For whatever product you see in the market, the selling price is always higher than the cost of production. Most times, product prices are set using a cost-plus pricing strategy, a term we’ll get to understand further in this article. This pricing method usually involves adding a percentage to the product’s production cost. Here, we’ll see some examples of where the cost-plus pricing method is used, including the advantages and disadvantages of using one.
What is Cost-Plus Pricing?
Cost-plus pricing is a pricing strategy in which a fixed percentage is added to the cost of producing one unit of a product (unit cost). The resulting number is the product’s selling price.
This pricing strategy considers only the unit cost and disregards competition prices. As a result, it isn’t always the ideal fit for many firms because it ignores external issues such as competition.
Clothing, supermarket and department stores frequently practice cost-plus pricing. In these circumstances, the things being sold vary, and different markup percentages might be applied to each product.
If you sell software as a service (SaaS), this pricing technique isn’t ideal because the value your products deliver is frequently more than the costs to manufacture them.
For firms that desire to pursue a cost-leadership strategy, the cost-plus pricing system is a natural fit. By communicating the company’s pricing strategy with customers and saying something like, “We’ll never charge more than X% for our products,” cost-plus pricing can be used as part of the company’s value proposition. This transparency fosters confidence among potential customers and enables firms to establish a renowned brand.
The formula for Cost-Plus Pricing
The cost-plus pricing formula is calculated by adding the expenses of materials, labor, and overhead and multiplying them by (1 + the markup amount). Overhead expenses are costs that cannot be clearly attributed to material or labor costs, and they are frequently operational costs associated with the creation of a product.
Markup
The markup is the percentage difference between the product’s unit cost and its selling price. It can be calculated by removing the unit cost from the sales price of the product and dividing the result by the unit cost. The markup % is then calculated by multiplying the final result by 100.
Example of Cost-Plus Pricing
Assume you founded a retail clothing brand and need to determine the selling price for pants. The following are the costs of producing one pair of jeans:
Materials cost $10, while labor costs $30.
Overhead expenses: $15
The entire cost comes to $55.00. With a 50% markup, the formula would be as follows:
Price to sell = $55.00 (1 + 0.50).
Selling price = $55.00 (1.50)
Selling price = $82.50
This results in a selling price of $82.50 per pair of jeans.
There are a few instances of businesses that may use cost-plus pricing:
Small Grocery Stores and Supermarkets
Most consumers know how much a pint of milk or a carton of eggs costs because most supermarkets and grocery stores operate on a Cost Plus basis and utilize the same unit prices to apply their markup. They will frequently get their supply from the same wholesaler or producer, and with Cost Plus Pricing, we are accustomed to seeing identical costs regardless of where we buy our milk!
Corporate Training Organizations
A training organization that uses freelance consultants and trainers to provide learning and development for company employees may use a Cost Plus model. To arrive at their price, that training organization will add a charge (their markup) on top of the freelance day rate (their costs).
Advantages And Disadvantages Of Cost-Plus Pricing
Cost-plus pricing has several advantages and disadvantages. The advantages are as follows:
#1. The cost-plus pricing method necessitates few resources.
Cost plus pricing does not necessitate extensive market research. Businesses are generally aware of the cost plus production by adding up various invoices, labor costs, and so on. Businesses can then take the total costs and add a margin that they believe the market will bear. It’s rather straightforward, and as a result, it’s a common method among tiny organizations or those where other parts of production must take precedence.
#2. The cost-plus pricing approach covers all costs while maintaining a consistent rate of return.
Cost plus pricing ensures that the complete cost of manufacturing the product or performing the service is covered, allowing the markup to provide a positive rate of return as long as whoever calculates the expenses per user or item adds everything up accurately. However, numerous extra costs are frequently overlooked, resulting in lower margins. Fortunately, by expanding the discretionary margin, firms may provide a cushion against unanticipated costs and variations in demand. Furthermore, because your rates remain inactive, you can simply forecast revenue for a particular month based on conversion history, marketing expenditure, and so on.
#3. Cost plus pricing protects against ignorance.
Cost plus pricing is very useful when you don’t know how much a consumer is willing to spend and there aren’t any direct competitors in the market. Essentially, the only data you have to influence your pricing selection is the computation or estimation of your costs, which allows you to set at least a starting price from which to work as the market and consumer evolve.
The disadvantages of cost-plus pricing are as follows:
#1. The cost-plus pricing technique is notoriously inefficient.
With a target rate of return guaranteed, there is minimal motivation to lower expenses or increase profitability through price differentiation. As the market and customers evolve, stakeholders can easily become complacent about price, allowing carelessness and profit atrophy. For context, the government employs this method of guaranteeing profit margins on costs to make contracts with private companies “easier.” As a result, there is an incentive to optimize expenses, resulting in billions of dollars wasted and substandard craftsmanship.
#2. The cost-plus pricing technique fosters a profit-losing isolationism culture.
This inward-looking strategy discourages market research. Although monitoring competition prices isn’t the be-all and end-all, it is crucial for pricing. You should be informed of the price of the rival good because it can influence your marketing and pricing methods. Furthermore, without research, you have little to no information about your customers’ perceived worth of the product (more in the last point).
#3. Consumers are not considered in cost-plus pricing.
The most significant disadvantage of a cost-plus pricing approach is that it completely ignores the customer’s willingness to pay. A consumer must be involved in order to make money. They are the most crucial aspect of selling anything, thus any pricing strategy that ignores customer value creates a vacuum that drains all of the profit out of the business.
