In this post, we work through the main steps of the cost-plus pricing formula using a step-by-step example.
Firstly, what is Cost-plus Pricing?
As suggested by the name, the cost-plus pricing formula provides an approach to calculating the retail price about products by marking up marking up (increasing) the firm’s product unit costs by a set percentage. This percentage increase is designed to cover both variable and fixed costs per unit, as well as generating target profitability.
It should be noted that because a percentage markup is added to the cost price, this pricing approach is sometimes also referred to as mark-up pricing – but they involve the same methodology and approach.
Main Steps in the Cost-Plus Pricing Formula
Step 1 = calculate the unit cost of the product
Our first step is to identify the unit cost of the product that we wish to markup. Generally, this should be easily identified through our accounting and purchase records.
In most cases, there should be a clear price set price that we pay for each product (or product ingredient). However, if our suppliers offer special deals and discounts from time to time, then the price paid by our firm may vary over time.
In this case we would need to use either:
- an average cost of the product, or
- the maximum cost of the product to us.
If we utilize average unit cost, then we will build in and pass on some of the discount that we receive to our end consumers. And if we utilize maximum unit cost, then we will retain all the discount for ourselves and not pass it on to the end consumers.
While this second approach will increase our profits, our suppliers may not be as happy, as they are providing a discount to us in order to pass some of it on and increase sales volumes in the channel.
Product Ingredients
If we are a retailer who is simply reselling products without change, then it is relatively straightforward to identify the cost that we pay for each product.
But if we are involved in integrating products, or we are a manufacturer who combines products/ingredients, then we will need to identify the individual product component costs and add them together.
For example, if we are a fast food restaurant, we will need to combine the cost of the bun, the meat, the salad, the cheese, and the sauce, plus the packaging required – to work out the total unit cost of producing a hamburger.
And we may also want to add in a proportion of staff time to the hamburger unit cost, or we could look to add a fixed cost component to all our products, which is included in a below step.
A worked example
For step one, let’s assume that we are that hamburger restaurant, and our best-selling hamburger has the following ingredients and costs:
- bun/bread = $0.15
- meat patty = $0.50
- average salad cost = $0.20
- cheese = $0.10
- sauce= $0.10
- packaging/paper = $0.15
- TOTAL unit cost for the hamburger = $1.20
Step 2 = identify and allocate fixed costs across product lines and sales
So far in Step 1 we have identified and calculated the variable cost of the hamburger.
However, we need to know the supporting cost of providing that hamburger. If we are a fast food restaurant, then we will have rental costs, kitchen costs, electricity, staff costs, management costs, cleaning costs, insurance, marketing costs, and so on.
In other words, we will have a lot of fixed costs that go in to producing hamburgers and other food items, as well as providing customer service. We need to take these into account, in order to ensure that we price our products appropriately.
If we fail to consider the fixed cost of production, then it is possible for us to underestimate our overall costs and end up with a retail price point which is insufficient to cover our costs and generate a profit.
Therefore in Step 2 we need to work out our total fixed costs and then identify how those costs will be allocated across product lines.
For example in this case, let’s make it easy and assume that our total fixed costs are $1 million per year, primarily rent and staff costs. We do NOT need to consider our food costs, because we have included them in Step 1 above.
And to make it easy, let’s assume that we have three main product lines, namely:
- burgers
- fries
- drinks
Our first task is to determine how to allocate our $1 million fixed costs to each product, or each product line in this case. Generally this is done based upon sales revenue or unit sales.
For this example, let’s assume that the following fixed cost allocation split has been determined by our management accountant:
- burgers = 40% of fixed costs
- fries = 30% of fixed costs
- drinks = 30% of fixed costs
Of course, these all add up to 100% – and our burgers need to cover $400,000 worth of fixed costs in the year.
We need to work out how many hamburgers we sell each year, in order to calculate the fixed costs PER hamburger. We will use this number and add it to our variable cost from Step 1 to work out the actual total cost of the hamburger – including it ingredients and the staff/premises/other costs required to deliver it to a customer.
For this example, let’s assume that we sell 250,000 hamburgers per year. That means that each hamburger has an additional $1.60 fixed cost in its production = $400,000÷250,000 hamburger units.
We then need to add this $1.60 fixed cost component to the $1.20 variable cost that we worked out in Step 1 – this means that the TOTAL cost of each hamburger to the business is actually $2.80.
Obviously, we repeat the exercise for both other product lines, namely fries and drinks. Please see the image at the end of the post for the full calculation across each product line.
Step 3 = mark-up the cost price by a suitable percentage
Next we get to the cost-plus component of the calculation, where we add a percentage to the cost that we have determined in Steps 1 and 2.
The percentage markup that we will use will depend upon numerous factors, including profit goals, competitiveness, positioning, and so on. But generally, when using the cost-plus formula for pricing, companies select a suitable profit margin percentage and tend to use that figure.
Let’s assume, for the purposes of this example, that management has decided on a 70% markup percentage.
As we identify from the above two steps, the total combined cost of the product (both variable and fixed costs) was $2.80 per hamburger.
When we markup this cost component by 70%, it gives us a retail price point of $4.76, which we would probably round to either $4.75 or $4.99 for marketing purposes. Let’s assume, we round the final price to $4.75.
This means for every hamburger sold, we received $4.75, of which $1.20 goes to cover variable costs and $1.60 goes to cut the fixed costs. This leads a profit contribution per hamburger of $1.95.
We could also calculate that this gives us a profit margin percentage per hamburger of 41% = which is $1.95 (margin) divided by $4.75 (price point).
Retailers and other businesses will often use a percentage margin. That way they know if they took in $10,000 in hamburger sales, then 41% of that is bottom-line profit, which provides a handy rule of thumb for how the business is traveling each day.
Step 4 = calculate/forecast the expected profits of the business
A final – but sometimes optional step – is to use this information above to work out the expected profits of the business. This involves applying the profit margin percentages to the expected sales volumes across each product line.
Continuing with our hamburger restaurant example, let’s say we forecast selling 300,000 hamburgers per week. Given our calculated profit per hamburger ($1.95), this would suggest an expected profit from hamburger sales alone of $585,000.
To complete this step, we would repeat the calculation for our other product lines (fries and drinks) using their respective costs, markups, and expected sales volumes. This will provide us with a comprehensive view of the business’s profitability across its different product lines.
It’s important to remember that this forecast is based on several assumptions – such as sales volume and cost stability. Therefore, it should be reviewed and adjusted regularly to reflect any changes in the business environment or internal operations.
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