What is Variable Cost-Plus Pricing
Variable cost-plus pricing is a pricing method in which the selling price is established by adding a markup to total variable costs. The expectation is that the markup will contribute to meeting all or a part of fixed costs, and yield some level of profit. Variable cost-plus pricing is especially useful in competitive scenarios such as contract bidding but is not suitable in situations where fixed costs are a major component of total costs.
BREAKING DOWN Variable Cost-Plus Pricing
Variable costs include direct labor, direct materials, and other expenses that change in proportion to production output. A firm employing the variable cost-plus pricing method would first calculate the variable costs per unit, then add a mark-up to cover fixed costs per unit and generate a targeted profit margin. For example, assume total variable costs for manufacturing one unit of a product are $10. The firm estimates that fixed costs per unit are $4. To cover the fixed costs and leave a profit per unit of $1, the firm would price the unit at $15.
Appropriate Use of Variable Cost-Plus Pricing
This method of pricing can be appropriate for a company when a high proportion of total costs are variable. A company can have confidence that its markup will cover fixed costs per unit. If the ratio of variable costs to fixed costs is low, pricing of a product may end up being inaccurate and unsustainable for the company to make a profit. Variable cost-plus pricing may also be suitable for companies that have excess capacity. In other words, it would not incur additional fixed costs per unit by incrementally increasing production. Variable costs, in this case, would comprise most of the total costs (e.g., no additional factory space would need to be rented for extra production), which would place the firm in the situation cited above.