Variable Cost-Plus Pricing
It is an accounting concept related to goods and services pricing
What Is Variable Cost-Plus Pricing?
Variable cost-plus pricing is an accounting concept related to goods and services pricing. Many companies use this pricing form, which is common among businesses today.
Variable cost-plus pricing adds a markup to the total variable cost of the goods or services sold. The basis of this mechanism is that the markup will compensate for all fixed costs relating to the production with a profit provision.
The markup can meet all or part of the fixed costs; simultaneously, the pricing mechanism is intended to yield some profit for the company.
Total cost is a summation of Fixed cost and variable cost. Relative to production, the cost pricing model determines the costs associated with producing goods and services.
Accountants agree that for a company using this pricing system to make a profit, the markup percentage must be reasonably high to cover fixed and administrative costs and provide a profit.
This model finds its roots in the Theory of production, a known subject of Economics. According to this theory, organizations and companies are rational and decide the entity's costs.
The theory states that a company decides what it will produce, the cost of labor and wages, electricity, raw materials, how much it will sell, the commodity it produces, and so on.
This economic theory of production attempts to justify the doctrines by which a business firm decides how much of each item it sells (goods or services).
The theory relates to pricing, what the company will produce, labor costs, raw materials, fixed capital goods, etc. Production theory affects some of the most basic principles of economics.
These include the relationship between the prices of items and the cost (Fixed costs like rent, compensations, and salaries) of the productive factors used to produce goods and services and the relationships between the prices of factors of production and production.
Additionally, the theory elaborates on the relationship between the quantities of these items and productive factors.
It is from this theory that the Variable cost-pricing model was developed.
Key Takeaways
- The Variable cost-pricing model is an accounting concept that relates to the pricing of the goods or services to be sold by adding a markup to the Variable cost. Hence, the rationale behind this pricing model is that the markup will compensate for all fixed costs, including profit provisions.
- The Theory of production is an important one relative to pricing models. The theory is the basis upon which the company prices its goods and services.
- One of the main prerequisites to adopting this pricing model is to ascertain the company's cost structure before using this system. Businesses and companies often use this pricing system with a high proportion of variable costs in the total costs.
- It should be noted that the model assumes that a business may not incur an expansion in fixed cost as it produces more goods; however, this is not always the case.
When is Variable Cost-Plus Pricing Used?
It should be noted that any company that intends to use the Variable-Cost plus pricing must meet certain conditions before the method is adopted; otherwise, it may negatively affect the company.
The question is when should the Variable cost-pricing model be adopted?
It is a known fact that adopting this method requires the company to review and study its cost structure. This model is suitable for a company with a high variable cost level.
Therefore, companies feel comfortable having variable costs that drive a huge portion of its cost. Hence, if the variable costs are lower than fixed costs, the company can run into problems.
This model assumes that a business or company may not incur an increased fixed cost as it produces more goods.
Therefore, it can be concluded that the Variable Cost-plus pricing model is held in high regard because of its flexibility and efficiency. These are the two most important features that are the main criticism of the traditional cost pricing model.
Example
Company ABC has a fixed cost of $110,000 for producing 10,000 bags of cement, while the variable cost of producing such cement is $200,000. The company can use the Variable cost plus price model.
How to Calculate Variable cost-plus pricing
Variable costs include various expenses, such as materials, that change with increased production levels. The lists also include packaging, commission, raw materials, and others.
Therefore, to answer the question of determining the Variable cost-plus price, the following are the steps.
Step 1
The company that intends to use this pricing model must determine its cost structure. This is a critical step because the company may have poor cost management systems, which may lead to losses.
The company must be away from the total cost of production of goods or services it intends to sell to the public. The total production cost comprises two categories of costs: fixed and variable costs.
Step 2
The second step is to evaluate the total variable costs of production of goods or services. The company needs to establish if the variable costs outweigh the fixed cost of production. Therefore, the company can be confident that the percentage markup will cover the production cost.
After that, the total cost of production is divided by the total quantity of goods produced to come up with a unit cost of production.
Step 3
After this, the company can add a markup percentage to the unit cost of production. This is done by multiplying the markup percentage times the per unit production costs. The markup percentage is added to the variable costs after considering both the variable and fixed costs.
Note
The methods determining the Variable cost-plus pricing may be from the traditional pricing method, namely, the Cost plus Pricing method.
