2018-02-27 14:02:58SalesEnglishCompare fixed pricing with cost-plus pricing. Review the pros and cons of these pricing models, and get tips on how to calculate cost-plus...https://quickbooks.intuit.com/ca/resources/ca_qrc/uploads/2018/02/Man-Examining-Fixed-Cost-Contracts.jpghttps://quickbooks.intuit.com/ca/resources/sales/fixed-price-cost-plus-contracts/Fixed-Price Versus Cost-Plus Contracts

Fixed-Price Versus Cost-Plus Contracts

3 min read

How much should you charge for your products or services? When you work for yourself, that can be one of the hardest questions to answer. In addition to narrowing in on the right numbers, you also have to decide how you are going to set up your contracts. Luckily, there are lots of options, and to get started, you may want to consider fixed and cost-plus pricing.

Fixed Pricing

Fixed pricing assigns a set price to a product or service. For instance, if you’re a taxidermist, you might set a fixed price of $500 for a deer head mount and $900 for a caribou head. If you’re a welder, you might set a fixed rate of $1,000 for making a truck grille with a winch. Regardless of how long the job takes or how many extra supplies you need to buy, the price stays at these levels, and the contract doesn’t change.

Cost-Plus Pricing

In contrast, contracts with cost-plus pricing use rates that change depending on the costs incurred, and there are multiple calculations you can use. The simplest formula multiplies the cost of materials by the markup rate plus one. To continue with the example above, imagine a taxidermists uses $100 worth of materials such as wood, a form for inside the deer’s head, and random hardware, and they apply a 400 percent markup for their services. When you add one to 400 percent, it becomes 500 percent, and when multiplied by the cost of materials, that leads to $500.

As you can see, this is the exact same amount the taxidermist charged as their fixed rate, but with this approach, the costs are built into the contract. If they end up being unexpectedly high, the taxidermist charges more and preserves their profit margin.

To give you another example of how this works, imagine a widget manufacturer uses $100 of supplies and applies 30 percent markup. To calculate cost-plus pricing, the formula looks like $100 x (1 + .30) = $130. If the price of supplies increases to $150, the formula changes to $150 x (1 + .30) = $195. In the first example, the widget maker earned a profit of $30, and in the second example, they earned a profit of $45, but their markup stayed the same.

On your contracts, you can tweak this formula to account for all kinds of variables. For instance, if you want to include overhead costs, add them together for the year. Then, multiply the total by the percentage of costs you plan to allocate to this project. Imagine you’re doing a project that should take a week. That’s 2 percent of a year, so you add in 2 percent of your overhead costs to your cost-plus contract.

Fixed Pricing Versus Cost-Plus Pricing

With fixed pricing, your clients know exactly how much they are going to pay, and that can be extremely reassuring to them. You also know how much you are going to get paid, but if supplies end up costing more than usual or if the project takes longer than expected, you end up taking the hit to your profits.

In contrast, with cost-plus pricing, the customer’s price changes if the cost of supplies increases. This set-up helps to protect you, but it can turn off clients who want predictable costs.

Both fixed and cost-plus contracts have pros and cons. Ultimately, you need to decide which approach works best for your bottom line, and you need to balance your needs with your clients’ expectations. On top of that, do some research to see which type of pricing is standard for your industry, and either toe the industry line by using the standard pricing model or get an edge on the competition by offering something different. Alternatively, take a completely different approach to pricing, and let clients pay what they want.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

Related Articles

Your Small Business Accounting Guide

Whether you handle your accounting by hand with a ledger or use…

Read more

Internal Reporting: How to Perform Cost Assignment

As a small business owner, you should know the true cost of…

Read more

Understanding Cost Behavior Classifications

When you run a small business, cost behaviour impacts how you price…

Read more