Understanding Cost-Plus Pricing
Cost-plus pricing has a longstanding history as a standard approach for setting prices for many B2B and B2C businesses. It's a model that prizes simplicity: tally up all the costs involved in the production or manufacturing of a product, set a margin that reflects your desired profit, and then add this to your total cost. This yields your selling price.
At first glance, cost-plus pricing seems to present a range of benefits:
- Ensures a consistent profit margin: By applying a uniform markup across all products, you safeguard a guaranteed, specified profit for each sale.
- Enables competition tracking: If you're informed about your competitors' standard markups, you can set your prices strategically, ensuring competitive relevance.
- Promotes fairness: Every customer is charged the same price, eliminating the potential for price discrimination.
- Supports price increases: When costs rise, a supplier can easily justify price increases to customers by referring to the associated increase in costs.
While these benefits may sound appealing, the cost-plus pricing model can lead to an overly simplistic view of value. The focus becomes about creating just enough value to persuade the customer to pay your cost-plus price. This approach could lead to underpricing and ultimately result in leaving money on the table. Why? Because this method doesn't optimize your profits nor does it consider the intricate nuances of human psychology.
Six Reasons Why Cost-Plus Pricing Can Be Detrimental
Inhibits Price Segmentation
Cost-plus pricing curtails your ability to set different prices for different segments of the market. Price segmentation allows for setting diverse prices based on how different customer segments perceive the value of your offer, a concept known as 'willingness to pay.' By capturing a larger portion of the market through different price points, you can maximize revenue. Experimenting with the price points for different customer groups is crucial for understanding your market better.
Ignores Customer Concerns
This might be a hard pill to swallow, but the truth is, customers often don't care about your production costs. Their focus is on the value your product brings to them, rather than how much it cost you to create. A customer's willingness to pay is dictated by the perceived value of your product, and your pricing strategy should reflect that.
Undermines Value Proposition
Cost-plus pricing can also lead to undervaluing your product. For example, a manufacturer who creates a tire that lasts twice as long as the competition may only increase their prices by 10% based on their production costs. However, the value to the customer is significantly more than just a 10% increase, meaning you could charge more and still offer good value.
Neglects Customer's Willingness to Pay
Companies often charge prices that far exceed their production costs, and customers are willing to pay these prices due to the perceived value. Starbucks, for instance, charges around £3.10 for a large Cappuccino. Customers are willing to pay this price because they value the entire Starbucks experience, not just the coffee. By charging a premium price, Starbucks ensures it can reinvest in the business to continue delivering the high-value experience their customers love.
Cost-plus pricing doesn't consider competitor prices or their potential actions, which can greatly influence your product pricing. If your price is significantly different from your competitors, you could lose market share and anticipated profits. Ignoring what competitors are charging can result in either significant losses in potential profits or in customers if you're priced too high.
Leads to Price Miscalculations
Cost-plus pricing can also lead to overpricing when demand is low and underpricing when demand is high. As the volume of production increases, the cost of manufacturing decreases. Thus, your price impacts how much you sell, which then affects your unit cost and can cause a chain reaction of miscalculations.
Transitioning Away From Cost-Plus Pricing
Breaking away from cost-plus pricing doesn't have to be a drastic change. Begin by identifying customer segments willing to pay more, and offer them a higher margin. If your product range includes basic, standard, and premium tiers, consider increasing the margin on the premium product. Slowly introduce more customer segments and incorporate new pricing strategies over time. By following this strategy, you'll eventually replace your cost-plus pricing model and might even see an increase in customers.
While cost-plus pricing might initially seem like a practical strategy, it could hinder your business in the long run. Customers invest in products they perceive as valuable, and pricing should reflect the value a product or service offers rather than just covering costs and adding a profit margin.
Cost-plus pricing fails to take into account competitor prices and the market's willingness to pay. As a result, products may end up overpriced and unable to compete, or underpriced and profitable revenue could be lost. Thus, moving away from cost-plus pricing and embracing a value-based pricing strategy could enhance both your profits and your customers' satisfaction.
- Forget Cost-Plus Pricing - Sell Value Instead
- What's Your Pricing Strategy? A look at Cost-Plus Pricing
- The Brutal Truth About Cost-Plus Pricing
Marketing: concepts and strategies, Lyndon Simkin and Sally Dibb, 2016
The Strategy and Tactics of Pricing, Tom Nagle and John Hogan, 2016
Confessions of the Pricing Man: how price affects everything, Hermann Simon, 2015
Pricing with confidence: 10 ways to stop leaving money on the table, Reed K. Holden and Mark Burton, 2014
Pricing for Profit: how to develop a powerful pricing strategy for your business, Peter Hill, 2013
Value-based pricing: drive sales and boost your bottom line by creating, communicating and capturing customer value, Harry Macdivitt and Mike Wilkinson, 2011