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What is Variable Cost Plus Pricing?

Variable Cost Plus Pricing

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Variable Cost Plus Pricing

Variable Cost-Plus Pricing is a pricing strategy in which the selling price is determined by adding a markup to the variable costs of producing each unit of a product. Unlike full cost-plus pricing, which takes into account both fixed and variable costs, variable cost-plus pricing focuses only on the variable costs associated with each unit. This pricing strategy is often used in competitive or price-sensitive markets where covering fixed costs is secondary to getting immediate returns on each unit sold.

Formula:

The formula to set the price using this strategy can be simplified as:

SellingĀ Price = VariableĀ CostĀ perĀ Unit + (VariableĀ CostĀ perĀ Unit Ɨ MarkupĀ Percentage)

Advantages:

  • Simplicity: It’s a straightforward method that can be quickly and easily calculated.
  • Competitiveness: It allows companies to set lower prices than they would under full cost-plus pricing, making them more competitive in price-sensitive markets.
  • Cash Flow: By ensuring that each unit sold at least covers its variable cost plus a margin, companies can generate immediate cash flow.

Disadvantages:

  • Ignores Fixed Costs: This strategy doesn’t take into account fixed costs like rent, salaries, and utilities, which can be risky in the long term.
  • Narrow Focus: By concentrating only on variable costs, you may overlook other important factors such as competitor prices, perceived value, or demand elasticity.
  • Low Profit Margins: The margins are often low, especially in highly competitive markets.

Example of Variable Cost Plus Pricing

Let’s use a fictional bakery named “WonderBread” to demonstrate the concept of Variable Cost-Plus Pricing.

Business Context:

WonderBread specializes in sourdough bread. Each loaf of bread they produce has variable costs associated with the flour, yeast, salt, and labor required for baking.

Variable Costs:

Here’s the breakdown of variable costs for making a single loaf of sourdough bread:

  • Flour: $0.60
  • Yeast: $0.10
  • Salt: $0.05
  • Labor (baker’s time): $0.75

The total variable cost per loaf would be $0.60 + $0.10 + $0.05 + $0.75 = $1.50.

Pricing Strategy:

WonderBread decides to use a Variable Cost-Plus Pricing strategy with a markup of 40% on the variable costs.

Price Calculation:

To set the selling price using this strategy, the bakery would use the following formula:

SellingĀ Price = VariableĀ CostĀ perĀ Loaf + (VariableĀ CostĀ perĀ Loaf Ɨ MarkupĀ Percentage)

Selling Price = $1.50 + ($1.50 x 40 / 100)

Selling Price = $1.50 + $0.60 = $2.10

So, each loaf of sourdough bread would be sold for $2.10 using the Variable Cost-Plus Pricing strategy.

Business Implications:

  • Immediate Coverage of Costs: With each loaf sold, WonderBread covers the variable cost and makes an additional $0.60, which can then be used to cover fixed costs or contribute to profits.
  • Competitive Pricing: By using only the variable costs as the base for pricing, WonderBread can offer competitive prices that might attract price-sensitive consumers.
  • Risks: Since this pricing strategy doesn’t account for fixed costs like rent, equipment, and utilities, WonderBread needs to ensure that the sales volume is high enough to cover these expenses in the long run.
  • Flexibility: This strategy also gives the bakery some flexibility. If there’s a sudden surge in demand, the pricing model easily adjusts for changes in variable costs, such as the cost of flour or labor.

By understanding Variable Cost-Plus Pricing through this example, we can see how it serves as a viable strategy for setting prices in specific market conditions, although it comes with its own set of challenges and risks.

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