Cost-Plus Pricing

Firms use different types of pricing strategies in determining the market price they will be assigning their products and services. Several factors are considered in making the price decisions. Some of the pricing strategies being used are premium pricing, competitive pricing, value pricing, and cost-plus pricing. It is important to choose the most appropriate pricing strategy for the products and services being offered. “Selecting a pricing strategy for [the] product is critical, because price is the most highly visible element of all marketing efforts.

Consumers and competitors easily can access pricing information on goods sold at the retail level” (Giddens et al, 2005). This paper will focus on the most common pricing strategy being used which is cost-plus pricing. The said strategy will be described in detail with a scenario applying cost-plus pricing; the advantages and disadvantages will also be discussed. Cost-Plus Pricing All firms selling any type of products and/or services need to determine the right selling price in order to maximize profit.

The most common and widely used pricing strategy is the so-called Cost-Plus Pricing. Most beginners in the industry use this type of pricing technique as it seems to be the easiest one to do. But before describing this specific pricing strategy, it would be best to define the terms involved in the discussion. The total amount to be spent on making the product is the cost of the product. This would include the overhead expenses as well such as employee salaries, utility bills, and other miscellaneous expenses relating to the making or manufacturing of the product.

The amount the customer or the buyer pays for the product or service is the price. The price should, of course, be greater than the total cost of the product in order to earn profit. The difference of the price and cost determines the profit for that product. Value, on the other hand, is the worth of the product and/or service to the customer. Knowing these definitions and from the name “cost-plus pricing” itself, this pricing strategy can easily be described as a product pricing determined by adding an additional amount to the total cost of the product.

That additional amount represents the desired profit for each product. This additional amount for the profit can be a percentage of the total cost or can just be set arbitrarily by the owner or maker of the product. There are also some considerations and things to be factored in when deciding for the final price of the product using this strategy. For one, the total cost of the product may not be a fixed amount all the time as prices of raw materials may also change every now and then.

The common formula used to compute for the product price using cost-plus pricing is: Price = (Ave. Variable Cost + %Fixed Cost) * (1 + %Markup) (Wikipedia, n. d. ) Given that total product cost may change, the formula above takes that into consideration and adds a certain percent of fixed cost depending on the variability of the product cost. The percent markup is dependent on the desired markup of the product manufacturer or firm owner. The formula above is just one example of how cost-plus is done. There are actually different methods of doing cost-plus pricing.

The above formula is the so-called standard markup pricing where “the selling price is the result of adding a fixed profit percentage, called markup, to the fixed cost of the product” (McCalley, 1996). The scenario below is a simple illustration of this cost-plus method: The materials used to manufacture a pen cost $10 while the labor and other overhead costs incurred per pen manufactured summed up to $5. Therefore, the total product cost is $15. The percent markup set by the manufacturing company for this pen is 50%.

Therefore, the total price of the pen is calculated as: $15 * (1 + 50%) = $22. 50. The profit (markup) for the pen, therefore, is $7. 50. Another method of calculating cost-plus pricing is basing the profit margin from the selling price instead of adding to the cost. Using the same scenario above, this method is illustrated as follows: The total cost of the pen is $15 and the selling price is $50. This means that the profit margin decided upon was 33. 33% of the selling price. This percent is calculated as follows: ($22. 50 – $15) ? $22.

50 = 0. 3333 or 33. 33%. The first method shown is a markup or additional amount to the total cost, while the second method is a profit margin against the actual selling price of the product. Coming up with the profit amount may be calculated differently but their concepts are essentially the same which is cost-plus pricing. Advantages One of the major advantages of cost-plus pricing strategy is the ease of calculation of the cost and price amount. There are no complex computations and formulas to be used in determining the product price.

Another plus factor of this is that there is not much complex information in order to determine the product price. Beginners or junior level managers can definitely adopt this kind of pricing strategy. If there would be an increase in the product costs, price increase would be rightfully justified with this type of pricing strategy. Moreover, if competitors would be adopting the same pricing strategy, product price differences would not be that big and could also reach a stable state (tutor2u, n.

d. ). Disadvantages With advantages come disadvantages as well. Jensen (n. d. ) enumerated the following problems that may be encountered with the cost-plus pricing strategy: (1) “the price [established] may be so high that [the firm] will lose money through lost sales;” (2) “all cost-plus calculations require an estimate of sales to be accurate;” and (3) “cost-plus pricing can cause [the firm] to underprice [the] products or services – thus cheating [the] company of sales it could have earned.

” Jensen (n. d. ) recommends that a better pricing strategy would be to consider the real value of the product and its worth to the customer. References Giddens, N. , Parcel, J. , & Brees, M. (2005). Selecting an Appropriate Pricing Strategy. Retrieved March 9, 2007 from http://www. extension. iastate. edu/agdm/wholefarm/html/c5-17. html Jensen, M. (n. d. ). How To Avoid The Most Common Pricing Mistakes. Retrieved March 9, 2007 from http://www. 1000ventures.

com/business_guide/marketing_pricing_psychology_p1_mistakes. html McCalley, R. W. (1996). Marketing Channel Management: People, Products, Programs, and Markets. Westport, CT: Praeger Publishers tutor2u. (n. d. ). pricing – full cost plus pricing. Retrieved March 9, 2007 from http://www. tutor2u. net/business/marketing/pricing_costplus. asp Wikipedia. (n. d. ). Cost-plus pricing. Retrieved March 9, 2007 from http://en. wikipedia. org/wiki/Cost-plus_pricing