Cost-plus pricing is a pricing method used by companies to maximize their profits.
The firms accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost, and then charging a price which is determined by the demand curve. However, in practice, most firms use cost-plus pricing, also known as markup pricing. There are several varieties, but the common thread is that one first calculates the cost of the product, then adds a proportion of it as markup. Basically, this approach sets prices that cover the cost of production and provide enough profit margin to the firm to earn its target rate of return.It is a way for companies to calculate how much profit they will make. Cost-plus pricing is often used on government contracts (cost-plus contracts), and has been criticized as promoting wasteful expenditures in the form of direct costs, indirect costs, and fixed costs whether related to the production and sale of the product or service or not. These costs are converted to per unit costs for the product and then a predetermined percentage of these costs is added to provide a profit margin.
Cost-plus pricing is used primarily because it is easy to calculate and requires little information. Information on demand and costs is not easily available, managers have limited knowledge as far as demand and costs are concerned. This additional information is necessary to generate accurate estimates of marginal costs and revenues. However, the process of obtaining this additional information is expensive. Therefore, cost-plus pricing is often considered the most rational approach in maximizing profits. This approach relies on arbitrary costs and arbitrary markups.
Read more about Cost-plus Pricing: Mechanics of Cost-plus Pricing, Reasons For Wide Use, Usefulness, Disadvantages, Cost-plus Pricing and Economic Theory