Cost-plus pricing is a pricing method in which selling price of a product is determined by adding a profit margin to the costs of the product.
Cost-plus pricing is appropriate where the units are not uniform and each order is different. In such cases price equals the cost estimate plus a profit (which may be a percentage of cost or percentage of sales price or a fixed amount). Estimating correct cost per unit is important because incorrect estimation of cost affects the selling price and ultimately the competitiveness of the firm.
Advantages and Disadvantages
Cost-plus pricing is easy to apply and in some situations it is the only method to determine a price when market price is not available, for example in case of government contracts.
However, despite its simplicity, it is not a preferred pricing method because it does not encourage efficiency. As compared to target costing, where price is fixed and companies have to keep costs low in order to squeeze in a profit, there is no such pressure in cost-plus pricing. Since all costs are reimbursed together with profit, companies may not be motivated enough to keep costs at their optimum.
Where the profit margin is based on cost, the price is calculated as follows:
Price = Cost × (1 + Profit Margin Percentage)
Where the profit margin is based on selling price, the price is calculated using the following formula:
Price = Cost/(1 - Profit Margin Percentage)
Where the profit is a fixed amount per unit:
Price = Cost + Profit
You work as a cost accountant at GP Engineers & Contractors (GP), which recently won a 10-year government contract for provision of electricity to the country's largest airport during power outages. For the purpose, GP is required to setup a small diesel-run power plant and operate and maintain it over the contract term. According to the contract, GP shall be reimbursed every month for the cost incurred per unit (kilowatt hour) of electricity consumed from GP system plus a 20% profit on cost.
During the first month, GP provided 98,000 units from its power plant to the airport. The plant consumed 30,000 litres of diesel during the month, which cost $1 per liter. Employees dedicated to the power plant earn $30,000 per month. Head office expenses allocated to the power plant on account of management fee for the month amount to $20,000. The plant is depreciated on straight-line basis at the rate of $15,000 per month over the 10-year contract period.
You are required to calculate the amount at which you will invoice the government for the first month?
Assume there is a change in management at the airport and the new CFO has asked GP to calculate profit at 20% of sales. Should GP accept such proposal?
Diesel cost is $30,000 (@1 per liter for 30,000 liters), direct labor is $30,000, management fee is $20,000 and depreciation is $15,000. Total costs are $95,000.
The invoice for the first month equals $114,000 (=$95,000 × (1 + 20%)).
GP should be glad accept the new proposal because calculation of invoice value at 20% profit based on sales would result in increase in invoice amount.
Invoice Value (@ 20% based on Sales) = $95,000/(1 - 20%) = $118,750
Such a change would increase profit from $19,000 (=$114,000 - $95,000) to $23,750 (=$118,750 - $95,000).