xPlease 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 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. That is 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 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, to set prices, 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.
What is cost plus pricing?
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). Many businesses use cost plus pricing as their main pricing strategy when releasing products.
A lot of companies calculate their production costs, 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 of thousand widgets. It’s really that simple. This method involves very little market research and also doesn't consider 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. However, 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 model still leaves quite a bit of the dartboard intact.
Advantages of cost plus pricing
1. Cost plus pricing strategy takes few resources.
Cost plus pricing doesn't require a lot of additional market research. Businesses are mostly aware of the cost plus production 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. Cost plus pricing model provides full cost coverage and a consistent rate of return.
As long as whoever 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, many additional costs often can’t be accounted for, which results in reduced margins. Fortunately, businesses can create a buffer against uncalculated costs and fluctuations in demand by increasing the arbitrary margin. Additionally, because your prices remain inert, you can easily estimate revenue for a given month based on conversion history, marketing spend, etc.
3. Cost plus pricing 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.
Disadvantages of cost plus pricing
1. Cost plus pricing strategy can be horribly inefficient.
The guarantee of a target rate of return creates little incentive for cutting costs or increasing profitability through price differentiation. As the market and customers continue to change, stakeholders easily become passive towards pricing, facilitating laziness and atrophy of profits. 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. Cost plus pricing method creates a culture of profit losing isolationism.
This inward-facing approach discourages market research. Although watching competitor prices isn’t the end all, it is pretty important because of pricing. You should be aware of how much the competing good costs because it can affect your 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. Cost plus pricing doesn’t take consumers into account.
Perhaps the biggest downfall of a cost plus pricing model 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 costs 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.
Who uses cost plus pricing?
Cost plus pricing isn’t ideal for most businesses unless you cannot spend 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 cost 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 tomorrow to learn more about competitor based pricing.
Cost plus pricing FAQs
How to calculate cost plus pricing?
Cost plus pricing formula is calculated by taking the total costs that have or will be incurred in manufacturing a product (material costs, direct labor costs, overhead costs, etc.) and multiplying them by 1.
How does cost plus pricing work?
Cost-plus pricing method requires you to take fixed costs and variable costs, and apply a markup percentage to them to estimate the price of a product.
What is the difference between a cost plus pricing and value based pricing?
To determine the selling price of a product, the cost plus pricing method considers the total costs of making a product. On the other hand, value based pricing relies on the potential customers' perceived value of the product.