Cost-plus pricing

Cost-plus pricing is a pricing strategy in which the selling price is determined by adding a specic dollar amount
markup to a products unit cost. Mark ups are when you
add a % to the cost to set the price. An alternative pricing
method is value-based pricing.[1]

put are driven to the point at which marginal cost equals

marginal revenue. In the long run, marginal and average
costs (as in cost-plus) tend to converge, reducing the difference between the two strategies. It works great when
a business is in need of short term nance.

Cost-plus pricing is often used on government contracts

(cost-plus contracts), and was criticized for reducing
pressure on suppliers to control direct costs, indirect costs 4 Elasticity considerations
and xed costs whether related to the production and sale
of the product or service or not.
One of the most common pricing methods used by rms
Cost breakdowns must be deliberately maintained. This is cost-plus pricing. In spite of its ubiquity, economists
information is necessary to generate accurate cost esti- rightly point out that it has serious methodological aws.
It takes no account of demand. There is no way of determates.
mining if potential customers will purchase the product
Cost-plus pricing is especially common for utilities and at the calculated price. To compensate for this, some
single-buyer products that are manufactured to the buyers economists have tried to apply the principles of price elasspecication such as military procurement.
ticity to cost-plus pricing.
We know that:

Mechanics
MR = P + ((dP / dQ) * Q)

The two steps in computing the price are to compute the

unit cost and to add a markup. The unit cost is the total where:
cost divided by the number of units. The total cost is the
sum of xed and variable costs. Fixed costs do not generMR = marginal revenue
ally depend on the number of units, while variable costs
P = price
do. The markup is a percentage that is expected to pro(dP / dQ) = the derivative of price with respect
vide an acceptable rate of return to the manufacturer.[1]
to quantity

Q = quantity

Rationale

Since we know that a prot maximizer, sets quantity at

Buyers may perceive that cost-plus pricing is a reasonable the point that marginal revenue is equal to marginal cost
approach. In some cases, the markup is mutually agreed (MR = MC), the formula can be written as:
upon by buyer and seller.
In product areas that feature relatively similar production
costs, cost plus pricing can oer competitive stability if
all rms adopt cost-plus pricing.

MC = P + ((dP / dQ) * Q)
Dividing by P and rearranging yields:

Cost-based pricing is a way to induce a seller to accept

a contract whose total costs represent a large fraction of
the sellers revenues, or in which costs are uncertain at
contract signing.

MC / P = 1 +((dP / dQ) * (Q / P))

And since (P / MC) is a form of markup, we can calculate
the appropriate markup for any given market elasticity by:

Economic theory
(P / MC) = (1 / (1 - (1/E)))

Cost-plus pricing is not common in markets that are

(nearly) perfectly competitive, in which prices and out- where:
1

6
(P / MC) = markup on marginal costs
E = price elasticity of demand

In the extreme case where elasticity is innite:

(P
/
MC)
=
(1/999999999999999)))
(P / MC) = (1 / 1)

(1

(1

Price is equal to marginal cost. There is no markup.

At the other extreme, where elasticity is equal to unity:
(P /MC) = (1 / (1 - (1/1)))
(P / MC) = (1 / 0)
The markup is innite.
Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):
(P / AVC) = (1 / (1 - (1/E)))
Technically, AVC is a valid substitute for MC only in situations of constant returns to scale (LVC = LAC = LMC).
When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be,
and often are, considering the price elasticity of demand,
whether consciously or not.

See also
Pricing
Price elasticity of demand
Markup (business)
Outline of industrial organization
Marketing
Microeconomics

References

[1] Jain, Sudhir (2006). Managerial Economics. Pearson Education. ISBN 978-81-7758-386-1.

REFERENCES

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