Variable cost-plus pricing is a pricing method whereby the selling price is established by adding a markup to total variable costs. The expectation is that the markup will contribute to meeting all or a part of the fixed costs and yield some level of profit. Variable cost-plus pricing is particularly useful in competitive scenarios, such as contract bidding, but it is not suitable in situations where fixed costs are a major component of total costs.
Key Takeaways
- Variable cost-plus pricing adds a markup to the variable costs to include a profit margin that covers both the fixed and variable costs.
- It is particularly useful for contract bidding where fixed costs are stable.
- This pricing method might also benefit companies that can produce more units without significantly increasing fixed costs.
- Variable cost-plus pricing does not account for market factors, such as demand or customer perceptions of value.
- It can yield pricing inefficiencies if the company’s variable costs are low.
How Variable Cost-Plus Pricing Works
Variable costs include direct labor, direct materials, and other expenses changing in proportion to production output. A firm employing the variable cost-plus pricing method would first calculate the variable costs per unit, then add a markup to cover fixed costs per unit and generate a targeted profit margin.
For example, assume that total variable costs for manufacturing one unit of a product are $10. The firm estimates that fixed costs per unit are $4. To cover the fixed costs and leave a profit per unit of $1, the firm would price the unit at $15.
This type of pricing method is purely inward-looking. It does not incorporate benchmarking with competitors’ prices or consider how the market views the item’s price.
When to Use Variable Cost-Plus Pricing
This method can be suitable for a company when a high proportion of total costs are variable. A company can be confident that its markup will cover fixed costs per unit. If the ratio of variable costs to fixed costs is low, meaning considerable fixed costs increase as more units are produced, the pricing of a product may end up being inaccurate and unsustainable for the company to profit.
Variable cost-plus pricing may also suit companies with excess capacity. In other words, a company that would not incur additional fixed costs per unit by incrementally increasing production. Variable costs in this case would compose most of the total expenses (e.g., no additional factory space would need to be rented for extra production) and adding a markup to the variable costs would provide a profit margin.
The significant shortcoming of this pricing method is that it does not take into account market perceptions of the product’s value or the prices of similar products sold by competitors.
Advantages and Disadvantages of Variable Cost-Plus Pricing
The main advantage of variable cost-plus pricing is its simplicity: it allows sellers to easily set a price that covers their costs while allowing a reasonable margin for profit. It simplifies setting contracts with suppliers and justifies price increases to consumers seen in rising production costs.
However, this method is unsuitable for companies with significant fixed costs or those whose fixed costs rise with increased production. In other words, any markup on variable costs might result in an unsustainable product price.
Pros & Cons of Variable Cost-Plus Pricing
Pros
- Comparatively simple way to cover the cost of producing goods
- Allows suppliers to lock in prices that cover costs
- Facilitates contract negotiation with a comparatively straightforward means of calculating prices
Cons
- Does not account for market demand, which can sometimes justify higher pricing
- Does not consider competitors’ prices, which can adversely affect sales
- Can result in inefficient pricing if the company’s variable costs are comparatively low
Variable Cost-Plus Pricing vs. Cost-Plus Pricing
Variable cost-plus pricing is distinct from cost-plus pricing, a more traditional model that sets costs based on the total cost of producing that good. Using cost-plus pricing, prices are set by taking the total cost of production and adding a markup. Variable cost-plus pricing adds a markup only to the variable costs, assuming the markup will cover the fixed costs.
Cost-plus pricing has faced criticism for not adequately incentivizing cost containment and improvements in efficiency. When prices are based on total costs, the company earns more revenue by bloating their fixed costs rather than by reducing inefficiencies.
What Is Rigid Cost-Plus Pricing?
Rigid cost-plus pricing, or simply cost-plus pricing, is a simple pricing model based solely on the total cost of producing and selling a product. This model computes the per-unit costs of delivering a product—including production, transportation, sales, and other services—and adds a fixed markup to arrive at the final price.
How Do You Calculate Variable Cost-Plus Pricing?
Variable cost-plus pricing is calculated by adding a markup to the per-unit costs of producing each additional good. For example, if materials, labor, and transportation for each bottle of soda add up to $1.00, the total price might be marked as $1.20. Although this model does not include fixed costs, such as facilities and utilities, it assumes that the markup is sufficiently high to cover these costs.
What Are Examples of Variable Costs?
Variable costs are production costs that increase when more units of a good are produced. Raw materials and labor are examples of variable costs because producing more units of a good requires more raw materials and labor. Fixed costs are those that do not change significantly when production is ramped up—for example, the costs of the facilities and machinery used to produce the good.
What Is Variable Cost Transfer Pricing?
Transfer pricing is the price for sales between related entities, such as different departments of the same company or between a parent company and its subsidiary. These bodies transact at arm’s length, so transfer prices rarely stray very far from market prices.
As with market pricing, transfer prices can be determined through various methods, including cost-based or profit-seeking pricing models. Variable cost transfer pricing refers to a price where the purchaser pays the variable costs of production without a markup.
Related Terms: markup, variable costs, fixed costs, cost-plus pricing, transfer pricing.
References
- Harvard Business Review. “When Is Cost-Plus Pricing a Good Idea”?
