Variable Cost-Plus Pricing

Definition

Variable cost-plus pricing is a pricing strategy in which a product’s selling price is determined by adding a fixed markup to its variable costs. In this method, the variable costs include the direct expenses associated with producing a product, such as labor and materials. The fixed markup represents the desired profit margin and helps a company cover its fixed costs, while also generating a profit on each product sold.

Phonetic

Variable Cost-Plus Pricing in phonetics is: ˈvɛər i ə bəl kɒst ˈplʌs ˈpraɪs ɪŋ

Key Takeaways

1. Variable Cost-Plus Pricing is a pricing strategy where a company sets the price of a product or service by adding a profit margin to the variable cost of production. This allows businesses to cover their variable costs, while still earning a profit on each unit sold.
2. This pricing strategy is commonly used in industries where the variable cost of production is significant, such as manufacturing or service-based businesses. It ensures that companies can remain competitive in the market and adapt to fluctuations in production costs.
3. While Variable Cost-Plus Pricing can be effective in certain situations, it does have its limitations. It may not always accurately reflect the true value of a product or service, leading to potentially lower profits. Additionally, it does not take into account fixed costs, which can be detrimental to the overall financial health of a company if they aren’t covered.

Importance

Variable Cost-Plus Pricing is an important concept in business and finance as it enables companies to determine the optimum selling price for their products or services, ensuring profitability and competitiveness in the market. This pricing strategy takes into account the variable costs related to producing a product, such as raw materials and labor, and adds a profit margin, known as the “mark-up,” to establish the final price. By utilizing Variable Cost-Plus Pricing, companies can effectively cover all production costs, generate desired profit margins, and remain responsive to fluctuations in cost factors or market conditions. Furthermore, it simplifies financial decision-making and helps businesses maintain a sustainable pricing model in the ever-changing economic landscape.

Explanation

Variable Cost-Plus Pricing is a strategic pricing approach utilized by businesses to determine the selling price of their products or services. The primary purpose of this method is to ensure that the company not only covers its variable costs (costs that change depending on the production volume) but also generates a profit in accordance to a predetermined markup percentage. By incorporating this pricing model, businesses can maintain a consistent profit margin that caters to fluctuations in production levels and market demand, subsequently enabling better financial planning and stability. This pricing technique is especially beneficial for companies in industries where production costs vary significantly or markets are highly competitive. By establishing the appropriate price for their offerings, businesses can remain flexible in their pricing decisions while capitalizing on opportunities to maximize profitability and market share. As Variable Cost-Plus Pricing accounts for the ever-changing nature of costs such as raw materials, labor, and even utilities, this approach helps render pricing decisions that are well-informed and align with the company’s financial goals. As a result, firms can secure their competitive advantage and create sustainable long-term growth.

Examples

Variable cost-plus pricing is a pricing strategy where businesses set the product’s price based on the cost of producing one additional unit (variable cost) and adding a markup to cover overhead costs and profit margins. 1. Manufacturing Industry: A furniture manufacturer incurs variable costs such as raw materials (wood, fabric, hardware), labor, and shipping costs for each piece of furniture produced. To determine the selling price, the manufacturer adds a markup percentage to the variable cost of producing one additional unit. For example, if it costs $100 to produce one more chair and the desired profit margin is 30%, the selling price would be $130 ($100 + $30). 2. Food Service Industry: A restaurant or cafe incurs variable costs such as ingredients, packaging, and labor for making dishes or drinks. In order to use variable cost-plus pricing, the owner would calculate the cost of making one additional menu item (e.g., sandwich, coffee) and add a markup to cover overhead costs (rent, utilities) and desired profit. For example, if it costs $2 to make one sandwich, and a 50% profit margin is desired, the selling price would be $3 ($2 + $1). 3. Clothing Retail Industry: A clothing store buys products from suppliers and incurs variable costs such as shipping costs, storage costs, and labor for each product. To set the selling price, the store would use variable cost-plus pricing by determining the cost of acquiring one more unit of a particular product and adding a markup to cover overhead costs like rent and utilities, and achieve the desired profit margin. For example, if it costs $20 to acquire one more T-shirt, and a 40% profit margin is desired, the selling price would be $28 ($20 + $8).

Frequently Asked Questions(FAQ)

Related Finance Terms

• Contribution Margin
• Break-Even Analysis
• Direct Material Costs
• Direct Labor Costs
• Cost-Volume-Profit Analysis

Sources for More Information

• Corporate Finance Institute
• AccountingTools
• The Balance
• Indeed