Cost-plus pricing is a pricing strategy by which the selling price of a product is determined by adding a specific fixed percentage (a "markup") to the product's unit cost. Essentially, the markup percentage is a method of generating a particular desired rate of return. An alternative pricing method is value-based pricing.
Cost-plus pricing has often been used for government contracts (cost-plus contracts), and has been criticized for reducing incentive for suppliers to control direct costs, indirect costs and fixed costs whether related to the production and sale of the product or service or not.
Companies using this strategy need to record their costs in detail to ensure they have a comprehensive understanding of their overall costs. Costco reportedly created rules to limit product markups to 15% with an average markup of 11% across all products sold.
Rationale
Buyers may perceive that cost-plus pricing is reasonable. In some cases, the markup is mutually agreed upon by buyer and seller. For markets that feature relatively similar production costs, companies do not have a dominant strategy. Therefore, cost-plus pricing can offer competitive stability, decreasing the risk of price competition (such as price wars), if all companies adopt cost-plus pricing. The strategy enables price changes to goods and services relative to increases or decreases in the product cost which are simple to communicate and justify to customers. When there is little market intelligence, the use of a cost-plus pricing strategy compensates for the lack of information by setting prices based on actual costs. This method is generally adopted by retail companies such as grocery or clothing stores. In spite of its ubiquity, economists rightly point out that it has serious flaws. Specifically, the strategy requires little market research hence it does not account for external factors such as consumer demand and competitor's prices when determining an appropriate selling price. To compensate for this, some economists have tried to apply the principles of price elasticity to cost-plus pricing.
We know that:<blockquote>MR = P + ((dP / dQ) * Q)</blockquote>
where: <blockquote>
MR = marginal revenue<BR>
P = price<br />
(dP / dQ) = the derivative of price with respect to quantity<BR>
Q = quantity</blockquote>
Since we know that a profit maximizer sets quantity at the point that marginal revenue is equal to marginal cost (MR = MC), the formula can be written as:<blockquote>MC = P + ((dP / dQ) * Q)</blockquote>
Dividing by P and rearranging yields:<blockquote>MC / P = 1 +((dP / dQ) * (Q / P))</blockquote>
And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:<blockquote>(P / MC) = (1 / (1 – (1/E)))</blockquote> where:<blockquote>(P / MC) = markup on marginal costs<BR>E = price elasticity of demand</blockquote>
In the extreme case where elasticity is infinite:<blockquote>(P / MC) = (1 / (1 – (1/999999999999999)))<BR> (P / MC) = (1 / 1)</blockquote>Price is equal to marginal cost. There is no markup.
At the other extreme, where elasticity is equal to unity:<blockquote>(P /MC) = (1 / (1 – (1/1)))<BR> (P / MC) = (1 / 0) </blockquote>The markup is infinite.
Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):<blockquote> (P / AVC) = (1 / (1 – (1/E)))</blockquote> Technically, AVC is a valid substitute for MC only in situations of constant returns to scale (LVC = LAC = LMC).
When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be, and often are, considering the price elasticity of demand, whether consciously or not.
See also
- Marketing
- Markup (business)
- Microeconomics
- Outline of industrial organization
- Price elasticity of demand
- Pricing