Full cost-plus and marginal cost-plus are two widely used pricing methods. Both methods calculate the selling price of a product per unit in different ways.
Both methods offer some benefits and limitations to their users. A business must consider a few key factors discussed below in detail before choosing one of these two methods.
Full Cost-Plus Pricing
It is a method of calculating the selling price of a unit by adding a markup to the total cost of a product or service.
As the name suggests, this approach considers the full cost of production of a product or rendering services. Full costs of a product include both fixed and variable costs.
It is one of the most common methods to calculate the selling price of a product. The business first calculates the total costs of a product. Then, it adds the desired markup to that amount, the resulting amount is the selling price.
This method is preferred by most retail businesses. This approach covers the full costs of production. So, a business can easily cover its other costs such as admin and selling through the added markup.
Marginal Cost-Plus Pricing
It is an approach that determines the selling price of a product by adding the markup over the marginal or variable cost of production.
Businesses with a larger proportion of variable costs prefer this method. These businesses add markup over variable costs only in anticipation of covering the fixed costs as well as generating profits.
This approach helps a business with different pricing strategies. For example, a business can use this approach for market penetration. Also, it lets a business remain competitive in a highly competitive market.
Marginal cost-plus pricing is closely aligned with the marginal costing method. It considers variable costs as a key metric.
Variable costs of production are usually direct product costs such as raw material, direct labor, and other direct expenses.
Fixed costs do not change with the production level of a product. These are also called sunk costs. Common examples of these costs include building rent, fixed salaries, utility bills, etc.
Full Cost-Plus Vs Marginal Cost-Plus Pricing: How to Calculate it?
The step-by-step approach to calculating the selling pricing using one of these two methods is the same. Both methods take a similar approach.
The only difference is between the type of cost used as a base number. Also, the markup percentage or the ratio of the markup would be considerably different in both methods.
The first step is to calculate the cost of production for a product or service. For the full costing method, the company will use the total cost of production including variable and fixed costs.
For marginal cost-plus pricing, the company will only take variable costs of production.
The next step is to calculate the cost per unit. It is derived by simply dividing the total cost calculated by the total number of units produced.
In the third step, the company will add the required markup. The company can use a percentage or a dollar value.
Full Cost-Plus Vs Marginal Cost-Plus Pricing: How Does it Work?
Let us discuss how both methods work.
Full Cost-Plus Pricing
This pricing method is commonly used by retail businesses. It is also suitable for businesses that produce products in bulk.
This approach calculates the full costs of production. Since it considers the full cost, the company can add a small markup. It can help a business remain competitive.
It is a flexible pricing method that helps a business recover the total costs as well as retain profits. If the input costs increase, the business can still make the same percentage of profit.
Marginal Cost-Plus Pricing
The marginal cost-plus pricing adds the required markup to the variable costs of production.
This approach is suitable for businesses that have a higher proportion of variable costs. The business can then add a higher markup percentage to recover the fixed costs as well as make profits.
This method works well for businesses that produce customized products and use sophisticated technologies.
Full Cost-Plus Vs Marginal Cost-Plus Pricing: When to Use It?
The full cost-plus method is suitable for retail businesses. It is also a preferred method for businesses that do not offer customized products.
It is also commonly used in cost-plus contracts. Construction companies add the required markup percentage on top of the total costs of a project. The markup percentage can be decided mutually with the client.
Contrarily, the marginal cost-plus pricing is a preferred choice of businesses that have a large proportion of variable costs. It is also used widely by businesses that have excess capacity.
It should be considered carefully as it takes into account variable costs only. A business must carefully analyze the markup percentage that can recover fixed costs and generate sufficient profits.
Both pricing methods can be used in similar industries. The key difference between the two approaches remains the calculation of the cost of production per unit. Subsequently, the markup ratio for both approaches will differ drastically as well.
Full Cost-Plus Vs Marginal Cost-Plus Pricing: When to Avoid it?
It is advised to avoid the full cost-plus pricing method in highly competitive markets. This approach ignores external market factors such as competition and customers’ preferences.
Full cost-plus pricing is also difficult to use for businesses that produce tailor-made products for their clients. Some businesses such as software as a service provide long-term benefits for their products/services. Thus, they cannot charge with a cost-plus method only.
Marginal cost-plus cannot be used for businesses that have higher fixed costs. If the business incurs heavy indirect costs, then this method should not be used.
Similarly, this pricing approach also does not consider external market factors. Thus, it is not a preferred method of price setting for businesses in a highly competitive market.
Businesses that have costly setup costs and sophisticated technology will have high fixed costs. Thus, a business should carefully consider the markup percentage that it adds over its variable costs.
Full Cost-Plus Vs Marginal Cost-Plus Pricing: Key Differences
Let us see some key differences between both pricing methods.
|Metric||Full Cost-Plus||Marginal Cost-Plus|
|Definition||Full cost and the markup to calculate the selling price per unit.||Variable cost and the markup to calculate the selling price per unit.|
|Formula:||SP = TC × (1+Markup)||SP= VC× (1+markup)|
|Use||Should be used when a product does not require much customization.||Preferrable method for products with the customization and large variable cost proportion.|
|Avoid||In a highly competitive market and for price-sensitive clients.||When a business has excess production capacity or with large fixed costs.|
|Key Advantage||Simple and easy method Covers full costs and provides profits.||Keeps a company competitive. Easy and simple method.|
|Main Drawback||Ignores external market factors. Markup can be too high.||Ignores fixed costs. Markup may not cover all bases for the business.|
|Preferred by||Retail businesses, contract-plus industry.||Businesses with customized products, Software companies.|
Full Cost-Plus Vs Marginal Cost-Plus Pricing: Advantages
Both methods provide some advantages to their users. The choice between the two methods would largely depend on the industry and production costs of a business.
Key advantages of the full cost-plus method include:
- It offers consistent returns.
- It is a simple and easy method.
- Considers full internal costs of production.
- Can be used as a transparent pricing policy.
Key advantages of the marginal cost-plus method include:
- It helps a company fully utilize its excess capacity.
- It is useful in the short term with market penetration strategies.
- It helps a business to stay competitive.
- It offers a flexible pricing approach.
Full Cost-Plus Vs Marginal Cost-Plus Pricing: Disadvantages
Both pricing methods also come with some drawbacks.
Disadvantages of the full cost-plus method include:
- It can make a product overpriced.
- It ignores market competition.
- It does not provide an incentive to company employees to increase operating efficiency.
- Customers may not be willing to pay higher prices.
Disadvantages of the marginal cost-plus method include:
- It ignores fixed costs that may contribute to a large proportion of costs.
- It is not suitable for businesses with excess production capacity.
- It can only be used as a short-term pricing strategy and it may not be a sustainable option for a business in the long run.
- It cannot be used by all types of businesses with a traditionally equal proportion of variable and fixed costs.
The full cost-plus method is a traditional pricing method that considers variable and fixed costs. It is an easy and simple method to adapt. It is commonly used by traditional businesses such as in the retail industry.
This method is suitable for businesses with cost-plus pricing strategies. For instance, construction businesses normally add the desired markup over the full costs of the project.
On the other hand, the marginal cost-plus method only considers variable costs. It is a widely used method where products have a large proportion of variable costs as compared the fixed costs.