Business, Legal & Accounting Glossary
Cost-plus pricing is a pricing method used by firms. It is used primarily because it is easy to calculate and requires little information. There are several varieties, but the common thread in all of them is that one first calculates the cost of the product, then includes an additional amount to represent profit. Cost-plus pricing is often used on government contracts and has been criticized as promoting wasteful expenditures.
The method determines the price of a product or service that uses direct costs, indirect costs, and fixed costs whether related to the production and sale of the product or service or not. These costs are converted to per-unit costs for the product and then a predetermined percentage of these costs is added to provide a profit margin.
There are several ways of determining cost, and the profit can be added as either a percentage markup or an absolute amount. One example is:
P = (AVC + FC%) * (1 + MK%)
An alternative way of doing a similar calculation is:
P = (AVC + FC%) / (1 − MK%)
It should be noted carefully that any pricing on a cost-plus contract can be audited by the government (see DCAA). How to do this pricing, what items can be included, and how the calculations are to be made is governed by the FAR (or Federal Acquisition Regulations). Failure to follow the precepts of FAR can lead to decreased contractor revenue or, in extreme cases, claims of penalties against the contractor under the False Claims Act and Contract Disputes Act.
To make things simpler, some firms, particularly retailers, ignore fixed costs and just use the purchase price paid to their suppliers as the cost term. They indirectly incorporate the fixed cost allocation into the markup percentage. To simplify things even further, sometimes a fixed amount is applied rather than a percentage. This fixed amount is usually determined by head-office to make it easy for franchisees and store managers. This is sometimes referred to as turnkey pricing.
Another variant of cost-plus pricing is activity-based pricing. This involves being more careful in determining costs. Instead of using arbitrary expense categories when allocating overhead, every activity is linked to the resources it uses.
Cost will need to be recalculated and the percentage markup will likely need to be adjusted as the product goes through its life cycle. This is sometimes referred to as product life cycle pricing, although it is seldom done deliberately or in a planned and organized manner. Price skimming and penetration pricing are also types of product life cycle pricing but they are demand-based pricing methods rather cost-based.
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This glossary post was last updated: 19th April, 2020 | 3 Views.