Overview

• What you’ll learn: Cost-plus pricing formulas, the choice of cost base (variable vs. full), target rate of return pricing, time-and-materials pricing for service firms, and the strengths and limitations of cost-based approaches.
• Prerequisites: Lesson 5 — Strategic Profitability Analysis
• Estimated reading time: 16 minutes

Introduction

The Grand Historian records: The merchant must know the cost of his silk before he names his price, lest he sell at a loss and call it commerce. Cost-based pricing begins with the fundamental question: what does this product cost to produce and deliver? Upon that foundation, a markup is added to achieve the desired profit. It is the most intuitive of pricing methods — and, as we shall see, both the most common and the most dangerous when used without wisdom.

Horngren (Chapter 12-13) presents cost-based pricing as one pillar of the pricing edifice, alongside market-based approaches. The cost accountant’s role is to ensure that the cost base is accurate, the markup is appropriate, and the resulting price is competitive.

Cost-Plus Pricing Formula

Price = Cost Base + (Markup Percentage × Cost Base)

Or equivalently: Price = Cost Base × (1 + Markup %)

Choosing the Cost Base

The broader the cost base, the smaller the markup percentage needed — but the larger the risk of including allocated fixed costs that distort the pricing signal.

Target Rate of Return Pricing

A common variant calculates the markup to achieve a target return on investment:

Target Price = Full Cost per Unit + (Target ROI × Invested Capital / Expected Units)

Example: Full cost = $80/unit, target ROI = 15%, invested capital = $2,000,000, expected volume = 10,000 units.

Target Price = $80 + (0.15 × $2,000,000 / 10,000) = $80 + $30 = $110 per unit.

The elegant simplicity of this formula conceals a circular problem: the price depends on volume, but volume depends on price. The target return is achievable only if the assumed volume materializes at the calculated price.

Time-and-Materials Pricing

Service firms (consulting, repair, professional services) often price using a two-component system:

• Time component: Labor cost + overhead markup + profit markup per labor hour.
• Materials component: Material cost + handling and storage markup.

Example: A consulting firm charges $200/hour (labor cost $80 + overhead $70 + profit $50) plus materials at cost + 15%.

Strengths and Limitations

Strengths

• Simple and systematic — provides a floor price below which the firm should not sell.
• Ensures cost recovery when applied correctly.
• Justifiable to regulators and customers — “cost plus fair profit.”
• Requires detailed cost information, which benefits the organization regardless of pricing method.

Limitations

• Ignores demand: The market does not care what your product costs. If your cost-plus price exceeds what customers will pay, you sell nothing.
• Circular logic: Full cost depends on volume; volume depends on price; price depends on full cost.
• Penalizes efficiency: Under cost-plus government contracts, reducing costs reduces revenue — creating a perverse incentive to maintain or increase costs.

太史公曰：The merchant who sets his silk price by doubling his cost may prosper when silk is scarce and customers desperate. But when a rival arrives with cheaper silk from the south, the cost-plus merchant discovers that the market sets the price — not his ledger.

Key Takeaways

• Cost-plus pricing adds a markup to a chosen cost base to determine selling price.
• The cost base can be variable cost, full manufacturing cost, or full absorption cost — each implies a different markup.
• Target return pricing calculates markup to achieve desired ROI but depends on volume assumptions.
• Cost-based approaches ensure cost recovery but ignore market demand and competition.
• Time-and-materials pricing is common for service firms with variable job scope.

What’s Next

In Lesson 7, we cross to the other side of the pricing equation — market-based pricing, target costing, and value engineering, where the market sets the price and the enterprise must engineer costs to fit.