Cost-Plus Pricing: How One of the Most Popular Pricing Strategies is Costing You Money
The idea behind cost-plus pricing is simple: base your prices on the cost of production plus your desired profit margin. The cost-plus pricing strategy is as easy as it is low risk, but that doesn’t mean it isn’t causing countless of businesses to lose thousands in profits.
In this post, we dig into cost-plus pricing, how to calculate a cost-plus price, and whether the advantages of cost-plus pricing outweigh the disadvantages. Then, we offer up some pricing alternatives that could take your profits from good to great.
Quick Review: What is Cost-Plus Pricing
Cost-plus pricing, sometimes called markup pricing, is a basic pricing strategy where a company will take the unit cost of a product or service, add a fixed percentage—a markup—and then use the total from that equation to establish a profitable price.
By using the unit cost (material cost, labor cost, machine maintenance, etc.) of a good or service as a base, a company can then set a markup percentage to guarantee a profit with every sale.
Example of Cost-Plus Pricing:
For a building products manufacturer to determine the sale price of a lighting fixture, they need to first establish the cost to produce one lighting fixture by adding up the fixed and variable costs:
Material costs: $17
Labor costs: $30
Overhead costs: $20
The total cost to make one lighting fixture is $67.00. The company now needs to multiply this unit cost by a markup percentage, say 35%, to establish the profit margin of the product:
Selling price: $67.00 (1 + 0.35)
Selling price: $67.00 (1.35)
Selling price: $90.45
Advantages of Cost-Plus Pricing
Though basic, a cost-plus pricing strategy does have some obvious advantages:
- Simple: calculating prices with a cost-plus pricing strategy needs very little time or research and can be done quickly.
- Assured Profits: By choosing to determine price by adding a markup to a product’s unit cost, a company ensures they will make a profit with every sale.
- Transparent: In the case of a price hike, a company can point to an increase in unit costs to justify the new price.
Cost-plus pricing is one of the most simplistic, efficient pricing strategies out there, but not without stark disadvantages. Since this pricing method focuses more on internal factors like production cost rather than external factors like consumer demand, companies that use cost-plus pricing run the risk of leaving a substantial amount of money on the table.
Disadvantages of Cost-Plus Pricing
- Cost-plus pricing doesn’t consider the consumer: One of the greatest drawbacks of cost-plus pricing is the lack of consumer insight. Willingness to pay (WTP), or the range a consumer is willing to spend on a product or service, is based off perceived value. If a company determines their prices solely off unit cost and a predetermined markup, they run the risk of losing out on potential profits from perceived value.
- Cost-plus pricing doesn’t consider competition: If a company has a higher unit cost or larger markup than their competition, their selling price will in turn be higher. This will cost the company in terms of lost sales and market share as consumers choose to do business with the lower-priced competitor. In contrast, if their price is lower than their competitors, it could result in a loss of potential profits from not charging the market rate. Cost-plus pricing, though easy and efficient, runs a risk of sub-standard profitability.
- Cost-Plus pricing limits innovation: Since cost-plus pricing does not take consumer insight or feedback into consideration, it means there is no incentive to improve a product to better meet the needs and wants for its target market. Instead, a company can simply continue to make their product as-is, ignoring the long-term benefits of consumer opinion. With no incentive to innovate, a company runs the risk of losing market share and falling behind their competition as their product becomes less and less desirable.
What a company can learn from the pitfalls of cost-plus pricing is that pricing should be approached with the same thoughtfulness and systematic thinking that goes into every other element of a successful business, whether that be initial product strategy, distribution models, growth opportunities, and so on.
Now let’s take a look at alternative pricing strategies that address the drawbacks of cost-plus pricing.
Alternatives to Cost-Plus Pricing
Value-based pricing, sometimes called customer-based pricing, refers to the strategy of basing the price of a product or service off how much the target consumer believes it is worth. With value-based pricing, it has more to do with something’s perceived value, and less to do with the actual production cost of the product or service.
SaaS products, clothing and cosmetic manufacturers, and technology companies all offer products that have a substantial perceived value on top of their basic production cost. If the price of these goods and services were based off their production cost alone, companies would lose money. Why? Consumers aren’t privy to internal cost structures, so they base their purchases off the value an item gives them, not off the cost it took to produce the item.
The most important step when implementing a value-based pricing strategy is determining the consumers’ willingness-to-pay (WTP), or rather, the perceived value a customer places on a product. To establish WTP, however, a business needs to spend a significant amount of time studying their audience and developing detailed buyer personas. Without data-driven information like this, it becomes extremely difficult to accurately predict consumer behavior.
Though having such a customer-centric approach is great for iterative learning and continuous product improvement, value-based pricing is time-consuming and data-heavy. Any organization considering a value-based pricing strategy needs to be prepared to spend ample time and resources conducting the research needed to nail their WTP.
Competition-based pricing is when a company looks at what their competitors are charging and uses that information as a foundation to build a viable pricing structure for their own goods and services. Often, competitive pricing is utilized within industries where businesses are selling similar products with minimal variation in price.
Businesses using a competitive pricing strategy have three options when setting the price of their good or service: below the average price, above the average price, or equal to the average price:
- Higher-than-average price: premium price signals luxury and exclusivity
- Lower-than-average price: undercuts the competition to quickly acquire customers
- Matched price: in line with competitors to minimize risk
The greatest advantage to competition-based pricing is efficiency. With minimal research required, companies can implement a low-risk pricing strategy quickly with significantly less effort than more data-driven strategies. There are, however, also disadvantages to a competitive pricing strategy that should be taken into consideration when evaluating potential benefits and risks.
Competitive pricing does not take demand or perceived consumer value into consideration. By not evaluating willingness to pay, companies that use this strategy run the risk of leaving money on the table. Another downfall of implementing this type of pricing strategy is limited flexibility. When a company relies on their competition to set their prices, they are assuming that competitor is using accurate research to find the best price for their product.
Every pricing strategy has unique strengths and weaknesses that should be considered before being implemented. The wrong strategy could cost you thousands, while the right strategy could set you on a trajectory of long-term success. What is important is taking the time to figure out which one is right for you and your business goals to optimize profits and expedite ROI.
Is It Time to Revisit Your Pricing Strategy?
More and more often we are finding that companies that use cost-plus pricing strategies are leaving significant amounts of money on the table. It is no longer profitable to set and forget your prices in a vacuum. To maximize profits, companies need to take a systematic approach to pricing that uses real market and consumer data to inform their decisions if they want to achieve long-term profitability.
Are you ready to establish a price that aligns with your company goals while still capitalizing on a consumer’s willingness to pay? Our 200+ skilled pricing professionals can help your company uncover new pricing opportunities and achieve continuous profit improvement. Contact us today to learn how INSIGHT2PROFIT can help develop a pricing solution that works for your company.