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The most important element of a company’s pricing model is bottom-line profits (i.e., revenue minus costs). Cost-plus pricing is a method of setting prices that adds a percentage to the cost of goods and services sold. It’s an easy way to accurately determine prices, with a few drawbacks and limitations.
What is Cost-Plus Pricing?
Cost-plus pricing is a basic pricing strategy that involves determining the cost of goods or services, and then adding a fixed percentage (the margin) as the markup.
For example, if your total costs are $100 and you want a 20% profit margin, you would add $20 to arrive at a selling price of $120.
Also known as “markup pricing,” this approach is used by many businesses because it is a simple and straightforward way to calculate prices.
Although it ensures a bottom-line profit from revenue generation, cost-plus pricing doesn’t ensure customers will actually respond favorably to the selling price.
- Cost-plus pricing model: The most straightforward model for setting prices—businesses take the cost of producing a product or service and add a fixed percentage to arrive at the selling price.
- Markup pricing: Adding a markup percentage to the total cost of goods sold (COGS) to arrive at a product’s selling price.
Why Use a Cost-Plus Pricing Strategy?
Cost-plus pricing helps businesses anticipate their profitability in advance, making it easy to set prices without continually adjusting them to changing market conditions.
When companies can quickly calculate unit economics they can make strategic decisions on future developments and market entries as well.
Because of its straightforward approach, the cost-plus pricing method is easy to implement. But it only makes sense to implement in the following scenarios:
- A company needs a quick and easy way to set prices
- Production costs are stable and predictable
- There is little to no competition
- Price elasticity is low (i.e., customers will still buy at a higher price)
- The goal is to recover costs and make a small profit
This type of pricing method is commonly used for government contracts because it offers a fair and transparent pricing strategy.
Grocery stores and other retailers with large volumes of products often use cost-plus pricing, as their sales volumes generally make up for any potential margins lost on lower-priced items.
Cost-Plus Pricing Formula
To calculate pricing using the cost-plus model, businesses need to follow this formula:
1. Determine the total cost.
To accurately estimate cost estimates, companies using this strategy have to maintain a comprehensive record of their expenses.
This entails detailed recording of costs to achieve a holistic understanding of overall costs, including materials, labor, overhead costs and marketing expenses.
2. Divide the total cost by the output.
The “output” can be items, services, time spent, or all three.
To quantify these factors, the company must divide the total cost of production by the units produced.
The result is known as unit cost—i.e., cost of goods sold (COGS).
3. Calculate the markup percentage.
Businesses then need to determine how much they want to add as their profit margin (a.k.a. “markup percentage”).
The markup percentage is determined by subtracting the unit cost from the desired price and dividing by the unit cost.
4. Calculate the selling price.
Finally, businesses can use the following formula to calculate their product’s selling price:
Selling Price = Cost + (Cost x Markup Percentage)
Cost-Plus Pricing Advantages & Disadvantages
In a sense, the simplicity of the cost-plus method sounds too good to be true. And that’s because in many cases, it is.
Advantages of Cost-Plus Pricing
The primary advantage of cost-plus pricing is that it ensures a profit on every sale. Other advantages of cost-plus pricing include:
- Perceived fairness. Buyers often view cost-plus pricing as reasonable, as it demonstrates that the seller is not overcharging for the product or service. In some cases, the markup may even be mutually agreed upon by both parties, further reinforcing the perception of fairness.
- Competitive stability in some markets. In markets where the cost of production is relatively similar among competitors, cost-plus pricing can provide competitive stability. By removing the incentive for aggressive price competition (such as price wars), businesses can focus on other aspects of their offerings to differentiate themselves.
- Easy price adjustments. Cost-plus pricing makes it simple for businesses to adjust their prices based on increases or decreases in production costs. This ensures that the company can maintain its desired profit margin while also justifying the price change to customers.
- Suitable for limited market intelligence. In cases where competitive intelligence is scarce or difficult to obtain, cost-plus pricing provides a practical solution for setting prices based on actual costs. This method is often adopted by retail companies, such as grocery or clothing stores.
- Induces contract acceptance. Cost-based pricing is effective in situations where a seller must accept a contract with uncertain costs or where the costs represent a large fraction of the seller’s revenues, as in research and development contracts. By basing the price on actual costs, sellers can mitigate risks and ensure a fair return on their investment.
Disadvantages of Cost-Plus Pricing
Despite its advantages, cost-plus pricing also has its drawbacks:
- Ignores demand. Cost-plus pricing does not take consumer demand into account, which can lead to overpricing or underpricing a product. This can result in lost sales, reduced profits, or an inability to compete effectively with rivals who have more demand-driven pricing strategies.
- No incentive for cost control. With cost-plus pricing, businesses aren’t as motivated to control costs, as they can pass on any cost increases directly to customers. This can lead to inefficiencies and higher prices, which may ultimately harm the company’s (and market’s) competitiveness.
- Lack of differentiation. Cost-plus pricing focuses solely on covering costs and achieving a specific profit margin. This makes it difficult for businesses to differentiate themselves from competitor prices, which may be important in some markets or industries.
- Potential for price wars. If all companies in a market adopt cost-plus pricing, the risk of price competition decreases. If one or more competitors adopt a more aggressive pricing strategy, price wars erupt, potentially harming all businesses involved.
