What is Cost Plus Pricing?

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 markup 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.

Synonyms

Cost-plus pricing model
Markup pricing

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.

How to Calculate Cost-Plus Pricing

The cost-plus model ensures profitability by determining the total cost of producing a product or delivering a service and adding a markup. The key to using this pricing method effectively is having accurate, detailed cost data and a clear profit target.

Cost-Plus Pricing Formula

The general cost-plus pricing equation is:

Selling Price

Total Cost per Unit

Markup Percentage)

Let’s break down the steps:

Determine the Total Cost

Start by calculating the total cost of production. This includes:

Direct costs: Raw materials, direct labor, and other costs directly associated with creating the product or delivering the service.
Indirect costs (overhead): Utilities, rent, administrative expenses, equipment depreciation, etc.
Additional costs: Marketing, distribution, packaging, and any other expenses necessary to bring the product to market.

Accurate cost tracking is essential. Businesses should use cost accounting methods to record and monitor all expenses, both fixed and variable, to gain a complete picture of total costs.

Calculate the Unit Cost

Once the total production cost is known, divide it by the total number of units produced or the number of service hours delivered.

Unit Cost = Total Cost / Total Output

Here, output refers to the number of units produced or service instances delivered. The unit cost is effectively your Cost of Goods Sold (COGS) per unit.

Determine the Markup Percentage

Next, decide on a suitable markup percentage, which is the percentage added to the unit cost to ensure a profit. The markup should reflect your desired profit margin while remaining competitive in your market.

To calculate the markup percentage, use this formula if you know the desired selling price:

Markup Percentage = (Selling Price – Unit Cost) / Unit Cost

Or, to set the selling price from a known markup:

Selling Price = Unit Cost × (1 + Markup Percentage)

Calculate the Final Selling Price

Now, apply the markup to the unit cost to arrive at the final selling price:

Selling Price = Unit Cost + (Unit Cost × Markup Percentage)

For example:

Total cost per unit = $50
Desired markup = 40% (0.40)

Selling Price = $50 + ($50 × 0.40) = $70

This approach ensures that each unit sold covers costs and contributes to profit.

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.

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.

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 a Cost-Plus Pricing Model

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)

Enterprise Resource Planning (ERP) systems are robust software platforms that integrate key business functions, including finance, supply chain, inventory management, procurement, and production planning, into a single cohesive system.

For companies using cost-plus pricing, ERPs are especially valuable because they centralize and automate the tracking of cost data. This includes real-time updates on material costs, labor expenses, overhead, and other operational inputs that affect the total cost of goods sold (COGS). With accurate, up-to-date cost insights, businesses can apply cost-plus pricing models more precisely and make informed adjustments as costs or profit targets evolve.

ERP systems help ensure that pricing remains both profitable and aligned with actual business expenses.

Configure, Price, Quote (CPQ)

CPQ (Configure, Price, Quote) software, like DealHub, streamlines the entire pricing and quoting process, especially for businesses selling complex products or services. In a cost-plus pricing model, CPQ tools are invaluable because they ensure pricing is both accurate and consistent by automatically pulling real-time cost data from integrated systems like ERP, CRM, and inventory management platforms.

With CPQ software, companies can:

Instantly calculate total cost and apply predefined markup rules
Automate quote generation based on cost-plus formulas
Adjust pricing dynamically based on cost changes, customer type, geography, or sales channel
Ensure compliance with internal pricing policies and approval workflows

CPQ is a powerful enabler for applying cost-plus pricing at scale. It eliminates manual errors, reduce quote turnaround time, and help businesses maintain desired profit margins across diverse and complex 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 management tools (e.g., accounting and billing software) help FinOps teams track and manage their transactions, budgets, and revenue forecasts.

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.

Cost-Plus Pricing