Advantages of Cost-Plus Pricing
This pricing model is preferred due to its features. Companies usually use this pricing model due to several reasons.
However, the advantages of this pricing model are for both the company that uses the pricing model as well as the suppliers of the said company.
The following are some benefits of using the Variable cost-plus pricing model.
1. Easy to Use
It is an easy method of determining the price of goods or services. Therefore, the company may not require special accounting expertise to determine the price.
2. Useful in contracts with suppliers.
The model makes it easier to seal supplier contracts. The suppliers are usually confident with this pricing model because it guarantees that the sales will cover their contracts.
For instance, a supplier may be more confident to enter into a trade credit agreement when the company on the other side has this pricing model.
3. Allows suppliers to justify prices.
The other benefit of this pricing method is that it makes it easier for suppliers to explain price increases.
4. Flexibility
Lastly, this pricing model is liked and preferred by management because it is flexible to changes in variable cost per unit of goods produced. This differs from the Cost plus pricing model, which is considered old and not flexible.
Disadvantages of Cost-Plus Pricing
Though this pricing model has the earlier stated benefits, it equally has a downside to it. Therefore, it is important to know and understand the drawbacks associated with this accounting model.
The disadvantages of this pricing model are both to the company that uses it and the people who buy the product.
The following are the disadvantages of the Variable cost-plus pricing model.
1. Ignores competition
It disregards or ignores the competition's pricing. As a result, the company may end up pricing its product or service higher than its competitors in the industry. This can lead to losing clients and customers.
2. Disregards Market variables.
The method also does not consider the market variables that relate to the value and price of the product. The product or service pricing must contemplate the consumer’s readiness to buy the goods or services.
3. Vulnerable to high Fixed cost entities.
The model may not work when the company has a huge proportion of Fixed costs compared to Variable costs; furthermore, when the company has Fixed costs that change relative to an increase in production.
4. It may encourage price hikes.
There is a chance that the supplier may adjust the prices of the materials when it's aware of the markup being charged by its customers.
Cost plus pricing Vs. the Variable cost-plus pricing model
There is a distinction between the two that is very important to understand. Though both accounting models relate to the pricing of goods and services, they differ.
People mustn't mistake the two concepts. To fully understand the Variable Cost plus pricing model, we will examine the Cost plus pricing model.
The Cost plus pricing model is considered the old and traditional method of pricing goods. Though it adds a markup percentage to the cost, there is a unique distinction, just like the Variable Cost plus Pricing model.
The distinction is that the Cost plus Pricing model adds a Fixed and specified markup to the fixed cost. This differs from the other pricing model, where the markup percentage is added to the Variable costs.
Professionals and management have criticized this traditional model as insufficient and inadequate. Because the prices are based on Total costs, more revenue gets lost in inefficiencies of production or management.
This is why this pricing model has been called the Rigid Cost plus pricing model. It is all due to the rigidity of basing a markup on the total production or manufacturing costs.
Note
The Cost plus Pricing model is called the Rigid Cost Plus Pricing Model.
This differs from the Variable Cost plus Pricing model, which bases its markup on variable cost. Additionally, the model supports businesses with a huge variable cost and a lower Fixed cost.
Government and public institutions contracts have usually used cost plus markup. Suppliers have criticized the same model because it has a low incentive to help them with direct and indirect costs.
The main drawback of this pricing model is that it demands a lot of details. It is a comprehensive process that details the overall costs of a company. Consequently, this makes the pricing model demanding.
Note
The two pricing methods consist of the same costs, namely, Fixed and Variable costs. However, the difference is in the convention of pricing the product or service.
Both methods include costs such as raw materials, transportation, sales, and other costs, but the basis upon which the markup is added in each model is different.
Below is a table showing the differences between the Cost plus pricing model and the Variable cost-plus pricing model
| Cost plus Pricing | Variable cost-plus pricing model |
|---|---|
| The Cost plus Pricing model adds a Fixed and specified markup to the fixed cost. | With this model, the markup percentage is added to the Variable costs. |
| This pricing model has been called the Rigid Cost plus pricing model because of basing a markup on the total production or manufacturing costs. | It is more flexible to changes in units per production. |
| This model is based on Fixed cost. | This model is focused on variable costs. |
| This model is criticized for being a long process that demands many details. | This model is easy and faster to adopt. |
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