November 30, 2020 Growing & Complex Businesses en_US Learn how your business can use cost-plus pricing to quickly price inventory and create transparency with customers. Read the complete guide from QuickBooks. https://quickbooks.intuit.com/cas/dam/IMAGE/A48B4KkIK/Cost-plus-pricing-tiered-pricing-and-building-a-profitable-company_featured.jpg https://quickbooks.intuit.com/r/growing-complex-businesses/pricing-strategies-models-cost-plus/ What is cost-plus pricing and how can you use it?
Growing & Complex Businesses

What is cost-plus pricing and how can you use it?

By Katrina Dalao November 30, 2020

Cost-plus pricing is one of the simplest ways to determine a selling price for your products. It takes the total production cost of a single unit, adds a fixed percentage on top, and you have your cost-plus price.

This straightforward pricing method focuses solely on costs within the company. Without taking consumer demand, perceived value, or competitor prices into account, cost-plus pricing allows companies to calculate prices quickly.

What is cost-plus pricing?

Cost-plus pricing (also referred to as markup pricing) is one of several methods you can use to determine a product’s price. Compared to other strategies, such as competitive pricing or dynamic pricing, it only considers factors under the company’s control.

Cost-plus pricing looks at all the costs incurred to produce a single unit of product. These include fixed and variable costs, specifically for any material, labor, and overhead. A markup percentage is then added to arrive at the final selling price.

The exact markup percentage varies, depending on what the company considers a reasonable rate of return. Sometimes, the markup percentage is set by both the client and the providing company, especially for client-based or contractual services.

What distinguishes cost-plus pricing is it disregards any external factors or estimations and sticks to business basics: Create something of value and price it above your costs.

Cost-plus pricing is often used by manufacturers and retailers of products common in the market (i.e., apparel, groceries, hardware supplies).

In these cases, production costs are generally standardized–and customers are accustomed to paying standard market prices.

If there’s no distinct value added by the company, the cost-plus pricing method can be a strategic choice. It allows companies to set a markup percentage they know brings a favorable return rate, leaving them free to focus on other business matters.

Three steps to cost-plus pricing

Compared to other pricing strategies, cost-plus pricing is one of the easiest to calculate. It doesn’t require any competitive analysis or research. Most of the information is likely already tracked by the company.

The cost-plus pricing formula is:

([Direct material costs + Direct labor costs + Overhead] / Number of Units) * (1 + Markup percentage) = Cost-plus price

Note: Direct material and direct labor costs are also referred to as variable costs, while overhead is typically a company’s fixed costs.

To calculate for cost-plus pricing, follow the three steps below:

1. Add the total cost

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
  • Direct labor cost
  • Overhead costs (operational costs that aren’t directly tied to the final product)

2. Divide the total cost by the number of units

Take the total production cost, and divide it by the number of units in the given production batch. This results in the cost per unit.

3. Multiply the unit cost by the markup percentage 

This last step requires some consideration. While there are suggested industry markups, the exact markup percentage is up to the individual company.

A markup is the difference between the cost of your product and its selling price. In other words, it’s your profit.

Markups are typically expressed as a percentage. The higher the markup percentage, the greater your profit for every product sold.

Multiply the cost per product (calculated in the previous step) by the selected markup percentage. The result is the product’s cost-plus price.

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

What is variable cost-plus pricing?

A type of cost-plus pricing is variable cost-plus pricing, which only factors variable costs into the formula.

Variable costs are costs that rise or fall in direct relation to the company’s production. Common variable costs are raw materials, packaging, and shipping fees.

Fixed costs, on the other hand, stay the same regardless of production (at least for the given period). Fixed costs are unavoidable and typically include rent, utilities, insurance, and depreciation.

By only calculating for variable costs, it’s expected for fixed costs to be covered in the markup percentage.

Variable cost-plus pricing works for companies with a high ratio of variable-to-fixed costs. With fixed costs being relatively low, a company can more easily tuck them into the markup percentage.