Furthermore, they don’t care how much something costs you to produce. They recognize that there are costs associated with operating a business, but consumers are more concerned with the amount of value you provide. Making a bottle of Rogaine, for example, may cost $3, $10, or $50, but customers only measure price against the value of a spouse with hair on his head, which may be 2x, 10x, or 100x the cost depending on follicular effectiveness. Simply pursuing a desired rate of return can result in diminishing demand that is ignored until significant losses occur. Even if customers are purchasing your product, there may be better pricing available for revenue optimization and price differentiation.
Who Uses Cost-Plus Pricing?
Cost plus pricing isn’t appropriate for most businesses until you can’t spend extra time on the most crucial component of your business, which might happen when you’re swamped by orders or the sheer amount of things you provide clients. Furthermore, some organizations have relatively consistent expenses associated with their goods that are the same for all rivals. In this case, margins are likely to be uniform as well, implying that pricing should be more competitive or market-based. Cost plus pricing should not be used by any software or SaaS company because the value you provide is typically considerably greater than your cost of doing business.
When is Cost Plus Pricing Ideal?
Cost Plus Pricing is useful in some instances. You might be a small business or one that offers services. Cost Plus Pricing also works effectively for resellers or firms with a wide range of products, where certain items are Cost Plus while others are not.
When is Cost Plus Pricing Not Ideal?
If you want to maximize your profit or if you’re in a competitive market, Cost Plus Pricing is probably not for you. Actually, Cost Plus Pricing is probably the wrong approach for most businesses. Because good pricing necessitates taking into account several factors such as consumers and competitors, we propose that you choose Competitive Based Pricing or Value-Based Pricing instead.
Cost Plus Pricing is unrelated to the consumer experience. This pricing plan does not take into account the customers’ willingness to pay that price. Customers are unconcerned about production costs or marketing expenses; instead, they examine how significant the product or service is to them and how much that benefit is worth to them.
If you suspect that your product or service provides significant value to your clients – that it will considerably assist them to solve a problem or make their life easier – you may be under-selling your product or service if you use a Cost Plus Pricing strategy. Underselling, of course, means you are not maximizing your earning potential.
If you compete in a market with competitors offering the same or very comparable products as you and they do not use a Cost Plus Pricing approach, you risk losing customers to them. If you do not consider competitive pricing, especially if you have used an excessive markup, your prices may be greater than those of your competitors. And if there is no client sense of additional value for the greater price, you may lose out.
Why Use Cost Plus Pricing?
The cost-plus pricing strategy ensures that a company covers all of its costs connected with creating a product or service while still making a profit.
How Does Cost-Plus Pricing Affect Supplier Behaviour?
Most businesses rely on suppliers to provide the products they sell, assist them in manufacturing their products, or deliver their services. When you choose a Cost Plus Pricing plan, your suppliers have greater leverage over your organization than when you use any other pricing method. Because the price your supplier charges you has an immediate and direct impact on the price you charge your clients. That position puts you in a weak negotiating position and puts your company at risk.
If you’re thinking about Cost Plus Pricing, you should check into Porter’s Five Forces and learn more about the Supplier Power dimension of that model. It will assist you in understanding the hazards associated with when your suppliers wield substantial power.
What Alternatives Exist to Cost Plus Pricing?
Given that Cost Plus Pricing isn’t always the greatest option for most businesses, it’s critical to grasp the alternatives.
Competitive Based Pricing is an alternate technique. Here, you analyze and investigate your competitors, taking their pricing points into account while setting your own. With Competitive Based Pricing, you analyze your prices in relation to the alternatives on the market.
Value-Based Pricing is another strategic alternative for pricing. Here, you’re more focused on your clients and trying to figure out what genuine value you provide for them. This is a difficult approach to master, but if done well, it may be one of the most profitable.
But, look, pricing is complicated; in practice, you’ll likely combine elements of all three techniques. Pricing should never be static – set once and forgotten. To guarantee you’re getting it right at any given time, you should continuously and frequently assess your pricing against aspects from all three pricing models.
What Is The Main Problem With Cost-Plus Pricing?
One major problem with cost-plus pricing is the possibility of profit loss. Your costs will decrease if you swap suppliers or obtain cheaper materials. Strictly cost-plus pricing would necessitate a decrease in your selling price. You would lose income if consumers were willing to pay more for the product.
What is Cost-Plus Vs Fixed Price?
A fixed-price contract is fixed. The price agreed upon at the start of the project is the price at the finish. A cost-plus contract, on the other hand, anticipates project costs but does not determine the ultimate price until the project is completed.
In Conclusion,
Cost-plus pricing is a pricing strategy in which a fixed percentage is added to the cost of producing one unit of a product
One key disadvantage of cost-plus pricing is that it takes no account of product or service demand. The algorithm is unconcerned about whether or not potential customers will really buy the product at the given price. To compensate, some business owners have attempted to apply price elasticity ideas to cost-plus pricing. Others may just examine rival offerings, trends, and business acumen to estimate the market price.
Related Articles
- Cost-plus Pricing Strategies: Formula and Examples
- COST PLUS PRICING: Meaning, Example, Advantages & Disadvantages
- PRICING STRATEGY: Best Strategies to Maximize profit
- How To Sign A Document Electronically: A Step-By-Step Guide
- Pricing Strategies: Top 7 Examples of Pricing Strategies
References
