COST-PLUS PRICING STRATEGY Cost-plus pricing is a strategy that is used to determine the retail and/or wholesale price of goods

and services offered for consumption. Businesses of all sizes tend to use this simplistic pricing model as a guideline for arriving at sale prices that will allow the company to cover all costs associated with the production and sale of the products, and still make a reasonable profit from the effort. The basic formula for cost-plus pricing works as well for calculating pricing goods such as the cost of a meal in a caf as it does for pricing services such as utilities or courier services The ultimate goal of cost-plus pricing is to allow the originator of a good or service to price goods and services in a manner that helps to ensure all costs associated with the effort are covered. At the same time, cost-plus pricing helps to promote the creation of a situation where the originator makes a profit and remains competitive with companies that offer similar goods and services. Fortunately, only a few simple pieces of information are required to establish a solid cost-plus pricing model for any business. The first key component to calculating cost-plus pricing is to establish what it costs to actually produce the end product or service. This involves considering all expenses that go into the production process, such as raw materials, labor and production costs, packaging, transport, and sales and marketing expenses. By dividing the cumulative expenses associated with producing the products by the number of units produced, it is possible to arrive at what is sometimes referred to as the unit cost. The unit cost represents the minimum price that must be charged in order for the producer to recoup his or her investment into the creation of the unit. Next, there is the matter of determining the additional price to attach to each unit offered for sale. Many companies will use what is known as a percentage allocation to determine this amount. For example, if the unit cost for a given item comes to $10.00 in United States Dollars (USD), the producer may choose to add $7.00 USD to the retail price for each unit, representing a 70% profit margin. For wholesale situations, the producer may choose to offer something along the lines of a 40% markup above expenses, thus offering wholesale clients a discount off the retail price that still allows the producer to earn a reasonable profit from each unit produced. Another factor that will influence the percentage markup is local competition. Using the same example above, a company cannot reasonably expect to make money if the $17.00 USD retail price per unit is higher than similar products available in the same market. With that in mind, the percentage of the markup may be adjusted downward to enhance the chances of capturing consumer attention and successfully capturing a section of the consumer market. Pricing method whereby a standard markup is added to the estimated cost of the product. The costplus price is computed by dividing the fixed costs of a product by the estimated number of units to be sold and then adding the variable cost per unit, or by adding the total variable costs and fixed costs and then dividing by the total number of units to be produced. This will determine the true unit cost. Once the true unit cost has been determined, that cost is divided by 1 minus the desired return on sales (a percentage) to determine the cost-plus price. For example, the fixed costs to produce an item are $300,000, the variable costs add up to $100,000, and the estimated number of units to be produced is 50,000. Add 100,000 to 300,000, divide by 50,000, and the true unit cost equals $8. If the desired return on sales is 20%, divide $8 by 1 minus .20, and the cost-plus price for this item will be $10. It is a clear and convenient way to establish a selling price. This method may be used in determining a contract price by a supplier seeking to avoid the uncertainty associated with predicting costs. Cost plus pricing may be found in developmental contracts for new products. Federal agencies deal with cost plus fixed fee contracts. In cost plus pricing, an item is priced at its cost (including direct material,

direct labor, and factory overhead) plus some fixed fee or profit markup. For example, if the total cost of a contract is $325,000 and the fixed fee is $100,000, the contract price would be $425,000. If a profit markup is used, it should be based on the nature of the product and corporate considerations (e.g., marketing aspects). For example, if cost is $200,000 and a profit markup on cost of 30% is desired, the contract price is $260,000. When cost plus pricing is used to determine a transfer price for an internal transfer of a product within the organization, it closely approximates an outside market price. Thus, the resulting synthetic market price is considered a good practical substitute. Cost-plus pricing is a pricing method used by companies. It is used primarily because it is easy to calculate and requires little information. There are several varieties, but the common thread in all of them is that one first calculates the cost of the product, and then includes an additional amount to represent profit. It is a way for companies to calculate how much profit they will make. Cost-plus pricing is often used on government contracts, and has been criticized as promoting wasteful expenditures. The method determines the price of a product or service that uses 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 and then a predetermined percentage of these costs is added to provide a profit margin. Advantages of cost-plus pricing 1. Easy to calculate 2. Minimal information requirements 3. Easy to administer 4. Tends to stabilize markets - insulated from demand variations and competitive factors 5. Insures seller against unpredictable, or unexpected later costs 6. Ethical advantages (see: just price) 7. Simplicity 8. It is readily available 9. Price increases can be justified in terms of cost increases Disadvantages of cost-plus pricing 1. Provides no incentive for efficiency 2. Tends to ignore the role of consumers 3. Tends to ignore the role of competitors 4. Uses historical rather than replacement value 5. Uses normal or standard output level to allocate fixed costs 6. Includes sunk costs rather than just using incremental costs 7. Ignores opportunity costs Businesses use different models to determine the prices of their products and services, and determining the type of model to use is an important consideration for success. The cost-plus pricing model is a popular pricing model, but like others it has advantages and disadvantages. Definition 1. In the cost-plus pricing model, the purchaser agrees to pay the production price of the good plus a fixed percentage to the seller for profit. This is often referred to as adding a markup, which is a percentage of the production costs, with the degree of markup determined by the level of anticipated sales. Considerations

