Variable Cost-Plus Pricing

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21 Aug, 2024

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Variable cost-plus pricing is a pricing strategy that businesses use to determine a product's selling price. It entails setting the selling price by calculating the variable production expenses and adding a markup to earn the desired profit margin. It enables businesses to cover their production costs and generate an adequate return on investment.

Variable costs are expenses that change in direct proportion to the production or sales volume, like raw materials, direct labor, and direct overhead costs. This pricing method offers flexibility, enabling businesses to adjust the selling price based on changes in variable costs or market conditions. It ensures that the companies earn profit while remaining competitive.

What Is Variable Cost-Plus Pricing?

Variable cost-plus pricing is a pricing strategy that businesses employ to calculate a product's selling price that can cover the variable production cost and earn the desired profit.
It involves estimating the total variable cost and adding a markup value to establish the selling price. The markup value is usually expressed as a percentage of the variable cost.
This pricing strategy allows businesses to adjust the selling price according to fluctuating input costs and market conditions. Furthermore, it will enable companies to enhance their revenue generation, which leads to profit optimization.

How Does Variable Cost-Plus Pricing Work?

Variable cost-plus pricing is a pricing method that companies employ to establish a product's selling price. It involves estimating the variable production cost and adding a markup value. This strategy ensures that the selling price is sufficient to cover the production expenses and generate a desirable profit.

This pricing system ensures that all the variable costs are covered and enables flexibility in adjusting the selling prices depending on the fluctuations in input costs or market conditions. However, it does not consider fixed costs or customer perception of value. As a result, it becomes necessary for businesses to employ additional pricing strategies to enhance revenue generation and optimize profitability.

When To Use?

Businesses can use this pricing system in the following scenarios:

Companies where a product's delivery or production cost varies significantly due to factors like labor wages, changes in raw material prices, or overhead expenses can use this pricing strategy. It enables businesses to adjust the selling price to cover the fluctuating variable costs and enhance profitability.
This pricing strategy is beneficial for businesses that must cover all variable costs associated with producing a product. Businesses can establish the selling price at a level that guarantees cost recovery by adding a markup to the variable costs. It is specifically beneficial for companies with excess capacity or businesses where cost control is crucial.

How To Calculate?

The calculation process for this pricing strategy is discussed below:

The business must identify all the variable costs incurred for manufacturing the product. These costs change in direct proportion to the production or sales.
Then the business must determine the profit margin they wish to achieve. The profit margin is generally expressed as a percentage of the variable costs. It signifies the additional amount the business desires to earn after covering the variable expenses.
Then they must multiply the total variable cost by the desired profit margin percentage. It will display the profit they want to add to the variable costs.
After determining the markup value, they must add it to the total variable cost. Adding the total variable cost and the markup will give them the selling price.

Examples

Let us understand this concept with the following examples:

Example #1

Let us assume that Fairworks Ltd. is a company that manufactures stationery products. The total variable cost for manufacturing one notebook is $15. The company calculated that the fixed cost for manufacturing per notebook unit is $5. Therefore, Fairowrks Ltd. set a $22 selling price for each notebook to cover the production cost and earn a $2 profit per unit. This is an example of this pricing strategy.

Example #2

Suppose Rose Cosmetics is a company that produces beauty and makeup products. The variable cost for producing one face cream is $10. The company applied a 40% markup percentage. The quoted price for the product amounted to $14, which was calculated as follows:

Price = Variable costs x Markup percentage

= $10 x 140% =$14

Rose Cosmetics has estimated the fixed costs at $1 per unit. Thus, the total production cost amounted to $11. Since they set the selling price as $14, the company earned a $3 profit on the sale of each unit of face cream. This is an example of this pricing method.

Advantages And Disadvantages

The advantages are as follows:

This pricing strategy allows businesses to cover their production costs by incorporating all variable costs into the selling price. It helps prevent losses on each unit sold and enables sustainable operations.
It assists businesses in adapting to fluctuations in variable costs or market conditions. If the input cost increases or the market demand shifts, companies can adjust the selling price by altering the markup. This flexibility helps increase profitability and competitiveness.
This pricing method ensures transparency in pricing to customers and stakeholders. Since the selling price is directly based on the variable costs, it becomes easier for customers to understand the cost breakdown and allows them to observe fair pricing.
Companies can have better control over their cost structure in this method as it focuses on variable costs. They can track and manage variable expenses more effectively. Furthermore, it allows them to make informed decisions to optimize costs.

The disadvantages are as follows:

This pricing method overlooks the fixed costs, like rent, utilities, salaries, and other overhead expenses, in the pricing calculation. It can lead to underestimating the business's total costs, resulting in establishing prices that do not cover all the costs or generate enough profit.
It does not directly consider market demand as it is primarily driven by cost recovery and desired profit margin. This approach may not align with the customer's willingness to pay or the competitiveness in the market. Furthermore, it may lead to missed opportunities for revenue optimization.
This pricing strategy can be susceptible to changes in variable costs. The business might need to adjust the selling price if there are sudden surges in the production cost. Thus, it can result in pricing volatility and restrict companies from maintaining consistent pricing levels.

Variable Cost-Plus Pricing vs Cost Plus Pricing

The differences are as follows:

Variable Cost-Plus Pricing: This pricing strategy focuses on including the variable costs associated with producing a product at its selling price. It calculates the total variable costs like direct labor, raw materials, and direct overhead expenses and then adds a markup to obtain the desired profit margin. This process ensures that the selling price covers all variable costs and provides a fair return on investment.
Cost Plus Pricing: This broader pricing strategy includes variable and fixed costs incurred on producing a product. Cost plus pricing calculates the total cost spent in the production process and adds a markup to determine the selling price. The markup is usually expressed as a percentage of the total costs. This pricing ensures that all the variable and fixed costs are covered and allows a desired profit margin.

Frequently Asked Questions (FAQs)

1. What is the difference between variable cost-plus pricing and fixed cost-plus pricing?

The variable cost-plus method focuses only on the variable costs of producing a product. In contrast, the fixed cost-plus pricing method includes variable and fixed costs in the pricing estimation. Fixed cost-plus pricing considers the expenses that do not change with the production volume, like salaries, rent, utilities, and other overhead costs.

2. Is variable cost-plus pricing suitable for all types of businesses?

A vast range of businesses uses this pricing method. Organizations where cost control is essential to use this pricing strategy. However, it may not be suitable for companies with massive fixed costs because this method does not directly account for them in the pricing estimation.

3. How does variable cost-plus pricing help in maintaining profitability?

This pricing ensures that the product's selling price includes all the variable costs. It helps prevent losses on each unit by adding a desired profit margin to the variable costs. Thus, companies can generate a decent return on investment and maintain profitability by using this pricing.