from the Sigma Investment Counselors blog
Cost-plus pricing is a pricing strategy in which the selling price is determined by adding a specific dollar amount or percentage to a producer’s relevant costs. This pricing protocol is typically used where the provider is a regulated monopoly, such as a public utility, or there is essentially a single buyer, such as the defense department.
Looking at cost-plus pricing from a practical perspective, consider building a new home. You can get competitive bids and firm pricing as long as you are totally specific on the final building. However, once you deviate from the original plan, like adding a fireplace, you will find yourself in a cost-plus situation.
Cost-plus pricing is an attempt to provide an equitable return on investment in situations where competitive bidding is not practical. Generally, public utility pricing is determined through negotiations between the provider (think the local gas and/or electric company) and the state public utility commission. Government purchasing activity is typically the result of negotiations between the provider and the applicable government agency. This can get quite complicated as the government, particularly in military applications, is seeking to purchase something that is still in the development process.
Investors in defense-related opportunities should make the effort to fully understand the process and how unexpected costs are allocated. In the public utility arena, mandates from one jurisdiction, usually the federal government, may not be quickly incorporated in the providers’ rate base, as determined by state utility commissions.