Cost plus pricing is one of, if not the most commonly used pricing technique in business today. After all, it’s easy to implement, it ensures you a decent margin, it makes competing predictable, and it’s fair to all your customers. Unfortunately, it leaves a great deal of money on the table. Let’s go through each of the pros and cons in detail.
The Benefits of Cost Plus Pricing
Easy to implement.
Once you’ve decided the margin you want, you simply multiply your variable costs by a markup to get your price. For example, if you want 50% margin, you multiply your variable costs by two. If you want 66% margin, you multiply it by three. This is especially beneficial when you have many different products and can’t set individual prices.
Ensures a reasonable margin.
By applying the same markup to all products, you know you’re guaranteed the same margin on each product. Firms with more complex pricing mechanisms may be surprised by smaller margins than they expected.
Competition is predictable.
If both you and your competitors have many products, it can be difficult to know how to price relative to your competition on every part. However, knowing your competitor uses a standard markup allows you to use your own standard markup, and remain consistently priced relative to your competition.
Many business owners aren’t comfortable charging different customers different prices, or even charging different markups for different products; they feel it isn’t fair. So, they opt for cost-plus pricing, which appears fair.
The Drawbacks of Cost Plus Pricing
Despite these benefits, cost-plus pricing is not a profit-maximizing pricing technique. In past posts we have talked about pricing according to how much our customers are willing to pay – this is how to maximize our profits. Price to our customer’s willingness to pay.
We should know the minimum margin we are willing to accept, but this isn’t cost-plus pricing – it’s a price floor. If our customers are not willing to at least pay an amount equal to our variable costs plus a small margin, then we should not be selling the product in the first place.
Are you currently using cost-plus pricing? Do you think the benefits of using cost-plus pricing are greater than the extra profit to be gained by pricing based on value? Or, are you unsure how to move away from cost-plus pricing?
The action you can take today
If you’re curious about making the transition, let me suggest you start with a modified cost-plus approach. Keep your current process, but find one customer segment who is willing to pay more, and charge a higher price to those customers. Or, if you have a good, better, best product family, raise the price on the best. You will quickly see there is a lot of money to be made by pricing based on customer value rather than your costs. Slowly add more segments or more techniques, and soon you will not be looking back at cost-based pricing at all.