Variable cost-plus pricing

Variable cost-plus pricing is a system for developing prices that adds a markup to the total amount of variable costs incurred. Examples of the variable costs incurred are direct materials and direct labor. For the seller to earn a profit under this pricing arrangement, the markup percentage must be sufficiently high to cover fixed costs and administrative costs, as well as a reasonable profit. This approach can work well when variable costs comprise the bulk of all costs incurred. However, it can result in unusual outcomes when variable costs comprise just a small proportion of total costs, since the markup multiplier may result in an unusually high or low price. Another situation in which variable cost-plus pricing can be used is when a company will not incur any additional fixed costs for each additional unit sold (a common occurrence when there is excess capacity). In this case, variable costs are the same as total costs, so the effect is the same as would be the case for cost-plus pricing.

For example, a manufacturer uses variable cost-plus pricing to develop a quote for a purple widget. The variable cost to produce one of these widgets is $20, and the firm uses a 40% markup percentage. This results in a quoted price of $28, which is calculated as follows:

$20 Variable costs x 1.4 Markup percentage = $28 Price

The company has fixed costs that are allocated at $6 per unit, which results in a total cost of $26. Since the price is $28, the company earns a $2 profit on the sale of each unit.