Additionally, variable cost-plus pricing can be applied if a company has excess production capacity. With all the fixed costs already covered, variable costs are the only items left to account for.

Cost-plus pricing examples

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

Manufacturer example

Say a manufacturer makes 100,000 picture frames for sale. For the entire production run, it incurs $150,000 in direct material costs, $250,000 in direct labor costs, and $100,000 in overhead costs.

Step 1: Add up the total cost of producing the picture frames. This is $150,000 + $250,000 + $100,000 = $500,000.

Step 2: Divide the total cost by the number of produced units: $500,000 / 100,000 = $5, which is the cost per product.

Step 3: Lastly, multiply the cost per product by the markup percentage. Using a 100% markup percentage, the calculation is $5 * (1 + 1.00) = $10.

The resulting cost-plus price for one picture frame is $10 (with a profit of $5).

Retailer example

In this second example, a small grocery store uses variable cost-plus pricing to profit from selling wholesale goods. It purchases 1,000 bottles of juice at wholesale for $4,500. It projects to sell the water within a week.

Step 1: The total variable cost is only the $4,500 spent for the water. All other expenses incurred by the grocery remain constant and are considered as fixed.

Step 2: Divide the total variable cost by the number of units: $4,500 /1,000 = $4.50, to get the cost per product.

Step 3: In an industry based on competitive prices and high-volume sales, groceries typically observe a maximum markup percentage of 15%. In this case, the calculation for the final selling price is $4.50 * (1 + 0.15) = $5.18 per bottle of juice.

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

Advantages of cost-plus pricing

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

It’s simple to use.

One of the most popular reasons for using cost-plus pricing is it requires the least amount of effort. There’s no need to do any research on your competitors or target consumers. With only a company’s existing data and a few simple calculations, you can easily arrive at cost-plus pricing.

It covers your costs, with a consistent profit.

Including only two factors in the cost-plus pricing formula–cost and markup–companies should be able to cover costs for every product sold. Suppose all costs are correct and a logical markup percentage is used. In that case, the cost-plus pricing strategy can generate a consistent and positive rate of return.

Prices are easy to explain and justify.

Cost-plus pricing is inherently clear, which makes it preferred by many consumers. Any potential consumer knows precisely what they’re getting in terms of price and quality.

Plus, any price increase can be easily explained by a corresponding increase in cost. By being upfront about adding a fixed profit margin to their costs, a company offers a value proposition of transparency and builds trust in the market.

Disadvantages of cost-plus pricing

Like any business strategy, cost-plus pricing comes with its share of disadvantages. Here are the key drawbacks to be aware of:

It 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.

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

There’s a chance it won’t cover all costs.

A company’s cost estimates and sales projections also need to be accurate for cost-plus pricing to bring in the expected profit.

If there are any unanticipated cost increases, such as equipment malfunctions, unsold products, or inventory shrinkage, a company may end up operating at a loss. For this reason, it’s recommended to revisit cost-plus pricing regularly as you continue to grow.

It can lead to inefficient operations.

If all costs are simply passed on to the consumer, there’s no incentive for a company to optimize its operations.

It can continue producing anything it wants without considering better materials or methods, leading to uncompetitive and overpriced products.

When does cost-plus pricing make sense for a business?

Cost-plus pricing offers a quick, common-sense approach to determining a final sales price. Even without any existing industry know-how, it can be applied by companies of all sizes to nearly any product.

This pricing strategy is particularly beneficial for companies with a significant cost advantage or the intent to offer transparent pricing. Cost-plus pricing can also be a good pricing decision for one-off projects or services.

Out of the many pricing models available, cost-plus pricing is a popular option and remains one of the easiest to use.

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Kat Dalao is a content manager based in New York. She spent the majority of her career in magazine publishing, first as a features writer and then a creative director, before making the move to digital. Read more