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Cost-plus pricing is a pricing strategy companies use to maximize their rates of return.
Firms may accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost and then charging a price which is determined by the demand curve. However, in practice, most firms use either value-based pricing or cost-plus pricing which is also known as mark-up pricing. (cost + mark-up = selling price).
There are several variations of cost-plus pricing, but the most common method is to calculate the cost of the product then add a percentage of the cost as markup. This approach sets prices covering the cost of production and provides enough profit margin for the firm to reach its target rate of return. It also provides a way for companies to calculate how much profit they will make.
Cost-plus pricing is often used on government contracts (cost-plus contracts), and has been criticized as promoting wasteful expenditures in the form of direct costs, indirect costs, and fixed costs whether related to the production and sale of the product or service or not. These costs are converted to per-unit costs for the product; then a predetermined percentage of these costs is added to provide a profit margin.
Information regarding demand and costs is not easily available, and managers have limited knowledge in these areas. This information is necessary to generate accurate estimates of marginal costs and revenues. However, the process of obtaining this additional information is expensive. Therefore, cost-plus pricing is often considered the most rational approach in maximizing profits in these situations because of its ease of calculation and because little additional information is needed. The cost-plus approach relies on arbitrary costs and arbitrary markups.
There are two steps which form this approach. The first step involves calculation of the cost of production, and the second step is to determine the markup over costs.
1. Calculation of cost of production
The total cost has two components: Total Variable cost and Total fixed Cost. In either case, costs are computed on an average basis. That is the average cost is:
AC = AVC + AFC
In this approach, the quantity is assumed. In cost-plus pricing we use quantity to calculate price but price is the determinant of quantity. To avoid this problem, a quantity is assumed. This rate of output is based on some percentage of the firm's capacity.
2. Determining the markup over costs
The objective of this approach is to set prices in a manner that a firm earns its targeted rate of return. If that return is Rs.X (Rs.= Ratio of the respective share) of total profit, then the markup over costs on each unit of output will be X/Q: then the price will be: P = AVC + AFC + X/Q
Firms vary greatly in size, product range, product characteristics, etc. Firms also face different degrees of competition in markets for their products. Therefore, a clear explanation cannot be given for the widespread use of cost-plus pricing. However the following points explain why this approach is widely used:
Cost-plus pricing is especially useful in the following cases:
Cost-plus pricing might appear to be inconsistent with the economic theory of profit maximization. Analysis based on "marginal cost equals marginal revenue" decision rule may appear to have become irrelevant due to the wide use of cost-plus pricing. However, this conflict is more apparent than real. A comparison of the two approaches to pricing starts with a consideration of costs. Cost-plus pricing is based on average costs and not marginal costs. However, in economic theory, long-run marginal and average costs are not very different. Thus, it can be said safely that usage of average costs for pricing may be considered a reasonable approximation of marginal cost decision making.
The second step in comparison involves the target rate of return and the resulting markup. Determination of the target rate of return depends on certain factors. Basically, the decision involves management's perception of demand elasticity and competitive conditions. This can be explained with an example of how grocery stores operate: Profits are held down due to the intense competition that exists among these firms with the average markup for most food items being approximately 12 percent over cost. If the markup over cost is based on demand conditions, cost-plus pricing may not be inconsistent with profit maximization. This can be shown mathematically.
Marginal revenue is the derivative of total revenue with respect to quantity. Thus
MR = d (TR)/ dQ = d (PQ)/ dQ = P + dP*Q /dQ
(P + dP *Q /dQ) can also be written as P (1 + dPQ /dQP) .Here, (dP /dQ) (Q /P) is 1/EP, where EP is price elasticity of demand. Thus
MR = P (1 + 1/EP ) (equation 1)
In order to maximize profit MR should be equal to MC. To simplify the assumption, let MC=AC. Thus the profit maximizing price is the solution to
P (1 + 1/EP) = AC
which can be written as
P (EP + 1 /EP) = AC
Solving for P yields
P = AC (EP /EP + 1) (equation 2)
Equation 2 can be interpreted as a cost-plus pricing or markup pricing scheme. That is, the price of the product is based on markup over average costs. (EP + 1 /EP), which is the markup, is a function of the price elasticity of demand. We can see from the equation that the markup and the price elasticity of demand are inversely related; as the demand becomes more elastic the markup becomes smaller.