Cost plus pricing is a cost-based method for setting the prices of goods and services. Under this approach, you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to it a markup (an increase in the cost of a product to arrive at its selling price) percentage (to create a profit margin) in order to derive the price of the product. Cost plus pricing can also be used within a customer contract, where the customer reimburses the seller for all costs incurred and also pays a negotiated profit in addition to the costs incurred.
For example, if the sales of Apple's iPod are 2 million units, the average cost at that output level might be $100 per iPod. Assuming that the normal markup at the company is 70%, Apple's selling price for an iPod would be $170. The size of the markup is determined either by the company's targeted internal rate of return on investment or by perceived "industry convention."
Advantages:
- Simple. It is quite easy to derive a product price using this method, though you should define the overhead allocation method in order to be consistent in calculating the prices of multiple products.
- Assured contract profits. Any contractor is willing to accept this method for a contractual agreement with a customer, since it is assured of having its costs reimbursed and of making a profit. There is no risk of loss on such a contract.
- Justifiable. In cases where the supplier must persuade its customers of the need for a price increase, the supplier can point to an increase in its costs as the reason for the price increase.
Disadvantages:
- Ignores competition. A company may set a product price based on the cost plus formula and then be surprised when it finds that competitors are charging substantially different prices. This has a huge impact on the market share and profits that a company can expect to achieve. The company either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues.
- Contract cost overruns. From the perspective of any government entity that hires a supplier under a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures - on the contrary, it will likely include as many costs as possible in the contract so that it can be reimbursed. Thus, a contractual arrangement should include cost-reduction incentives for the supplier.
- Ignores replacement costs. The method is based on historical costs, which may have changed. The most immediate replacement cost is more representative of the costs incurred by the entity.
- Ignores value. Perhaps most importantly, cost-plus ignores the value your product or service provides. An LED Light Bulb for example may only cost £0.99 to produce, but is sold at £9.99 compared to a conventional light bulb which may only cost you a few pounds. The reason for this is because the LED gives the added value of reducing energy costs, and lasting longer thus being better for the environment. If a cost plus approach is used, you loose out on being able to charge a higher price.