2. In all pricing models, the price that is charged to customers or clients must cover costs and profits and also be established to assure sales, according to Entrepreneur.com. The most effective way to lower prices is to lower costs, and prices must be reviewed frequently to make sure that they continue to reflect cost, market demand, and response to competition and profit objectives. Costs of running a business may include property and/or equipment leases, loan repayments, inventory, utilities, salaries, and even things like employee discounts and the costs of markdowns and damaged merchandise. Objectives 3. The cost-plus pricing model is used when the objectives of a company are market share and profit, according to the University of Missouri Extension article Selecting an Appropriate Pricing Strategy. Such companies have a two-tiered focus, on costs and return on sales. The markup must provide a sufficient profit but not exceed what customers are willing to pay. Advantages 4. The cost-plus pricing model is simple and straightforward, using the easily available internal information of financial and accounting records. It does not require examining the market or considering competition or other factors that impact pricing. It also allows companies to easily defend their prices based on cost, according to ReferenceforBusiness.com. Disadvantages 5. A disadvantage of the cost-plus model is the difficulty in determining the cost of a unit before its price, since costs may vary depending on volume. Although the cost-price model is an age-old pricing model, many business analysts contend that it is not appropriate for modern marketing conditions, according to ReferenceforBusiness.com. Cost-plus pricing often leads to high prices in weak markets and low prices in strong markets, which is the opposite result of strategic pricing that takes into account market conditions. Calculating price using the cost-plus method There are several ways of determining cost, and the profit can be added as either a percentage markup or an absolute amount. One example is: P = (AVC + FC %) * (1 + MK %) where: P = price AVC = average variable cost FC% = percentage allocation of fixed costs MK% = percentage markup For example: If variable costs are 30 yen, the allocation to cover fixed costs is 10 yen, and you feel you need a 50% markup then you would charge a price of 60 yen: P = (30 + 10) (1 + 0.50) P = 40 1.5 P = 60 An alternative way of doing the same calculation is: P = (AVC + FC %) / (1 MK %) To make things simpler, some firms, particularly retailers, ignore fixed costs and just use the purchase price paid to their suppliers as the cost term. They indirectly incorporate the fixed cost allocation into the markup percentage. To simplify things even further, sometimes a fixed amount is applied rather than a percentage. This fixed amount is usually determined by head-office to make it easy for franchisees and store managers. This is sometimes referred to as turnkey pricing. Another variant of cost plus pricing is activity based pricing. This involves being more careful in determining costs. Instead of using arbitrary expense

categories when allocating overhead, every activity is linked to the resources it uses. Cost will need to be recalculated and the percentage markups will likely need to be adjusted as the product goes through its life cycle. This is sometimes referred to as product life cycle pricing, although it is seldom done deliberately or in a planned and organized manner. Price skimming and penetration pricing are also types of product life cycle pricing but they are demand based pricing methods rather cost based. Advantages of cost-plus pricing 1. easy to calculate 2. minimal information requirements 3. easy to administer 4. tends to stabilize markets - insulated from demand variations and competitive factors 5. ethical advantages Disadvantages of cost-plus pricing 1. tends to ignore the role of consumers 2. tends to ignore the role of competitors 3. use of historical accounting costs rather than replacement value 4. use of normal or standard output level to allocate fixed costs 5. inclusion of sunk costs rather than just using incremental costs 6. ignores opportunity costs MARGINAL COSTING Application of Marginal Costing Marginal costing can be applied in the area of fixation of selling price. The next important area is whether to make or buy decision. When a company has unused capacity and wants to manufacture some components, it has two alternatives: (A) To make within the organization or (B) To buy from the market. Often, firms face the question whether to outsource production of a component or continue to make it in the factory. Comparison of the relevant costs of both the alternatives in such cases will show whether to continue the existing arrangement or change to buying it, discontinuing the current production. The answer depends upon whether the firm has the option to use the freed capacity, profitably, or not. Marginal Cost (MC) The marginal cost of an additional unit of output is the cost of the additional inputs needed to produce that output. More formally, the marginal cost is the derivative of total production costs with respect to the level of output. Marginal cost and average cost can differ greatly. For example, suppose it costs $1000 to produce 100 units and $1020 to produce 101 units. The average cost per unit is $10, but the marginal cost of the 101st unit is $20 Theory of Marginal Costing The theory of marginal costing as set out in A report on Marginal Costing published by CIMA, London is as follows:

In relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output. Conversely, a decrease in the volume of output will normally be accompanied by less than proportionate fall in the aggregate cost. The theory of marginal costing may, therefore, is understood in the following two steps: 1. If the volume of output increases, the cost per unit in the normal circumstances reduces. Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000 units at a total cost of Rs.3,000 and if by increasing the output by one unit the cost goes upto Rs.3,002, the marginal cost of additional output will be Rs.2. 2. If an increase in output is more than one, the total increase in cost divided by the total increase in output will give the average marginal cost per unit. If, for example, the output is increased to 1020 units from 1000 units and the total cost to produce these units is Rs. 1,045, the average marginal cost per unit is Rs.2.25. It can be described as follows: Additional cost_ Rs. 45 = Rs.2.25 Additional units 20 The ascertainment of marginal cost is based on the classification and segregation of cost into fixed and variable cost. In order to understand the marginal costing technique, it is essential to understand the meaning of marginal cost. Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods. For example, if a manufacturing firm produces X unit at a cost of Rs. 300 and X+1 units at a cost of Rs. 320, the cost of an additional unit will be Rs. 20 which is marginal cost. Similarly if the production of X-1 units comes down to Rs. 280, the cost of marginal unit will be Rs. 20 (300280). The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost which is kept separate under marginal cost technique. Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a method or technique of the analysis of cost information for the guidance of management which tries to find out an effect on profit due to changes in the volume of output. In this connection, a management accountant is a navigator and a Chief Executive Officer (CEO) is the captain of a ship. A management accountant provides necessary relevant information through various periodical reports to management. With the help of these reports, management becomes able to feel the financial and operational pulses of the organization. There are different phrases being used for this technique of costing. In UK, marginal costing is a popular phrase whereas in US, it is known as direct costing and is used in place of marginal costing. Variable costing is another name of marginal costing. Marginal costing technique has given birth to a very useful concept of contribution. It represents the difference between sales and marginal cost.

Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio which remains the same under given conditions of production and sales. Features of Marginal Costing The main features of marginal costing are as follows: 1. Cost Classification The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique. 2. Inventory Valuation Under marginal costing, inventory for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method. 3. Marginal Contribution Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.

Advantages and Disadvantages of Marginal Costing Technique Advantages 1. Marginal costing is simple to understand. 2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided. 3. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead. 4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business. 5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. 6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. 7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making. Disadvantages 1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results. 2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. 3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit and true and fair view of financial affairs of an organization may not be clearly transparent. 4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. 5. Application of fixed overhead depends on estimates and not on the actual and as such there may be under or over absorption of the same. 6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. 7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer. COST SHEET: MEANING AND ITS IMPORTANCE Cost sheet is a statement, which shows various components of total cost of a product. It classifies and analyses the components of cost of a product. Previous periods data is given in the cost sheet for comparative study. It is a statement which shows per unit cost in addition to Total Cost. Selling price is ascertained with the help of cost sheet. The details of total cost presented in the form of a statement are termed as Cost sheet. Cost sheet is prepared on the basis of : 1. Historical Cost 2. Estimated Cost

Historical Cost Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost prepared after incurring the actual cost is called Historical Cost Sheet. Estimated Cost Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before the commencement of production is called estimated cost sheet. Such cost sheet is useful in quoting the tender price of a job or a contract. Importance of Cost Sheet The importance of cost sheet is as follows: _ Cost ascertainment The main objective of the cost sheet is to ascertain the cost of a product. Cost sheet helps in ascertainment of cost for the purpose of determining cost after they are incurred. It also helps to ascertain the actual cost or estimated cost of a Job. _ Fixation of selling price To fix the selling price of a product or service, it is essential to prepare the cost sheet. It helps in fixing selling price of a product or service by providing detailed information of the cost. _ Help in cost control For controlling the cost of a product it is necessary for every manufacturing unit to prepare a cost sheet. Estimated cost sheet helps in the control of material cost, labour cost and overheads cost at every point of production. _ Facilitates managerial decisions It helps in taking important decisions by the management such as: whether to produce or buy a component, what prices of goods are to be quoted in the tender, whether to retain or replace an existing machine etc. COMPONENTS OF TOTAL COST The Components of cost are shown in the classified and analytical form in the cost sheet. Components of total cost are as follows: _ Prime Cost It consists of direct material, direct wages and direct expenses. In other words Prime cost represents the aggregate of cost of material consumed, productive wages, and direct expenses. It is also known as basic, first, flat or direct cost of a product. Prime Cost = Direct material + Direct Wages + Direct expenses Direct material means cost of raw material used or consumed in production. It is not necessary that all the material purchased in a particular period is used in production. There is some stock of raw material in balance at opening and closing of the period. Hence, it is necessary that the cost of opening and closing stock of material is adjusted in the material purchased. Opening stock of material is added and closing stock of raw material is deducted in the material purchased and we get material consumed or used in production of a product. It is calculated as: Material Consumed = Material purchased + Opening stock of material Closing stock of material. Factory Cost In addition to prime cost it includes works or factory overheads. Factory overheads consist of cost of indirect material, indirect wages, and indirect expenses incurred in the factory. Factory cost is also known as works cost, production or manufacturing cost.

