Variable Cost-Plus Pricing: Definition, How It Works, and Example
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Summary:
Variable cost-plus pricing involves adding a markup to variable costs for profit, making it beneficial for contract bidding. However, it falls short in considering market factors and can lead to pricing inefficiencies. Explore how this pricing method works, its advantages and disadvantages, and when it’s apt for use.
What is variable cost-plus pricing?
Variable cost-plus pricing is a strategic method employed in determining the selling price by incorporating a markup to total variable costs. The primary goal is to encompass both fixed and variable costs, thereby securing a profit margin. This pricing approach proves advantageous in competitive scenarios, such as contract bidding, emphasizing simplicity in cost determination. However, it may encounter limitations in situations where fixed costs exert a substantial influence on overall expenses.
How variable cost-plus pricing works
In the intricate workings of variable cost-plus pricing, variable costs, encompassing elements like direct labor and materials, are meticulously computed on a per-unit basis. Following this, a calculated markup is introduced to account for fixed costs and generate a targeted profit margin. For example, if the variable costs for manufacturing a single unit amount to $10, and fixed costs are estimated at $4 per unit, setting the unit price at $15 ensures profitability.
Example of variable cost-plus pricing
Let’s illustrate the application of variable cost-plus pricing with a hypothetical scenario involving a manufacturing company. Suppose the variable costs per unit, including direct labor and materials, amount to $8. The fixed costs per unit are estimated at $4. To generate a desired profit margin of $3 per unit, the company applies a markup to cover both variable and fixed costs.
Calculation:
- Variable Costs: $8
- Fixed Costs: $4
- Markup (Profit Margin): $3
Total Price per Unit: $15
This example demonstrates how variable cost-plus pricing enables the company to set a competitive price while ensuring coverage of both variable and fixed costs, ultimately leading to a targeted profit margin.
Variable cost-plus pricing vs. cost-plus pricing
Variable cost-plus pricing stands apart from traditional cost-plus pricing through its focal point on variable costs. In contrast to cost-plus pricing, which considers the total cost of production and adds a markup, variable cost-plus pricing relies on the assumption that the markup on variable costs adequately covers fixed costs.
Challenges and criticisms of variable cost-plus pricing
While variable cost-plus pricing offers simplicity and ease of application, it is not without its challenges and criticisms. Here are some considerations:
- Market dynamics ignored: One significant drawback is that variable cost-plus pricing tends to overlook market dynamics, such as demand fluctuations. Ignoring these external factors can lead to missed opportunities for optimal pricing.
- Competitor pricing: The model doesn’t account for competing products or pricing strategies employed by competitors. In instances where a company’s products may be superior, a more flexible pricing approach might be beneficial.
- Potential for inefficient pricing: In situations where a company’s variable costs are notably low, adding a standard markup may result in inefficient pricing. The model might fail to capture the true value or uniqueness of a product.
- Limited strategic value: Variable cost-plus pricing might be viewed as a more tactical approach rather than a strategic one. Businesses seeking to align pricing with broader strategic goals may find this method restrictive.
The bottom line
In summary, variable cost-plus pricing offers a straightforward approach to determining the selling price by incorporating a markup to variable costs. While advantageous in competitive scenarios and for businesses with excess capacity, it may face limitations in addressing market dynamics and competitor pricing. The key lies in understanding the balance between variable and fixed costs, ensuring the pricing strategy aligns with the business’s unique characteristics. Variable cost-plus pricing provides a pragmatic tool but should be applied judiciously, considering the broader context of the business environment.
Frequently asked questions
What is rigid cost-plus pricing?
Rigid cost-plus pricing, often referred to as cost-plus pricing, adheres to a simpler model. It establishes pricing solely based on the total cost of producing and selling a product. In this model, the per-unit costs, encompassing production, transportation, sales, and additional services, are computed, and a fixed markup is added to derive the final price.
How do you calculate variable cost-plus pricing?
The calculation of variable cost-plus pricing involves adding a markup to the per-unit costs of producing each additional item. For example, if the costs of materials, labor, and transportation for a bottle of Pepsi amount to $1.00, a total price of $1.20 might be set. While this model excludes fixed costs like facilities and utilities, the assumption is that the markup sufficiently covers these expenses.
What are examples of variable costs?
Variable costs represent production expenses that escalate with increased unit production. Raw materials and labor are quintessential examples, as the production of more units necessitates additional raw materials and labor. Conversely, fixed costs, such as those associated with facilities and machinery, remain relatively stable.
What is variable cost transfer pricing?
Variable cost transfer pricing pertains to transactions between related entities, like different departments of the same company or a parent company and its subsidiary. In this context, the purchaser pays only the variable costs of production, excluding any markup.
Is variable cost-plus pricing suitable for all businesses?
Variable cost-plus pricing can be effective for businesses with a high proportion of variable costs and those with excess production capacity. However, its suitability depends on the specific characteristics of the business. Companies with significant fixed costs or those operating in markets with high demand fluctuations may find this pricing model less advantageous. It’s crucial to assess the nature of costs, production capacity, and market conditions before adopting variable cost-plus pricing as a primary strategy.
Key takeaways
- Variable cost-plus pricing simplifies cost coverage for goods.
- It is effective for contract negotiation and locking in prices with suppliers.
- However, it may lead to inefficient pricing in markets with low variable costs.
- Doesn’t consider market demand or competitors, potentially affecting sales.
- Understanding when to use it is crucial; high variable costs and excess capacity make it more suitable.
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