What Is Variable Cost-Plus Pricing?
Let me explain variable cost-plus pricing directly: it's a pricing method where you set the selling price by adding a markup to your total variable costs. The idea is that this markup will help cover all or part of your fixed costs and still leave you with some profit. You'll find this approach especially useful in competitive situations, like when you're bidding on contracts, but it's not the right fit if fixed costs make up a big chunk of your total costs.
How Variable Cost-Plus Pricing Works
Variable costs are things like direct labor, direct materials, and other expenses that go up or down based on how much you're producing. If you're using this method, you start by calculating the variable costs per unit, then you add a markup to cover the fixed costs per unit and hit your target profit margin.
Take this example: suppose your total variable costs for making one unit of a product are $10. You figure your fixed costs per unit are $4, and you want $1 profit per unit. So, you price it at $15. That's straightforward, right?
When to Use Variable Cost-Plus Pricing
You should consider this pricing method if a high proportion of your total costs are variable. That way, you can be confident your markup will cover the fixed costs per unit. But if variable costs are low compared to fixed ones—especially if fixed costs rise with more production—your pricing could end up inaccurate and unsustainable for turning a profit.
It's also a good option if you have excess capacity, meaning you can ramp up production without adding more fixed costs per unit. In that case, variable costs dominate, and your markup on them provides a solid profit margin. The big downside? This method ignores how the market values your product or what competitors are charging.
Advantages and Disadvantages of Variable Cost-Plus Pricing
The main advantage here is simplicity: you can quickly set a price that covers costs and includes a profit margin. It also simplifies contracts with suppliers, who like locking in prices that guarantee profits rather than dealing with unpredictable models. Plus, it's easy to explain price hikes to customers by pointing to increased production costs.
On the flip side, this model doesn't factor in market conditions, so you might miss out on higher profits if demand is strong. It also overlooks competitors—if your product is better, you could charge more, or if you undercut them by lowering prices, you might boost revenues. And if your variable costs are low, it can lead to inefficient pricing overall.
Pros & Cons of Variable Cost-Plus Pricing
- Pros: Comparatively simple way to cover the cost of producing goods; Allows suppliers to lock-in prices that cover costs; Facilitates contract negotiation with a comparatively simple means of calculating prices.
- Cons: Does not account for market demand, which can sometimes justify higher pricing; Does not account for competitors' goods, which can adversely affect sales; Can result in inefficient pricing if the company's variable costs are comparatively low.
Variable Cost-Plus Pricing vs. Cost-Plus Pricing
Variable cost-plus pricing differs from traditional cost-plus pricing, which bases prices on the total cost of production—including both variable and fixed—then adds a markup. With variable cost-plus, you're only marking up the variable costs, assuming that covers the fixed ones.
Critics say cost-plus pricing doesn't encourage efficiency because companies can inflate fixed costs to justify higher prices, rather than cutting inefficiencies.
Additional Notes on Related Concepts
What about rigid cost-plus pricing? That's basically the standard cost-plus model, calculating per-unit costs for everything from production to sales and adding a fixed markup.
To calculate variable cost-plus pricing, add a markup to the per-unit variable costs—like if materials, labor, and transport for a product cost $1, you might set the price at $1.20, assuming the markup covers fixed costs like facilities.
Examples of variable costs include raw materials and labor, which increase with production volume, unlike fixed costs such as factory rent or machinery that stay mostly the same.
Finally, variable cost transfer pricing is when related entities, like company departments, price internal sales based just on variable costs, without markup, though it stays close to market rates.
Other articles for you
The stock market capitalization-to-GDP ratio, or Buffett Indicator, measures market valuation by comparing total stock market value to GDP to assess if markets are over or undervalued.
A term sheet is a nonbinding document outlining basic terms for investments, deals, or loans to facilitate negotiations before a formal contract.
A hard-to-borrow list is a brokerage's record of stocks that are difficult to borrow for short selling.
Weak hands describe traders who lack conviction or resources, often selling low and buying high, contrasting with strong hands.
The Hope Scholarship Tax Credit was a nonrefundable education tax credit for the first two years of college, replaced by the American Opportunity Tax Credit in 2009.
A habendum clause defines the rights, interests, and ownership aspects in property-related contracts, commonly used in real estate and oil/gas industries.
An unearned discount is prepaid loan interest recorded as a liability and gradually recognized as income over the loan's term.
Internalization is the process where businesses handle transactions or projects internally to save costs instead of outsourcing them.
Asset management is the process of managing investments to grow wealth while balancing risk according to client goals.
A hands-off investor uses a passive strategy with index or target-date funds held long-term, requiring minimal monitoring and adjustments.