What is variable cost-plus pricing?
Variable cost-plus pricing is a method whereby the selling price is established by adding a markup to total variable costs. The markup is expected to contribute to meeting all or a part of the fixed costs and yield some profit. Variable cost-plus pricing is advantageous in competitive scenarios, such as contract bidding. Still, it is unsuitable when fixed costs are a significant component of total costs.
How Variable Cost-Plus Pricing Works
Labor, direct material costs, and other expenditures that fluctuate with manufacturing output are variable costs. When using the variable cost-plus pricing strategy, a business would determine its variable costs per unit and then apply a markup to cover its fixed expenses and reach its desired profit margin.
For example, the total variable expenses for producing a single product unit are $10. According to the company, fixed expenses come to $4 per unit. The company would price the unit at $15 to pay the fixed costs and still make a $1 profit per unit.
This kind of pricing strategy is entirely inward-focused. It doesn’t take the market’s perception of an item’s price into account or benchmark pricing against those of rivals.
When to Apply Cost-Plus Pricing Variables
A business with a large percentage of variable expenses may find this pricing strategy appropriate. A company may be sure their markup will compensate for fixed fees for each unit. When a product’s price is low compared to its fixed costs, it indicates that the firm’s fixed costs are increasing as more units are produced, which may lead to erroneous and unsustainable pricing that prevents the company from turning a profit.
Businesses with surplus capacity may also find variable cost-plus pricing appropriate. Otherwise, a company might gradually raise output without reducing its fixed expenses per unit. In this scenario, most expenses would be variable costs (i.e., more output wouldn’t need renting more factory space), and a profit margin would be created by marking up the variable expenses.
This pricing method’s main flaw is that it needs to account for the value that the market places on the product or the costs of comparable goods offered by other companies.
The Benefits and Drawbacks of Cost-Plus Pricing
Variable cost-plus pricing’s primary benefit is its simplicity, which enables sellers to quickly determine a price that pays for their expenses plus a fair profit margin. Additionally, it facilitates entering into contracts with suppliers, who often choose fixed fees that guarantee profits over less predictable models. Additionally, because a price increase can be easily justified to customers as an increase in manufacturing costs, it also makes price hikes simpler to defend for consumers.
Any markup on the variable costs on top of the fixed costs per unit might result in an unsustainable price for the product; hence, variable cost-plus pricing is not appropriate for businesses with high fixed costs or fixed costs that rise as more units are produced.
Conversely, the variable cost-plus pricing strategy may miss out on revenue since it ignores market circumstances. For instance, manufacturers may increase profits if customers have a strong demand for a particular line of items by boosting the pricing of those products.
Similarly, the model does not consider rival items. In some instances, a business may see an increase in profit margins if its goods outperform those of its rivals. On the other hand, if a company lowers its pricing and outbids its competitors, it can boost sales.
Benefits and Drawbacks of Variable Cost-Plus Pricing
- comparatively easy method of defraying manufacturing costs
- Permits vendors to establish rates that adequately cover expenses
- allows for easier contract negotiation with a very straightforward pricing calculation method
Cons:
- Ignores consumer demand, which sometimes justifies higher prices
- Ignores the products of rivals, which may hurt sales
- This might lead to wasteful pricing if the variable expenses of the business could be more manageable.
- Cost-plus pricing vs variable cost-plus pricing
Variable cost-plus pricing differs from the more conventional cost-plus pricing model, which bases expenses on the overall cost of manufacturing the item. When using cost-plus pricing, a markup is added to the entire cost of manufacturing to determine prices. With variable cost-plus pricing, just the variable costs are marked up, with the expectation that the markup will be enough to pay for the fixed expenses.
Some management experts have criticized cost-plus pricing for failing to provide sufficient incentives for cost control and efficiency gains. When prices are set based on total costs, the business makes more money by inflating its fixed expenses than by cutting those inefficiencies.
Rigid Cost-Plus Pricing: What Is It?
Cost-plus pricing, or rigid cost-plus pricing, is a straightforward pricing strategy that considers the whole cost of manufacturing and selling a product. In this model, the manufacturing, shipping, sales, and other expenses associated with providing a product are calculated per unit, and a set markup is added to determine the final price.
How is variable cost-plus pricing calculated?
The cost per unit of manufacturing each extra product increases by a markup when using the variable cost-plus pricing approach. For instance, the total cost may be shown as $1.20 if the cost of labor, supplies, and shipping for each bottle of Pepsi is $1.00. The markup is assumed to be large enough to cover fixed expenses, such as utilities and facilities, even though they are not included in this model.
What Kind of Costs Are Known to Be Variable?
Manufacturing expenses, known as variable costs, rise when more units of a thing are produced. Since more labor and raw materials are needed to make more units of an item, labor and raw materials are examples of variable costs. Fixed costs are expenses, such as those for the buildings and equipment needed to create the goods, that stay relatively high when output increases.
Variable Cost Transfer Pricing: What Is It?
The price for sales between related entities, such as departments within the same business or a parent firm and its subsidiary, is known as transfer pricing. Transfer prices seldom deviate significantly from market pricing, even if these entities may be connected. Instead, they interact at arm’s length.
Transfer prices may be established using techniques similar to market pricing, such as profit-seeking or cost-based pricing models. The term “variable cost transfer pricing” describes a price at which the buyer, without any markup, pays the variable costs of manufacturing.
Conclusion
- Variable cost-plus pricing adds a markup to the variable costs to incorporate a profit margin that covers fixed and variable expenses.
- Contract bidding occurs when fixed costs are predictable; variable cost-plus pricing is constructive.
- This pricing strategy makes sense for businesses that can increase production without significantly impacting fixed costs.
- Demand and consumer perceptions of value are two examples of market characteristics not considered by variable cost-plus pricing.
- Inefficient pricing may also result from variable cost-plus pricing if the organization has low variable expenses.