Factory Cost = Prime cost + Factory overheads Adjustment for stock of work-in-progress In the process of production, some units remain to be completed at the end of a period. These incomplete units are known as work-in-progress. Normally, the cost of incomplete units includes direct material, direct Labour, direct expenses, and average factory overheads. Hence, at the time of computing factory cost, it is necessary to make adjustment of opening and closing stock of work in progress to arrive at the net Factory cost/works cost. TOTAL COST AND COST SHEET If office and administrative overheads are added to factory or works cost, total cost of production is arrived at. Hence the total cost of production is calculated as: Total Cost of production = Factory Cost + Office and Administration Overheads Cost of goods sold It is not necessary, that all the goods produced in a period are sold in the same period. There is stock of finished goods in the opening and at the end of the period. The cost of opening stock of finished goods is added in the total cost of production in the current period and cost of closing stock of finished goods is deducted. The cost of goods sold is calculated as: Cost of goods sold = Total cost of production + Opening stock of Finished goods Closing stock of finished goods Total Cost i.e, Cost of Sales If selling and distribution overheads are added to the total cost of production, total cost is arrived at. This cost is also termed as cost of Sales. Hence the total cost is calculated as: Total Cost = Cost of Goods sold + Selling and distribution overheads Sales If the profit margin is added to the total cost, sales are arrived at. Excess of sales over total cost is termed as profit. When total cost exceeds sales, it is termed as Loss. Sales = Total Cost + Profit

There is no prescribed format of a Cost sheet. It may change from industry to industry. A specimen format of a Cost Sheet is given as under: Particulars A. Materials Consumed: Purchases Add: Opening Stock of Raw material Expenses on Purchases Less: Closing Stock of Raw Material Direct Material consumed B. Direct Labour (Wages) C. Direct Expenses D. Prime Cost (A + B + C) E. Factory/Works Overheads Add: Opening Stock of Work-in-Progress Less: Closing Stock of Work-in-Progress F. Works/Factory Cost (D + E) G. Office and administration overheads H. Total Cost of Production (F + G) Add: Opening Stock of finished Goods Cost of Goods available for sale Less: Closing Stock of finished Goods I. Cost of production of goods Sold or cost of good sold J. Selling and Distribution Overheads K. Total Cost (I + J) = Cost of Sales L. Profit M. Sales (K + L) Key: Cost Sheet: Meaning: Cost sheet is a statement, which shows various components of total cost of a particular product. Cost sheet is prepared on the basis of: _ Historical Cost _ Estimated Cost The importance of cost sheet is follows: Cost ascertainment Fixation of selling price Help in cost control Total (Rs.) .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. ..............

Facilitates managerial decisions

Components of Total Cost Prime Cost = Direct material + Direct Wages + Direct expenses works/ factory cost; Factory Cost = Prime cost + Factory overheads Cost of production/office cost = Factory Cost + office and administration overheads Cost of production of goods sold = Cost of Production + Opening stock of Finished goods closing stock of finished goods Total Cost = Cost of Production of goods sold + Selling and distribution overheads Sales = Total Cost + Profit The various components of cost explained above are presented in the form of a statement. DEMAND BACKWARD PRICING It is a pricing method in which an estimation is made of the price that customers are willing to pay for a given product; this price is then compared to the per unit cost to see if it meets the firm's profit objectives. Remember when you were in elementary school and many students bought teachers little gifts before the holidays or on the last day of school. Typically, parents set an amount such as $5 or $10 for a teachers gift. Knowing that people have certain maximum levels that they are willing to pay for gifts, some companies use demand backward pricing. They start with the price demanded by consumers (what they want to pay) and create offerings at that price. If you shop before the holidays, you might see a table of different products being sold for $5 (mugs, picture frames, ornaments) and another table of products being sold for $10 (mugs with chocolate, decorative trays, and so forth). Similarly, people have certain prices they are willing to pay for wedding giftssay, $25, $50, $75, or $100so stores set up displays of gifts sold at these different price levels. IKEA also sets a price for a productwhich is what the company believes consumers want to pay for itand then, working backward from the price, designs the product. Demand-Backward Pricing When the price is in the process of walking backwards, which means The Corporation believes that a price level that consumers are willing to pay, the company should determine the margin paid to wholesalers and retailers. After that, the new price may be determined