What is Variable Cost-Plus Pricing?
Variable cost-plus pricing is a type of pricing method wherein the selling price of a given product is determined by adding a markup over the total variable cost of production of that product. The markup is expected to meet all or a given percentage of the fixed cost of production, and then generate a given level of profit revenue.
The Classical Producer Theory states that a company should continue to operate in a market as long as revenues cover variable costs. The intuition behind such a line of reasoning is that any fixed cost that the producer incurred should be treated as a sunk cost and not be factored into future decisions.
Thus, variable cost-plus pricing allows (at least in theory) producers to make super-normal profits in the market. In a competitive market, in the long run, no company is able to charge a price greater than the variable cost of production, which also happens to be the marginal production cost.
- Variable cost-plus pricing is a type of pricing method wherein the selling price of a given product is ascertained by adding a markup over the total variable cost of production of that product.
- Variable costs include expenses that are subject to changes with production output.
- The variable cost-plus pricing method of pricing is suitable for firms where a high percentage of the total costs are variable.
How to Calculate
Variable costs include expenses such as direct overheads, direct materials, etc. They are expenses that are subject to changes with production output. A company that uses the variable cost-plus pricing method needs to employ the following steps to cover fixed costs and generate its target profit margins.
Step 1: Determine the total cost of production of a given product or service. The total cost is the sum of the fixed costs and variable costs.
Step 2: Determine the unit cost by dividing the aforementioned total cost by the number of units produced.
Step 3: Determine the selling cost by multiplying the unit cost by the predetermined markup percentage.
When is Variable Cost-Plus Pricing Used?
The variable cost-plus pricing method is suitable for companies where a high percentage of the total costs are variable. In such a situation, the company can be certain that the predetermined markup will cover its per-unit fixed costs. In a situation where the percentage of variable costs from total costs is low, such a method of pricing may be inaccurate. It is because there may be significant fixed costs that can increase as the number of units produced rises.
The pricing method can also be considered in situations where a company experiences excess capacity. In such a case, the company will not incur additional fixed costs per unit if it increases production up to a given level. It is because, for example, the business will not need extra factory space in order to produce extra units.
Advantages of Cost-Plus Pricing
- In competitive scenarios, such as contract bidding, variable cost-plus pricing is particularly useful.
- It is a simple method of determining the selling price of a product.
- Using variable cost-plus pricing makes it easier to lock revenues with contracts. It is because suppliers generally prefer contracts that guarantee sales with a set profit level and an assurance that all production costs will be covered. It also negates any risk of loss due to inefficient price setting.
- The variable cost-plus pricing method also makes it easier for suppliers to justify price increases. It is because companies can simply explain price increases as a consequence of rising production charges.
Disadvantages of Cost-Plus Pricing
- Cost-plus pricing doesn’t always consider the competition. A situation may arise where a product can end up priced too high compared to different brands of the same product. It can adversely affect the company by decreasing sales and market share. The alternative can also be true; the set selling price can be too low compared to market competition. It can cost the company an opportunity of making profits.
- The method also fails to consider the market perception of the value and price of the product compared to the competition. The product’s pricing must also consider the consumer’s willingness to pay.
CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: