The Brutal Truth About Cost-Plus Pricing

By Moira McCormick on August 30, 2016

Cost-plus pricing is a common approach to pricing used by many B2B businesses. It's simple really - in order to reach your cost-plus price you figure out all the costs of production or manufacture, set a desired margin for each unit and add that margin onto your cost. Hey presto, you have your price!

 

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This method of arriving at a price appears at first glance to be logical because:

  • It ensures a reasonable margin. By using the same markup on all products, you know that you are getting a specified margin.

  • If you know your competitions’ standard markup you can always price appropriately.

  • It’s fair. Every customer is charged the same price so there is no price discrimination whether the customer is rich or poor.

 

However, when you sell based on “cost plus,” your focus is merely on creating enough value for the customer to be willing to pay your cost-plus amount. The result is you undersell. So, it's definitely not smart pricing and you could be leaving a lot of money on the table using this pricing strategy because it doesn't maximise your profits or take into account human psychology, which comes into play when you use a psychological pricing strategy.

 

Why is Cost-Plus Pricing Such a Bad Idea?

1. It Limits Your Ability to Use Price Segmentation

Cost-plus pricing limits your ability to price to different segments of the market. By setting a variety of prices based on how different customer segments value your offer (otherwise known as their willingness to pay) you capture a greater portion of the market, maximising revenue at each point on the demand curve.

 

2. Customers Don't Care About Your Costs

Customers don’t care about your costs, they only care about the attributes of your product and what value it offers them. For example, customers will be willing to pay more for a Smartphone that has the features that best meet their needs regardless of the manufacturing costs. If a customer’s willingness to pay is not based on the cost of goods, your price shouldn’t be either.

 

3. You're Giving Away Profits

You'll miss out on increased revenue and profit, which could be substantial. For example, a tyre manufacturer develops a more durable, longer lasting tyre. If this manufacturer implements a cost-plus pricing strategy their prices would be about 10% higher than competitive products reflecting the higher cost of materials required for greater durability. This would result in the manufacturer missing out on millions in profit, because the price would only be 10% higher but durability is 100% better than competitive tyres. The manufacturer is not selling the true value of the tyre.

 

4. It's Not Based on Your Customer's Willingness to Pay

As an example, Starbucks charge around £3.20 for their Cappucinno. Does it cost Starbucks £3.20 to produce? No! A price of 50p for a cup is probably a lot closer to “cost-plus” than £3.20 – and yet coffee lovers willingly pay the premium price. Why? Well, they value the cafe ambiance and the "specialness" of a Starbucks coffee. They appreciate it more because it is expensive.

Would Starbucks sell more coffee if it was 50p a cup? Presumably yes, but they would make less variable profit, and customers would not value their product so much. Charging £3.20 allows Starbucks to have the variable profit they need to invest in the business to make locations what they are and where they are. By taking the variable profit and reinvesting it, they’re creating even more value for the consumer.

 

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5. It Does Not Take Into Account Future Demand

This method does not take into account the future demand for a product which should be the base before deciding the price of a product and therefore a serious limitation of this method.

 

6. What about your Competitors?

It also does not take into account competitor actions and the effect these will have on the price of your product. In today's competitive world, if you solely depend on cost plus pricing it can lead to the failure of your company’s product in the market.

 

7. It Leads to Over and Under Estimating Prices

Cost plus pricing will cause you to over-price your product when there is a weak market and will cause you to under-price your product when there is a strong market. As the volume of products being created goes up, the costs of manufacturing goes down. If you are managing a service the same thing is true – the more subscribers you have, the lower the cost per subscriber.

Since your unit cost is changing with volume, your price will determine how much you sell. This will then impact volume which then impacts unit cost.

 

How to Move Away From Cost-Plus Pricing

Start slowly. Keep your current pricing model, but look for customer segments willing to pay more - and charge a higher margin to those customers. Or, if you have a good/better/best product raise the margin on the “best” product. You will quickly see that there is a lot of money to be made by pricing based on customer value rather than your costs.

Over time you can slowly add more segments and/or more techniques. Soon your cost-plus pricing model will disappear, and you’ll have even more customers than before!

 

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Conclusion

Although it might seem a logical strategy at first, cost-plus pricing is a bad move for your business. Basically it can be bad for both you and your customers because those customers don’t want to buy anything, regardless of the price. What they are willing to do is invest — they’re willing to invest in anything they feel will create real value for them – and if you create value for your customers they see more in what you have to offer and will either pay more for each product or buy in greater volume.

Cost-plus pricing is also not acceptable for determining the price of a product to be sold in a competitive market, primarily because it does not factor in the prices charged by competitors. Thus, this method is likely to result in a seriously overpriced product. Further, prices should be set based on what the market is willing to pay - which could result in a substantially different margin than the standard margin typically assigned using this pricing method. Cost-plus pricing is bad news – consider changing your pricing strategy pronto!

 

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