accounting

# Cost-plus pricing: What is it and when to use it

## What is cost-plus pricing?

Cost-plus pricing involves calculating the cost of production and adding a markup percentage to determine the selling price of the product.

Figuring out how to price your products can be a time-consuming process. However, certain pricing strategies can make it easy (or at least easier). Cost-plus pricing, aka markup pricing, is one of several methods you can use to determine a product’s price. However, compared to other strategies, such as competitive pricing or dynamic pricing, it only considers factors under the company’s control.

The best thing is you can calculate it using just info from your accounting software. Let’s dive into exactly how to calculate your prices using cost-plus pricing:

## How to calculate cost-plus pricing

Cost-plus pricing looks at all the costs to produce a single unit of product. You then add a markup percentage to arrive at the final selling price. The exact markup percentage varies, depending on what the company considers a reasonable profit.

Compared to pricing other production processes, cost-plus pricing is one of the easiest to calculate. It doesn’t require any competitive analysis or research. Most of the information you’re likely already tracking.

The formula for cost-plus pricing formula is:

([Direct material costs + direct labor costs + overhead] / number of units) x (1 + markup percentage)

Note that direct material and direct labor costs are also known as variable costs, while overhead are the fixed costs. To calculate cost-plus pricing, follow the three steps below:

### 1. Find your total costs

The first step is to determine how much it costs to produce a certain quantity of products. To get your total cost, add together:

• Direct material cost: These are the costs of materials you use to produce a product.
• Direct labor cost: This is the cost of ‌labor to create the product
• Overhead costs: These are operational costs that aren’t directly tied to the final product, such as rent and utilities.

This will give you the total cost of producing one unit of your product or service.

### 2. Divide costs by units

Take the total production cost and divide it by the number of units in the given batch. This results in the cost per unit. For example, if your costs were \$1,000 and you made 100 units, your cost per unit would be \$100 (\$1000 / 100).

FYI: Cost-plus pricing focuses solely on costs within the company without taking consumer demand, perceived value, or competitor prices into account.

### 3. Multiply by your markup

This last step requires some consideration. While there are suggested industry markups, the exact markup percentage is up to you. A markup (versus margin) is the difference between the cost of your product and its selling price (aka your profit).

Markups are typically a percentage. The higher the markup percentage, the greater your profit for every product you sell. You’ll multiply the cost per product (calculated in the previous step) by your markup percentage. The result is the product’s cost-plus price.

FYI: A company can have different markup percentages for different products.

## Cost-plus pricing example

The following cost-plus pricing examples show how to apply the cost price formula in two different instances:

### Manufacturer example

Say a manufacturer makes 100,000 picture frames for sale. The entire production incurs \$150,000 in direct material costs, \$250,000 in direct labor costs, and \$100,000 in overhead costs. Here’s how the manufacturer calculates ‌cost-plus pricing:

• Add up the total cost of producing the picture frames:
• \$150,000 + \$250,000 + \$100,000 = \$500,000

• Divide the total cost by the number of produced units to get the cost per product:
• \$500,000 / 100,000 = \$5

• Multiply the cost per product by the markup percentage. At a 100% markup percentage, the calculation is:
• \$5 * (1 + 1.00) = \$10

The resulting cost-plus price for one picture frame is \$10, which includes a profit of \$5.

### Retailer example

Now consider a small grocery store that uses variable cost-plus pricing to profit from selling wholesale goods. It purchases 1,000 bottles of juice at wholesale for \$4,500. It expects to sell the water within a week. Here’s how it calculates its cost-plus pricing:

• The total cost of the water is \$4,500.

• Divide the total cost by the number of units: to get the cost per product:
• \$4,500 / 1,000 = \$4.50

• Groceries operate in an industry with competitive prices and high-volume sales, so they limit their markup percentage to 15%. The calculation for the final selling price is:
• \$4.50 * (1 + 0.15) = \$5.18 per bottle

For the grocery store, the variable cost-plus pricing for a bottle of juice is about \$5.18 (with a profit of \$0.68).

