Is cost plus pricing too simple? Choosing the right pricing strategy can seem so hard.
‘Pricing is either your most powerful weapon or your worst enemy.’
Cost plus pricing is just one of the options you have. Choosing the right pricing strategy for your product will help your pricing be the powerful weapon and not the enemy! Pricing your products can be a minefield. People tend to shy away from pricing or even try to ignore. But your business will thank you and reward you if you give pricing the time and effort it deserves.
When choosing a pricing strategy, you should assess the different types of strategy and the reasons for choosing one over another. Our Product Pricing Strategy Series explores the key strategies for getting the price of your product right. You can then be clearer which method you should use. We will take you through three founding pricing methods and why you should or shouldn’t use them.
We are going to start with cost plus pricing. Why? Well because that is where most people start and usually where they stop too. But before you blindly copy the method that about 80% of other businesses are using, let’s stop and explore it to see if it really is the right method for you. We will examine what it is, why it works and doesn’t work and where it works best.
Learn Your Way:
What is Cost Plus Pricing?
Cost plus pricing is the simplest method for pricing a product. In fact, it stands for the basics of doing business. You make something. You then sell it for more than you spent making it. More because you’ve added value by supplying the product. It is a straightforward method that, in theory at least, ensures a profit.
The method itself is quite simple. You merely add together all the costs of a product and add your mark-up to make your price. You may choose an absolute number to add on or more likely a percentage. This simple formula can be used:
Cost + mark-up = price
Or an expanded one and this Marketing Insider article details more formulae for cost plus pricing should you need them.
Here is an example of a more detailed formula:
As a side note, remember that your mark-up% will not be the same as the margin % you will make. (You can find resources in the Pricing Hub that lay out the differences and stop the confusion. There is even a conversion chart which people find particularly helpful.)
Therefore, in its simplest form this method simply looks at your internal costs and adds ‘a bit’ to ensure you make a profit. However, it does not consider any other factors such as what your competitors charge or what consumers are willing to pay.
Who uses cost plus pricing?
A research survey questioned 1000s of SME businesses about their pricing methods. 80% replied that they used cost plus pricing. This was not particularly surprising. What was surprising was the considerable number that use this method even though they know there are better methods out there. The most common reasons for using this as their main pricing strategy was when releasing new products or have little time to spend on pricing.
Therefore, almost any business can use cost plus pricing but traditionally fashion brands have particularly used it. They relied upon cost-plus pricing for its simplicity and convenience. However, the increased consumer awareness of retail prices, especially online, means that this method is no longer as relevant as it once was as the competition can no longer be ignored.
Cost Plus Pricing: Why it’s great!
There are clearly reasons why this pricing strategy is so popular, and there are advantages of cost plus pricing.
Firstly, it is extremely easy to apply. It is straightforward to make a list of your products and their costs. And then use a simple formula to add profit to create your prices. You do not need any specialist skills. It can be done straight away once you have your cost information so takes little time. For those that must price hundreds or even thousands of products at the same time, this is clearly a life saver as the method is not only simple but also time efficient. This can help companies keep their costs down as the method takes up fewer resources, both in time and money.
Secondly, if calculated correctly, it makes sure you cover your costs so that you do make money on each sale. If you had simply copied a competitor’s price without analysing whether you can afford to, you could set yourself up for trouble. You need to know and understand your costs so you know what you can and can’t afford to do. At the very least you should combine this method with others to make sure that you can always make a profit.
And finally, this method is justifiable to customers. Not that we would ever advocate sharing your costs or your costing methods with your customers. However, if you are challenged on price you would have the option of being clear why you cannot go below a certain price. What can be a more reasonable explanation for a price increase than to state, “Our costs went up by 5% this year, so we are raising our prices by 5%”? Be warned though, never give out any cost information to competitors or customers.
Cost Plus Pricing: Watch outs
However, it is not all good and many think that this method is far too basic and does not get the most value out of your products nor will it make you the most money. Let’s look at the watch outs, the disadvantages of cost plus pricing now.
Firstly, it completely ignores competitor prices. It is all very well if your cost plus prices are in line with your competitors, but what if they are not? What if your cost plus price comes out much lower? If you sell at that lower price you may take sales from your competitors. But have you also lost out on potential profit? And if your price comes out much higher than your competitors? What then? You would not be as attractive and may not get sales as consumers are used to paying less.
Secondly it neglects product value. Just because it cost you the same to produce two items does not mean that they have the same value. If they deliver extremely different values to the customer, they should have different prices. If you ignore the value you are giving to the consumer, you may well be leaving money behind on the table. They may have been willing to pay more and you will have lost out.
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Remember ALL your costs
Finally, there is a watch out in how you do this method, rather than the method itself. You must be careful to include ALL costs in your calculations. It is all too easy to miss something out. This might be ok, albeit not ideal, if it is something minor but not if it makes a significant difference. I know of businesses that have failed because they did not calculate their costs properly. When we use this method, we recommend you add up ALL your business costs, including time, to really understand what you need to cover with your pricing.
Your costs to include, among others, are:
- Product related costs
- Shipping and distribution, including any extra packaging
We then like to add up all the costs that your business has to pay whether you sell any items or not as you need to know that any profit you make can cover these costs too. And remember to look at the future of your costs too. Are your costs likely to go down if your volume increases? Are the raw materials likely to be more expensive soon? Do you have any other information about your costs? Take all the information you have into account to be thorough with this method.
Cost Plus Pricing: Summing up
Even though cost plus pricing is a basic pricing method, it certainly does have merits. It is simple and easy to understand and it should help you make a profit. Unfortunately, using cost-plus pricing as the sole pricing strategy can reduce your competitive strength as it does not take competitors or consumer behaviour into account.
However, whichever pricing strategy you choose it is always great to use cost plus pricing as the base of your pricing strategy at least. This will make sure that your prices do not go below your costs so you can continue to make a profit. Remember to always include all those costs though.
In our next article in the product pricing series we will be looking at competitor based pricing so look out for it to see how your pricing can be impacted by your competitors and their pricing.
If you need a few pointers on how to choose a strategy or some extra pricing guidance sign up to the Pricing Learning Hub for access to pricing calculators, fact sheets, how-to guides and more.
Alternatively, if you have a specific question, then our Pricing Power Hours can help un-muddle you and set you on the right pricing track.
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