Please note: This post is the first post in a five part, week long series on the main pricing methodologies, highlighting the pros and cons of each.
Pricing is the most important aspect of your business. Period. If you don’t believe us, check out the evidence in our previous pricing strategy blog post. To summarize though, a 1% improvement in pricing results in an average increase in profits of 11.1%. It’s that huge. Hence, why understanding pricing is essential to the success of your business. We’ve put together this series to show you the landscape of pricing strategies, and to help you be more educated about your pricing decisions.
As we explained in a previous post, pricing is a process with the goal of your pricing strategy to reduce as much doubt as you can to make a final, profit maximizing decision. Think of pricing like a dartboard. You want to get a bullseye, but if it were as easy as simply wishing, we’d all be dart divas. Instead, we use data to hone in more and more on the all important central point.
To understand this a bit better, let's take a look at what cost plus pricing entails, uncover the methodology's pros and cons, before exploring who should and shouldn't utilize cost plus pricing.
Cost plus pricing: The oldest and simplest (mostly) method of setting prices
Cost plus pricing is the simplest method of determining price, and embodies the basic idea behind doing business. You make something, sell it for more than you spent making it (because you’ve added value by providing the product), and buy your wife a bouquet of flowers and yourself a nice bottle of scotch with the difference. At least that's how the black and white movie player in my mind imagines the corner store working in the 19th century. Nowadays, many businesses still use cost plus pricing and it still works pretty similarly, except in color.
A lot of companies calculate their cost of production, determine their desired profit margin by pulling a number out of thin air, slap the two numbers together and then stick it on a couple thousand widgets. It’s really that simple. This method involves very little market research, and also doesn't take into consideration consumer demands and competitor strategies.
The mark up is often only a target rate of return, similar to a thought through wishlist a kid makes for Santa when he knows it's really his parents stuffing the stockings. In other words, it's not completely off the deep end in unicorn land, but it still doesn't
have a great chance of becoming reality, because you’ll never truly calculate all of your costs nor does an arbitrary margin have anything to do with how much your customer is actually willing to pay. As such, cost plus pricing still leaves quite a bit of the dartboard intact.
Pros of cost plus pricing
1. It takes few resources.
Cost plus pricing doesn't require a lot of additional market research. Cost of production is something businesses are mostly aware of by adding up different invoices, labor costs, etc. Businesses can then take the summed costs and place a margin on top of them that they believe the market will bear. It’s pretty simple and for this reason, it's a popular strategy among small businesses or businesses where other aspects of production must take precedent.
2. It provides full coverage of cost and a consistent rate of return.
As long as whomever is calculating the costs per user or item is adding everything up correctly, cost plus pricing ensures that the full cost of creating the product or fulfilling the service is covered, allowing the mark-up to ensure a positive rate of return. Yet, often times there are many additional costs that can’t be accounted for, which results in reduced margins. Fortunately, by increasing the arbitrary margin, businesses can create a buffer against uncalculated costs and fluctuations in demand. Additionally, because your prices remain inert, you can easily estimate revenue for a given month based on conversion history, marketing spend, etc.
3. It hedges against incomplete knowledge.
Cost plus pricing is especially helpful when you have no information about a customer’s willingness to pay and there aren’t direct competitors in the marketplace. Essentially, the only data you have to guide your pricing decision is the calculation or estimation of your costs, which allows you to push forward at least a starting price to work from as the market and customer develop.
Cons of cost plus pricing
1. It's horribly inefficient.
The guarantee of a target rate of return creates little incentive for cutting cost or for increasing profitability through price differentiation. Stakeholders easily become passive towards pricing, facilitating laziness and an atrophy of profits as the market and customer continues to change. Just for some perspective, the government uses this strategy of guaranteed profit margins on costs to make contracts with private businesses “easier.” The result is an incentive to maximize costs, which wastes billions of dollars and results in shoddy workmanship.
2. It creates a culture of profit losing isolationism.
This inward facing approach discourages market research. Although watching competitor prices isn’t the end all, be all of pricing, it is pretty important. You should be aware of how much a competing good costs because it can affect your own marketing and pricing strategies. Plus with no research, you have little to no data on your customer's perceived value of the product (more in the last point).
3. It doesn’t take into account consumers.
Perhaps the biggest downfall of cost plus pricing is that it completely disregards the customer’s willingness to pay. To make money, a customer must be involved. They’re the most important part of selling anything, so any pricing strategy that doesn’t take customer value into account is creating a vacuum that’s sucking all of the profit out of the business.
Furthermore to be blunt, customers don't care about how much something cost you to make. They understand there are costs associated with doing business, but consumers care more about how much value you’re providing. For example, making a bottle of Rogaine may cost $3, $10, or $50, but consumers only weigh price against the value of a husband with hair on his head, which depending on the customer could be 2x, 10x, or 100x the cost depending on follicle effectiveness. Simply barreling ahead with a desired rate of return can result in declining demand that is disregarded until substantial losses occur. Even if consumers are buying your product, there could still be a better price for revenue optimization and price differentiation.
Summary: Very few companies should use cost plus pricing
To summarize, cost plus pricing isn’t ideal for most businesses, unless you truly cannot spend some extra time on the most important aspect of your business, which sometimes happens when you’re bogged down by fulfilling orders or the sheer number of items you’re offering customers. Additionally, some businesses have very uniform costs surrounding their offerings that are the same for all competitors. In this case, margins will probably be uniform, as well, which means the pricing methodology should be more competitive (tomorrow’s post) or market based (Thursday’s post). No software or SaaS company should use cost plus pricing, because the value you’re providing is traditionally much more than your costs of doing business.
To learn more, check out our Pricing Strategy ebook, our Pricing Page Bootcamp (it’s free!), or learn more about our price optimization software. Also, check back in tomorrow to learn more about competitor based pricing.