## Pros and cons of cost-plus pricing

Cost-plus pricing offers several advantages for both companies and consumers. The three most common ones are:

• Simple to use: One of the most popular reasons for using cost-plus pricing is that it requires the least effort. There’s no need to do competitor analysis or customer research. With only a company’s existing data and a few simple calculations, you can easily perform cost-plus pricing.
• Covers costs: Including only two factors in the cost-plus pricing formula—cost and markup—allows you to cover costs for all products you sell. Assuming all costs are correct and you use a logical markup percentage. In that case, the cost-plus pricing strategy can generate a consistent and positive rate of return.
• Easy to explain: Cost-plus pricing is inherently clear, which makes it easy for potential consumers to see what they’re getting in terms of price and quality.

An added benefit is that you can easily explain any price increase by a corresponding increase in cost. By being upfront about adding a fixed margin to their costs, a company offers a value proposition of transparency and builds trust in the market.

But like any business strategy, cost-plus pricing comes with its share of disadvantages, such as:

• Might not cover all costs: A company’s cost estimates and sales projections must‌ be accurate for cost-plus pricing to bring in the expected profit. If there are any unanticipated cost increases, such as equipment malfunctions or unsold products, a company may end up operating at a loss. For this reason, it’s beneficial to revisit cost-plus pricing regularly as you continue to grow.
• Can lead to inefficient operations: If a company passes all costs on to the consumer, it may not have the incentive to optimize operations. It may continue to produce without considering better materials or methods, leading to uncompetitive and overpriced products.
• Doesn’t take advantage of profit maximization: When pricing takes an inside-out approach, a company loses the opportunity to align with consumer demands or market conditions. In some cases, cost-plus prices may be too high to be competitive or too low to maximize profits.

Note that cost-plus pricing is especially disadvantageous for SaaS or subscription-based companies, where the cost-plus model doesn’t fully represent the service’s value.

## Should you use cost-plus pricing? 3 considerations

As a business owner, pricing strategies are critical to the success of your small business. Cost-plus pricing is popular for many reasons, but is it the right pricing strategy for your business? Here are three considerations to keep in mind:

• Are you creating a new product or service? If you have a new product or service, it might be impossible to plan demand. This also means the costs might be unknown. It’s difficult to price your product using a set markup when you’re unsure of the costs it’ll take to produce. And if demand is low, you may need to lower your price to sell your product or service.
• What is the competition charging? It's important to consider what your competitors are charging for similar products or services. If your competitors are charging lower prices, you may need to lower your price as well to stay competitive.
• Do you need to generate a set profit? Some industries require flexibility in pricing. For example, in the retail industry, customers are often very price-conscious, meaning they are very picky about price. In this case, cost-plus pricing may not be the best strategy, as you may be pricing your products too high.

Overall, cost-plus pricing can be a good pricing strategy in some cases. However, it's important to consider the demand for your product or service, the industry you’re in, and your competition before deciding whether to use this pricing strategy.

FYI: Cost-plus pricing is often used by manufacturers and retailers of products common in the market, such as apparel, groceries, and hardware supplies.

## Cost-plus pricing best practices

To get the most out of cost-plus pricing, you’ll want to do the following:

• Have a clear understanding of your production costs—recall that production costs include the variable and fixed costs of your product or service.
• Determining the true cost per unit will help you calculate the appropriate markup percentage to set your selling price profitably.
• It's also vital to keep your eyes on the competition when setting your product prices. Understanding your competitor's pricing strategy will enable you to set your markup percentage in line with industry standards, giving you an edge in the market.
• You’ll also want to listen to customer feedback to ensure you’re meeting their needs.

Don’t forget to consider external factors such as economic changes, regulations, and the availability of raw materials when creating your cost-plus pricing strategy.

Cost-plus pricing is particularly beneficial for companies with a significant cost advantage or the intent to offer transparent pricing and for one-off projects or services.

## Streamline your accounting and save time

Out of the many pricing strategies available, cost-plus pricing is a popular option and remains one of the easiest to use. It offers a quick approach to determining a final sales price. Even without industry know-how, companies of all sizes can use it for nearly any product.

Cost-plus pricing is especially helpful if you’re job costing or projecting profitability, which you can do with accounting software like QuickBooks.

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