Variable Cost-Plus Pricing

Variable Cost-Plus Pricing

Variable cost-plus pricing sets a product’s selling price by adding a markup to the variable cost per unit. The markup is intended to contribute toward fixed costs and produce a profit. This method is inward-looking: it focuses on internal costs rather than market demand, competitor prices, or perceived customer value.

How it works

1. Identify variable costs per unit (direct materials, direct labor, variable overhead).
2. Add a markup intended to cover a portion of fixed costs and provide a profit margin.
3. Set the selling price = variable cost per unit + markup.

Example:
– Variable cost per unit = $10
– Estimated fixed cost allocation per unit = $4
– Desired profit per unit = $1
– Price = $10 + $4 + $1 = $15

Note: The method assumes the markup will sufficiently cover fixed costs; it does not explicitly allocate total fixed costs across units.

When to use it

• When a high proportion of total costs are variable.
• For contract bidding where fixed costs are stable and known.
• When a company has excess capacity (additional units don’t substantially raise fixed costs).
  It is less suitable when fixed costs are large or increase with production, or when market-based pricing (demand, competition, value perception) is important.

Advantages

• Simple to calculate and explain.
• Useful for transparent supplier contracts and predictable pricing.
• Easier to justify price changes tied to production cost changes.

Disadvantages

• Ignores market demand and competitor pricing — may leave profit on the table or cause lost sales.
• Can produce inefficient pricing if variable costs are low relative to fixed costs.
• Unsuitable when fixed costs rise with output or when fixed costs are a large portion of total costs.

Pros & Cons (summary)

Pros:
* Simple and straightforward
* Facilitates contract negotiation
* Ties price to production costs

Cons:
* Doesn’t reflect market conditions
* Can misprice products relative to competitors
* Risk of unsustainable pricing if fixed costs are significant

How it differs from cost-plus pricing

• Variable cost-plus pricing adds a markup only to variable costs (assuming the markup covers fixed costs).
• Traditional cost-plus (rigid cost-plus) pricing adds a markup to the total cost (variable + fixed) per unit.
  Criticisms of total cost-based pricing include weaker incentives for cost control, since higher reported costs can justify higher prices.

Calculating variable cost-plus pricing (steps)

1. Sum all variable costs per unit (materials, labor, variable overhead).
2. Decide desired markup or target profit per unit.
3. Add the markup to the variable cost to set the price.
4. Check whether the markup plausibly covers fixed costs at expected volume; adjust if necessary.

Examples of variable costs

• Raw materials
• Direct labor tied to production hours
• Packaging per unit
• Shipping cost per unit
  Fixed costs (not included in variable cost calculation) typically include rent, depreciation, and salaried management.

Variable cost transfer pricing

Variable cost transfer pricing sets the internal transfer price equal to the selling division’s variable cost, often with no markup. It is commonly used when related entities transact internally at near arm’s-length terms; it covers incremental costs but does not allocate fixed overhead or profit.

Key takeaways

• Variable cost-plus pricing is useful when variable costs dominate and fixed costs are stable or minimal.
• It is straightforward but inward-looking and may not capture market opportunities or competitive pressures.
• Always validate that markups will cover fixed costs at planned production volumes; when they won’t, consider full cost-plus or market-based pricing.