What it means
Variable costs are the costs that rise and fall with output, such as materials, packaging, sales commissions and the labour paid per item. Fixed costs, such as rent, salaries and insurance, stay the same whether the business makes ten units or ten thousand.
Variable cost-plus pricing starts from the first group only, then adds a markup to cover the second and to earn a return. The key idea is contribution, which is the selling price minus the variable cost per unit.
Each unit sold contributes that amount towards fixed costs, and once enough units have been sold to cover the fixed costs in full, the contribution on every further unit becomes profit. This differs from full-cost pricing, where a share of the fixed costs is built into the unit cost before the markup is added.
Variable cost-plus is more flexible, because it lets a manager see the minimum price that still adds to profit and decide how much room there is to negotiate. It is often used for one-off orders, bids and spare capacity.
A factory with idle machines might accept an order at a price well below its usual one, as long as the price covers the variable cost and makes some contribution, because the fixed costs are being paid anyway. The main risk is that the markup is set too low, or that too many orders are taken at thin contributions.
If the total contribution never reaches the level of fixed costs, the business loses money overall even though every individual sale looks profitable. Customers and competitors also matter.
A cost-based price ignores what the customer is willing to pay, so it can leave money on the table where demand is strong or price the product out of the market where competitors are cheaper.
In practice
Real-world examples.
Example
A print shop quotes for a run of wedding invitations. Paper, ink and the operator's time come to $2 per set, and the owner adds a 150% markup to price at $5 per set. The contribution of $3 per set helps pay the shop's rent and equipment costs.
Example
A furniture maker has spare capacity in the winter. A hotel asks for 200 chairs, and the maker works out that each chair costs $75 in wood, fittings and direct labour. Pricing at $105 gives a $30 contribution, which brings in $6,000 that the workshop would not otherwise earn.
Example
A software company sells a licence that costs it $8 per customer in hosting and support. It adds a markup of 400% to price the licence at $40. The finance team watches that total contribution covers the development team's salaries.
Formula
Calculation
Selling price = Variable cost per unit x (1 + Markup percentage)
Contribution per unit = Selling price - Variable cost per unit
Break-even units = Fixed costs / Contribution per unit
A small manufacturer makes a product with a variable cost of $40 per unit, and applies a markup of 50% on variable cost. Selling price = 40 x 1.50 = $60. Contribution per unit = 60 - 40 = $20. If fixed costs are $60,000 a year, break-even units = 60,000 / 20 = 3,000 units. To earn a profit of $30,000 as well, the business needs (60,000 + 30,000) / 20 = 4,500 units.Case study
Seen in the real world.
This illustrative story is about a fictional bakery, Marlow Street Breads, that supplied cafes with sandwich rolls. The owner priced each roll at its variable cost of $0.40 plus a 25% markup, giving $0.50, and kept the price low to win orders.
Sales grew quickly, yet profits did not. The finance adviser pointed out that the contribution was only $0.10 per roll, and fixed costs of $48,000 a year meant the bakery needed 480,000 rolls just to break even. The bakery was selling about 400,000.
The owner raised the markup to 50%, giving a price of $0.60 and a contribution of $0.20, which cut the break-even point to 240,000 rolls. Most cafes accepted the change, and the fictional bakery moved into profit the following quarter.
Watch out
Common mistakes.
- Forgetting that the markup must cover fixed costs as well as profit. A markup that only covers profit leaves the fixed costs unpaid.
- Treating every sale at variable cost plus a small markup as safe. If the total contribution never exceeds fixed costs, the business makes a loss.
- Ignoring customer demand and competitor prices. A cost-based price can be too high to sell or too low to be fair to the business.
Questions
People also ask.
What is the difference between markup and margin?
Markup is the profit as a percentage of cost, while margin is the profit as a percentage of the selling price, so a 50% markup on $40 gives a margin of 20 / 60, which is about 33%.
When is variable cost-plus pricing most useful?
It is useful for special orders, bids and using spare capacity, where the fixed costs are already covered by regular business.
How is it different from full-cost pricing?
Full-cost pricing includes an allocated share of fixed costs in the unit cost, while variable cost-plus starts only from the costs that change with output.
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