Cost-plus pricing is a simple method of setting sales prices. The prices are set to the cost of the goods (as in COGS) with percentage mark-up added. Cost-plus contracts use a similar method: a contractor receives their costs plus a set markup

Cost-plus pricing

The advantages of cost-plus pricing are that it is very simple and it guarantees margins — which type of margin it guarantees depends on which. The only information that it requires are costs, and these are likely to be tracked for other purposes anyway. The choice of what costs to include obviously makes a huge difference.

The problem with cost-plus pricing is that it pays no attention to market prices. This means that it inevitably leads to either margins that are lower than they need be, or last sales. In the extreme case, applying cost-plus pricing to a commodity (not that anyone would — not for long anyway!), could lead to no sales at all if the cost-plus price was above the market price.

A pricing method similar to cost-plus is sometimes imposed by regulators on monopolies such as some utilities (Ofwat's methods of setting prices, for example). This is usually somewhat different as the the price setting process is modified to give sellers motivation to be efficient: for example, by basing it on what the regulator calculates costs should be, rather than on actual costs.

Cost-plus contracts

Cost-plus contracts use somewhat problematic inclusion of cost-plus pricing in contract terms. This may mean either a percentage mark-up or a fixed addition to costs. The key problem with this is an agency one.

The contractor either (with a fixed amount of markup) has no incentive to reduce costs, or (with a percentage mark-up) an incentive to increase prices. Some contracts attempt to address this through incentive payments for efficiency or good performance, but this is tricky to get right. This is why the use of cost-plus contracts by governments is often controversial.

Copyright Graeme Pietersz © 2005-2016