Variable Cost-Plus Pricing: Overview, Advantages, and Disadvantages

Explore the ins and outs of Variable Cost-Plus Pricing, a strategic pricing method that involves adding a markup to total variable costs to determine the selling price. Understand its advantages, disadvantages, and practical applications.

Variable Cost-Plus Pricing is a method where the selling price of a product or service is established by adding a predetermined markup to the total variable costs. This approach ensures that all variable costs are covered, while the markup provides the profit margin.

Break Down of Variable Costs

Variable costs are expenses that change in proportion to the volume of goods or services produced. These costs include:

• Raw Materials: Basic materials required for production.
• Direct Labor: Wages for workers directly involved in manufacturing.
• Utilities: Costs like electricity and water needed for production.
• Packaging: Expenses related to the packaging of products.
• Shipping: Costs for sending products to customers.

Calculation Formula

The basic formula for Variable Cost-Plus Pricing is:

$$ \text{Selling Price} = \text{Total Variable Costs} + \text{Markup} $$

where:

• Total Variable Costs (VC) include all variable costs (raw materials, labor, etc.)
• Markup (MU) is a percentage or fixed amount added to the total variable costs.

Example Calculation

Imagine a company produces a product with the following monthly variable costs:

• Raw materials: $1000
• Direct labor: $800
• Utilities: $200
• Packaging: $100
• Shipping: $100

Total Variable Costs (VC) = $1000 + $800 + $200 + $100 + $100 = $2200

If the company wants a markup of 30%:

$$ \text{Markup} = 0.30 \times 2200 = 660 $$

Therefore, the Selling Price (SP) would be:

$$ SP = VC + MU = 2200 + 660 = 2860 $$

Advantages of Variable Cost-Plus Pricing

Simplicity

The method is straightforward, making it easy to calculate and implement. It ensures all variable costs are covered while adding a clear profit margin.

Flexibility

It provides flexibility in adjusting markups based on competitive conditions, market demand, and cost changes.

Risk Mitigation

Ensures that variable costs are covered, diminishing risks associated with underpricing and operating at a loss.

Transparency

The method offers clear justification for pricing decisions, which can build trust with customers due to its straightforward nature.

Disadvantages of Variable Cost-Plus Pricing

Ignoring Fixed Costs

This method overlooks fixed costs such as rent, salaries of permanent staff, and depreciation, which might lead to underestimating the total cost of production.

Competitive Disadvantages

It does not consider competitor pricing, which can result in setting prices that are too high or too low compared to the market.

Demand Insensitivity

The method ignores consumer demand factors and price elasticity, potentially leading to missed opportunities for profit maximization.

Potential for Overpricing

Adding a too high markup can result in overpricing, reducing sales volume and market share.

Practical Applications

Manufacturing

Widely used in manufacturing industries where variable production costs are significant.

Contract Bidding

Common in contract bidding and project-based industries to ensure cost coverage and profit.

Small Businesses

Often adopted by small businesses seeking simple and straightforward pricing strategies.

Quality Assurance

Useful in industries focused on quality control and precise cost management.

FAQs

How does Variable Cost-Plus Pricing differ from Full Cost-Plus Pricing?

Variable Cost-Plus Pricing adds a markup to variable costs only, while Full Cost-Plus Pricing includes both fixed and variable costs before adding the markup.

Is Variable Cost-Plus Pricing suitable for all businesses?

It may not fit all business models, especially those with significant fixed costs or those operating in highly competitive or demand-sensitive markets.

Can the markup percentage be adjusted?

Yes, businesses can adjust the markup percentage based on market conditions, competitive analysis, and cost changes.

What are some industries where Variable Cost-Plus Pricing is not ideal?

Highly competitive industries, such as retail or technology, where pricing strategies need to be more dynamic and competitive, may not find this method ideal.

How can businesses address the limitation of ignoring fixed costs?

Businesses can combine variable cost-plus pricing with other methods or keep a parallel track for allocating fixed costs to ensure comprehensive pricing strategies.

Summary

Variable Cost-Plus Pricing offers a simple, flexible, and risk-mitigating approach to pricing by covering all variable costs with an added markup for profit. While it has clear advantages, such as transparency and operational ease, it falls short by ignoring fixed costs and competitive dynamics. Businesses need to weigh these pros and cons carefully to decide if this method fits their specific industry and operational needs. By understanding and potentially combining it with other pricing strategies, companies can strike a balance between cost coverage and market competitiveness.

References

• Financial Management by Eugene F. Brigham - A comprehensive book that delves into various pricing strategies, including Variable Cost-Plus Pricing.
• Principles of Economics by N. Gregory Mankiw - Provides foundational knowledge on supply, demand, and cost management.
• Pricing Strategies: A Marketing Approach by Robert M. Schindler - Offers insights into different pricing methodologies and their practical applications.