, equating to the targeted 60% markup on cost.
However, the company should not rely solely on cost-plus pricing. Assessing the competitiveness of the $40,000 price point in the market is crucial. If competitors offer similar machines at lower prices or if customers perceive the value of the machine to be lower than the cost-plus price, the manufacturer may need to adjust its pricing strategy.
Conversely, if the machine offers unique features or superior performance compared to alternatives, the manufacturer might have an opportunity to command a higher price and potentially improve its margin profile from the increased markup percentage (i.e. pricing power).
In closing, our interactive exercise demonstrates the utility of the cost-plus pricing strategy, where the method can establish pricing, or serve as a starting point — where further adjustments are applied from an optimization standpoint upon analyzing the competitive landscape, market dynamics, and perceived value from the target end market.