- Ineffective in dynamic markets. Cost-plus pricing may not be effective in markets with rapidly changing costs or unpredictable demand. In these situations, businesses may struggle to keep up with fluctuations and may miss opportunities to optimize their pricing for maximum profitability.
Cost Plus Pricing Model Examples
To better understand the cost-plus pricing model, let’s consider two real-world examples from different industries: physical products and B2B SaaS.
1. Physical Products: Handcrafted Furniture
Imagine a small business that specializes in handcrafted wooden furniture.
The owner calculates the cost of raw materials (wood, varnish, screws, etc.), direct labor costs, and overhead (rent, utilities, marketing) required to produce each piece of furniture.
Suppose that the total cost to produce a dining table is $500. The owner decides to add a 30% profit margin to the cost, resulting in a markup of $150 ($500 * 0.3).
The final selling price for the dining table would be $650 ($500 + $150).
By using the cost-plus pricing model, the owner ensures that the business covers its costs and achieves the desired profit margin for each piece sold.
2. B2B SaaS: Project Management Software
Now, let’s consider a B2B SaaS company offering project management software to businesses.
In this case, the costs involved in producing the software are different from those of physical products.
Instead of direct material costs, a SaaS company’s costs include software development, server infrastructure, customer support, and marketing expenses (in addition to overhead costs similar to those of other companies).
Suppose the company’s total monthly cost is $50,000, and it has 1,000 active users. The cost per user would then be $50 ($50,000 / 1,000).
The company decides to implement a cost-plus pricing model, aiming for a 40% profit margin. To achieve this, it would add a $20 markup to the cost per user ($50 * 0.4), resulting in a final selling price of $70 per user per month ($50 + $20).
For each new user, the company covers its product costs and earns its desired profit margin.
Technology to Execute Cost-Plus Pricing
Technology helps businesses implement and manage cost-plus pricing strategies effectively. Software streamlines the process of calculating fixed and variable costs, applying margins,, considering external factors, and setting prices while providing valuable insights for decision-making.
Enterprise Resource Planning (ERP)
ERP systems are comprehensive software solutions that help businesses manage their financial, operational, and supply chain processes.
By integrating various functions like inventory management, procurement, and production planning, ERP systems give businesses accurate data regarding their physical product costs.
That way, they can easily apply cost-plus pricing models and make adjustments as needed, based on changes in costs or desired profit margins.
Configure, Price, Quote (CPQ)
CPQ software simplifies the quoting and pricing process by automatically configuring complex products, applying pricing rules, and generating quotes for potential customers.
CPQ integrates with ERP, CRM, and other data sources to curate up-to-date cost information, allowing businesses to apply cost-plus pricing strategies efficiently.
With CPQ software, businesses can also manage pricing for different customer segments, regions, and channels, ensuring that the desired profit margin is achieved across various sales scenarios.
Business Intelligence (BI) and Analytics Tools
Business intelligence and analytics tools can provide valuable insights into cost structures, pricing strategies, and market trends.
By analyzing historical cost data and monitoring changes in costs over time, businesses can refine their cost-plus margin to better reflect market conditions and maintain competitiveness. It can also help them identify potential cost-saving opportunities, such as process improvements or renegotiating supplier contracts (even though there may be less incentive to use them).
Pricing Optimization Software
Pricing optimization software uses advanced algorithms and machine learning techniques to determine the optimal pricing strategy, taking into account factors like fixed costs, competition, and customer preferences.
These tools aren’t focused solely on cost-plus pricing, but they incorporate cost data into their models, which allows companies to balance cost-plus pricing with other pricing considerations.
This results in more effective pricing strategies that maximize profitability, even in a competitive market.
Financial Management Tools
Financial software gives detailed insights into costs at various stages of the production process, allowing businesses to create bills of materials, calculate their costs, and apply cost-plus pricing models.
By streamlining financial data management and providing robust reporting capabilities, financial management software enables companies to make informed decisions about their pricing strategies and monitor the impact of those decisions on overall profitability.
People Also Ask
When should companies use cost-plus pricing?
Companies can consider cost-plus pricing in the following scenarios:
* In markets with consistent industry wide production costs
* When facing limited or negligible competition
* When customers are less sensitive to price changes
* When the primary objective is to cover expenses and generate modest profits
* When a transparent pricing approach is necessary, as in the case of government contracts
What are the alternatives to cost-plus pricing?
Cost-plus pricing has numerous alternatives, including:
Value-based pricing: Pricing based on the perceived value of the product or service to the customer
Competitive pricing: Setting prices based on competitors’ rates and market trends
Penetration pricing: Offering low prices initially to gain market share, then raising them later
Skimming: Setting high initial prices to capture customers with a higher willingness to pay, then lowering prices over time to attract more price-sensitive customers
Freemium pricing: Offering a basic version of the product or service for free, while charging for premium features or upgrades
Pay-as-you-go pricing: A form of usage-based pricing where businesses charge customers based on their actual usage of the product or service
Bundle pricing: Selling a group of products or services together at a lower price than if purchased separately
Tiered pricing: Offering different pricing levels based on features, usage, or customer segments
Dynamic pricing: Adjusting prices in real-time based on factors such as demand, inventory, and competitor pricing
What’s the difference between cost-based, competitive, and value-based pricing?
Cost-based pricing focuses on covering production costs plus a profit margin, competitive pricing sets prices based on competitors and market trends, and value-based pricing emphasizes the product or service’s perceived value to the customer, aiming to capture the maximum amount they are willing to pay.