What is a pricing example?

The Simplicity and Certainty of Cost-Plus Pricing: An Illustrative Example

In the competitive landscape of business, pricing strategies are crucial for survival and growth. One of the most straightforward, and often reliable, methods is cost-plus pricing. It’s a strategy that prioritizes profitability by guaranteeing a specific margin on every item sold. While more dynamic strategies exist, the inherent predictability of cost-plus pricing makes it an attractive option, particularly for businesses dealing with complex manufacturing or project-based services.

But what does cost-plus pricing actually look like in practice? Let’s explore a concrete example.

Imagine a small, artisanal furniture workshop that specializes in handcrafted wooden chairs. To understand their pricing, we need to consider all the costs associated with producing a single chair. These costs can be broken down into two main categories:

• Direct Costs: These are directly attributable to the creation of the chair. This includes:

  • Raw Materials: The cost of the wood, screws, glue, fabric (if applicable), and any other physical components needed. Let’s say this totals $50 per chair.
  • Direct Labor: The wages paid to the craftsman building the chair. If it takes 4 hours to build a chair and the craftsman earns $20 per hour, the direct labor cost is $80.

• Overhead Costs: These are the expenses incurred by the business regardless of the number of chairs produced. They are allocated proportionally. This could include:

  • Rent: The cost of the workshop space, allocated per chair based on the production volume. Let’s assume the monthly rent is $1,000 and the workshop produces 100 chairs per month, resulting in a rent allocation of $10 per chair.
  • Utilities: Electricity, heating, and other utilities. Let’s estimate this at $5 per chair.
  • Administrative Costs: A portion of salaries for office staff, insurance, and other administrative expenses, allocated proportionally. We’ll estimate this at $5 per chair.
  • Depreciation: Wear and tear on equipment. Let’s estimate this at $2 per chair.

Calculating the Total Cost:

• Total Direct Costs: $50 (Raw Materials) + $80 (Direct Labor) = $130
• Total Overhead Costs: $10 (Rent) + $5 (Utilities) + $5 (Administrative) + $2 (Depreciation) = $22
• Total Cost per Chair: $130 (Direct Costs) + $22 (Overhead Costs) = $152

Now that the workshop knows the total cost of producing a single chair, they can apply their desired markup to determine the selling price.

Applying the Markup:

Let’s say the workshop wants to achieve a 30% profit margin on each chair. This means they want to earn 30% of the total cost as profit.

• Markup Amount: $152 (Total Cost) * 0.30 (Desired Profit Margin) = $45.60

Determining the Selling Price:

• Selling Price per Chair: $152 (Total Cost) + $45.60 (Markup Amount) = $197.60

Therefore, using cost-plus pricing, the furniture workshop would sell each handcrafted wooden chair for $197.60. This price guarantees that they cover all their costs and achieve their desired 30% profit margin.

The Benefits of Certainty:

This simple example demonstrates the power of cost-plus pricing. It provides a clear and predictable method for setting prices, ensuring that the business consistently achieves its profitability targets. It’s particularly valuable for businesses in industries with fluctuating material costs, as the price can be adjusted accordingly to maintain the desired margin.

While not suitable for all business scenarios, especially those where price sensitivity is high, cost-plus pricing remains a fundamental and reliable strategy for businesses seeking to secure a profitable and sustainable operation. It offers a level of certainty that allows businesses to focus on production and quality, knowing their financial goals are built directly into the price.