The cost-plus approach is a method used by businesses to determine what price to offer a product for. Cost-plus methods are best understood in contrast with alternative approaches to setting prices, such as the price-minus approach.
The Cost-Plus Approach
In the cost-plus approach, company managers look at how much it costs the company to produce a particular product. Once the managers know the cost of the product, they add a profit margin to this amount and offer the product for sale on the market.
The Price-Minus Approach
The price-minus approach is the opposite of the cost-plus approach. In the price-minus system companies use market research to determine how much consumers will pay for a particular product. Once they know have this information, they work backwards, subtracting a profit margin and working out how to produce the product at this final target cost.
Pros and Cons of Both Approaches
Cost plus has the advantage that it is simple and does not require extensive market research. However, cost plus has the disadvantage that it ignores the role of the consumer demand in determining prices and provides no incentive for efficiency.
Price minus has the advantage that it encourages companies to reduce costs as much as possible, but it can be expensive to acquire all the necessary information about the market.