Cost-plus pricing is a strategy that is used to determine the retail and/or wholesale price of goods and services offered

for consumption. Businesses of all sizes tend to use this simplistic pricing model as a guideline for arriving at sale prices that will allow the company to cover all costs associated with the production and sale of the products, and still make a reasonable profit from the effort. The basic formula for cost-plus pricing works as well for calculating pricing goods such as the cost of a meal in a caf as it does for pricing services such as utilities or courier services. The ultimate goal of cost-plus pricing is to allow the originator of a good or service to price goods and services in a manner that helps to ensure all costs associated with the effort are covered. At the same time, cost-plus pricing helps to promote the creation of a situation where the originator makes a profit and remains competitive with companies that offer similar goods and services. Fortunately, only a few simple pieces of information are required to establish a solid cost-plus pricing model for any business. The first key component to calculating cost-plus pricing is to establish what it costs to actually produce the end product or service. This involves considering all expenses that go into the production process, such as raw materials, labor and production costs, packaging, transport, and sales and marketing expenses. By dividing the cumulative expenses associated with producing the products by the number of units produced, it is possible to arrive at what is sometimes referred to as the unit cost. The unit cost represents the minimum price that must be charged in order for the producer to recoup his or her investment into the creation of the unit. Next, there is the matter of determining the additional price to attach to each unit offered for sale. Many companies will use what is known as a percentage allocation to determine this amount. For example, if the unit cost for a given item comes to Rs.10 in Indian Rupees, the producer may choose to add Rs.7 to the retail price for each unit, representing a 70% profit margin. For wholesale situations, the producer may choose to offer something along the lines of a 40% markup above expenses, thus offering wholesale clients a discount off the retail price that still allows the producer to earn a reasonable profit from each unit produced. Another factor that will influence the percentage markup is local competition. Using the same example above, a company cannot reasonably expect to make money if the Rs.17 retail price per unit is higher than similar products available in the same market. With that in mind, the percentage of the markup may be adjusted downward to enhance the chances of capturing consumer attention and successfully capturing a section of the consumer market. The mechanism of cost plus pricing decision can be well understood from the following detailed example.

Consider a business with the following costs and volumes for a single product: Fixed costs: Factory production costs Research and development Fixed selling costs Administration and other overheads Total fixed costs Variable costs Variable cost per unit Mark-Up Mark-up % required Budgeted sale volumes (units) What should the selling price be on a cost plus basis? The total costs of production can be calculated as follows: Total fixed costs Total variable costs (8.00 x 500,000 units) Total costs Mark up required on cost (5,625,000 x 35%) Total costs (including mark up) Divided by budgeted production (500,000 units) = Selling price per unit The advantages of using cost plus pricing are: 1. Easy to calculate 2. Price increases can be justified when costs rise 3. Price stability may arise if competitors take the same approach (and if they have similar costs) 4. Pricing decisions can be made at a relatively junior level in a business based on formulas The main disadvantages of cost plus pricing are often considered to be: 1. This method ignores the concept of price elasticity of demand - it may be possible for the business to charge a higher (or lower) price to maximize profits depending on the responsiveness of customers to a change in price 1,625,000 4,000,000 5,625,000 1,968,750 7,593,750

750,000 250,000 550,000 325,000 1,625,000 8.00 35% 500,000

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2. The business has less incentive to cut or control costs - if costs increase, then selling prices increase. However, this might be making an "inefficient" business uncompetitive relative to competitor pricing; 3. It requires an estimate and apportionment of business overheads. For example, total factory overheads need to be calculated and then allocated in some way against individual products. This allocation is always arbitrary. 4. If applied strictly, a cost plus pricing method may leave a business in a vicious circle. For example, if budgeted costs are over-estimated, selling prices may be set too high. This in turn may lead to lower demand (if the price is set above the level that customers will accept), higher costs (e.g. surplus stock) and lower profits. When the pricing decision is made for the next year, the problem may be exacerbated and repeated. Amongst the factors that influence the choice of the mark-up percentage are as follows: 1. Nature of the market - a mark-up should reflect the degree of competition in the market (what do the close competitors do?) 2. Bulk discounts - should volume orders attract a lower mark-up than a single order? 3. Pricing strategy - e.g. skimming, 4. Stage of the product in its life cycle; products at the earlier stages of the life cycle may need a lower mark-up percentage to help establish demand.