Cost-plus Pricing Contracts
Gina Picaretto is a productions manager at Rich Manufacturing and every year her unit purchases 100,000 machine parts from Bhagat Incorporation. Rich has a contract with Bhagat that states that Rich will pay Bhagat’s production costs plus a $5 markup (cost-plus pricing). Currently Bhagat’s costs per part are $10 for labor and $10 for other costs. Thus the current cost is $25’s per part. The contract provides an option to Rich to buy up to 100,000 parts at this price. Rich must purchase a minimum volume of 50,000 parts. Bhagat’s workforce is heavily unionized. During recent contract negotiations, Bhagat agreed to a 30 percent raise for workers. In this labor contract, wages and benefits are specified. However, Bhagat is free to choose the quantity of labor it employs. Bhagat has announced a $3 price increase for its machine parts. This figure represents the projected $3 increase in labor costs due to its new union contract. It is Gina’s responsibility to evaluate this announcement (Brickley, Smith & Zimmerman, 2009, p. 170).
Cost-plus pricing is one of the most popular pricing methods, and the simplest. The logic seems simple: if your business does not have sources of income other than the sale of the product (e.g. subsidy), the price must equal, or exceed, production costs (Nagle, Hogan & Zale, 2010). Essentially, cost-plus pricing is an easy to use calculation that analyzes the risk based on little research. Costs are constantly changing due to unpredictable variables (i.e. cost of machine down time, labor rates, and the ever changing fuel charges). Costs included are both fixed and variable but are given a time frame on pricing. The issue in Rich’s scenario, is that they are contracted into an uncontrollable cost association. With some operation costs being held fixed, Rich agrees to accept variable cost changes to keep production continued (variable costs being labor and machine costs).
The contract allows full range of motion in the quantity of labor in production, and is now altering machine costs based on either machine down time and/or improvements. Another valid mistake in this scenario is the longevity of the contract. Similarly, when dealing with constant changes in production costs, its imperative to determine when changes are typically made. In this scenario, there is a mutual agreement that neither variable nor fixed costs will change within a year’s time frame. This is certainly not the case given the sudden changes in machine costs.
The current contract allows for price changes on the part of Bhagat Incorporation, which ultimately affect Rich Manufacturing. Gina should contest the changes in the price increases based on misrepresentation of costs. The initial, and agreed upon, cost-plus pricing contract states that quantity of labor is subject to change with other costs equaling $10’s per part. Seeing that machine costs have been held constant, there would be no reason to increase costs on machinery based on unionization. The unionization of labor does not dictate a reason to pass on costs. Bhagat is in breech of contract.
In the short run, Gina should contest the cost changes and pause all dealings with Bhagat. In the long run, Bhagat should alter its variable costs to meet the demand of the union, so that all costs are displayed to Rich’s Manufacturing before being signed off on (good display of research). The $3 cost change association with machinery will ultimately affect Gina’s decision to purchase more parts from Bhagat.
Brickley, J., Smith, C., & Zimmerman, J. (2009). Managerial Economics & Organizational Architecture. (5th ed., p. 38). New York: McGraw-Hill Irwin.
Nagle, T., Hogan, J., & Zale, J. (2010). The strategy and tactics of pricing: A guide to growing more profitably. (5th ed.). Upper Saddle River, New Jersey: Prentiss Hall. Retrieved from http://thesocialmarketplace.org/toolkit/price/cost-plus-pricing/