How to Use CostPlus Pricing in Managerial Economics
Costplus pricing means that you determine price by starting with the good’s cost and then adding a fixed percentage or amount to that cost. One of the primary reasons costplus pricing is so popular is its simplicity.
Often information on marginal revenue and marginal cost is difficult to obtain with precision, making it impossible to exactly determine the point of profit maximization. By using costplus pricing, you can simply include a desired rate of return in the markup.
Another advantage of costplus pricing is its desirability from the standpoint of public relations. This pricing technique provides an obvious rationale for price increases when cost increases occur.
Costplus pricing typically involves two steps. First, the firm determines the per unit cost or average total cost of producing the good. Because average total cost varies as the quantity of output produced changes, the firm’s determination of per unit cost requires the specification of an output level.
After the firm establishes the per unit cost, the firm adds a markup to the per unit cost. The markup is typically in the form of a percentage, and it represents costs that can’t be easily allocated to a specific product produced by the firm plus a return on the firm’s investment.
The following equation illustrates how to determine price with costplus pricing:
where P is the good’s price, ATC is the average total cost or cost per unit, and the markup is the percentage added to average total cost.
One criticism of costplus pricing is that it focuses on average rather than marginal costs. Because profit maximization requires marginal cost equals marginal revenue, costplus pricing may not result in profit maximization.
Another criticism of costplus pricing is that it ignores demand conditions. By ignoring demand, the firm can establish a costplus price that’s above the market’s equilibrium price, resulting in a surplus. As a consequence, the firm doesn’t sell all the units it produces.
It’s logical to wonder whether costplus pricing ever maximizes profit. In order for profitmaximization to occur, costplus pricing must result in the firm producing the output level where marginal revenue equals marginal cost.
In the shortrun, the difference between marginal cost and average total cost may be sizeable. However, studies have shown that longrun average total cost is typically constant for many firms. Constant longrun average total cost implies constant marginal cost; therefore, marginal cost equals average total cost in this situation. The use of average total cost in the place of marginal cost for pricing results in minimal differences, or
Still, because this simple approach ignores demand, it’s unlikely to result in maximum profit. However, when you use marginal cost in the previous equation, it looks very similar to the profitmaximizing equation.
Thus, if one plus your markup equals the second part of the earlier equation, or
costplus pricing maximizes your profit.
Manipulating the earlier equation allows you to determine the markup
Your company determines that the price elasticity of demand for its product is –4. In order to determine the profitmaximizing markup, you take the following steps:

Substitute –4 for the price elasticity of demand in the markup equation.

Calculate the value of the denominator.

Divide the numerator by the denominator.
The resulting value is 0.33, or the markup should be 33%.