Variable cost-plus pricing definition
/What is Variable Cost-Plus Pricing?
Variable cost-plus pricing is a system for developing prices that adds a markup to the total amount of variable costs incurred. Examples of the variable costs incurred are direct materials and direct labor. Essentially, any cost that changes in relation to production output should be considered a variable cost. For the seller to earn a profit under this pricing arrangement, the markup percentage must be sufficiently high to cover fixed costs and administrative costs, as well as provide a reasonable profit.
What are Variable Costs?
A variable cost is a cost that varies in relation to either production volume or the amount of services provided. If no production or services are provided, then there should be no variable costs. If production or services are increasing, then variable costs should also increase.
Advantages of Variable Cost-Plus Pricing
Here are the advantages of using variable cost-plus pricing:
Simplified pricing calculation. It is fairly easy to calculate prices - just add a fixed markup to your variable costs. Requires minimal analysis or market research, making it easy to implement, especially for small businesses or companies with limited pricing expertise.
Works when variable costs fluctuate. This approach works well for products with fluctuating variable costs, because the price can be adjusted accordingly.
Ensures that costs are covered. This pricing method ensures that variable costs are covered, which is critical for short-term survival and to avoid selling at a loss.
Works well when most costs are variable. This approach can work well when variable costs comprise the bulk of all costs incurred. It can also be used when a company will not incur any additional fixed costs for each additional unit sold (a common occurrence when there is excess capacity). In this case, variable costs are the same as total costs, so the effect is the same as would be the case for cost-plus pricing.
Encourages incremental sales. This approach can be advantageous in scenarios where the business already covers fixed costs (e.g., during off-peak times) and wants to focus on covering variable costs to achieve incremental profits.
Tends to avoid over-pricing. Since pricing is based on actual costs plus a reasonable markup, it minimizes the risk of setting prices that are too high, and thereby alienating customers.
Provides pricing transparency. This approach provides clear justification for price increases or changes, which can help in negotiations or when explaining pricing decisions to customers.
Disadvantages of Variable Cost-Plus Pricing
Variable cost-plus pricing can result in unusual outcomes when variable costs comprise just a small proportion of total costs, since the markup multiplier may result in an unusually high or low price. Stated differently, this is not a good pricing option when fixed costs comprise the bulk of the costs being incurred for a product.
Generally, it is better to base prices on the going market rate, since this maximizes profits. If a price is set too high with variable cost-plus pricing, then customers will not buy the product. If prices are set too low, then the company is losing profits that it might have earned if profits had been set at the market rate.
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Example of Variable Cost-Plus Pricing
A manufacturer uses variable cost-plus pricing to develop a quote for a purple widget. The variable cost to produce one of these widgets is $20, and the firm uses a 40% markup percentage. This results in a quoted price of $28, which is calculated as follows:
$20 Variable costs x 1.4 Markup percentage = $28 Price
The company has fixed costs that are allocated at $6 per unit, which results in a total cost of $26. Since the price is $28, the company earns a $2 profit on the sale of each unit.