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Cost-plus: The Backbone of Traditional Pricing Models

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Maciej Wilczyński
Managing Partner, Founder Valueships
August 17, 2023
pricing

Deciding on how to price your products or services is one of the most important but also complicated decisions you will make as a business. To make the decision a bit easier, many companies opt for the simplest - Cost-plus pricing method. 

And for many industries (like retail), this method works perfectly well. You should know, however, that this pricing method also has a few downsides, which might make it a poor fit for your product or service.

So to help you make the right decision, we’ll talk today more about what cost-plus pricing is and when it might be a good idea to use it for pricing your products.  

What is a Cost-plus pricing strategy?

Cost-plus pricing (or markup pricing) is one of the simplest methods businesses can use to determine how much they should charge for a product. 

Here’s how it works:

  • First, a company estimates how much it costs them to make a product (including the materials costs, labor, and overhead expenses)
  • Then they add a markup percentage to the production costs, and this way, they get the final price for a product.  
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By doing so, businesses can ensure that the product sales will cover the production costs while the margin percentage lets them make a profit from the sales.

Cost-plus pricing example

Let’s say you want to calculate a price for selling sweaters at your retail store. The production costs for making one sweater look like this:

  • Material costs: $20
  • Labor costs: $30
  • Overhead costs: $20

That would make the total production cost for one sweater $70. You want to make a profit selling the sweaters though, so you also add a 50% markup (a retail standard) to the production costs. 

The cost-plus pricing formula would then look like this:

Unit cost = $70

Markup = $35 (50%)

Production cost + markup = $105. 

This gives you a selling price of $105 for each sweater.

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Advantages of Cost-plus Pricing 

As you can see, Cost-plus method is pretty straightforward - you just need to know the production costs, add the markup percentage, and you have a final price. But besides the simplicity, there are also a few other benefits:  

All production costs included

When calculated correctly, cost-plus pricing takes into account all of your production costs, including both direct and indirect ones. That way, the risk that product sales won’t cover the expenses and you will be in the red is lower.

Predictable revenue

Adding a fixed margin percentage to the product price ensures that you make a profit with every sale. As an added benefit, the fixed margin also makes it easier to predict your revenue, as you know how much you will earn from each sale.

Transparent 

With a cost-plus approach, it’s clear what goes into the final price of a product, so customers are also more likely to agree to pay for the product. And in case you need to raise the prices (for example, because the production costs have grown), you can show the raise as justifiable.   

A convenient option for new or small businesses

The cost-plus pricing approach can also be very useful for brands that are just starting and, as such they don’t yet have any data on customer expectations, competitor pricing, or market demand. They can begin first by setting a price that covers both their expenses and a profit margin and then adjust the prices as they learn more about their audience and can estimate the demand.

Disadvantages of Cost-plus Pricing

Considering those benefits, cost-plus pricing might sound like an ideal pricing method. But as every rose has its thorns, cost-plus pricing also has a fair number of disadvantages you should keep in mind if you plan to use it for pricing your products, as well as its actual costs and final cost.

You might be underpricing/overpricing your products

A cost-plus approach focuses on production expenses and margin - and only those two aspects. It doesn’t take into account product demand, customer’s willingness to pay, market trends, or competitor pricing. While that makes it faster to calculate the prices, there’s the risk that you might either set the price too high (and discourage potential customers) or too low (and limit your profits).  

Lack of focus on customer value

Focusing solely on the costs rather than on the product value is something we see as one of the biggest drawbacks of the cost-plus approach. Rather than think about how much your customers can gain from using these products or services, you only charge them for how much it costs you to design the product or run the service.

In that way, you might be unwittingly putting customers off because:

  • A too low price might make them suspect that the product value might also be poor.
  • Too high price might discourage them from trying the product, especially if they don’t know whether it will meet their needs.   

Not a good option for dynamic markets

Cost-plus pricing works best when both production costs and margins are stable, that’s why it works so well for retailers, manufacturers, or restaurants. For brands that can’t predict the demand for their products or whose production costs are fluctuating (like customized product makers), cost-plus pricing might not be the best choice though. 

For example, since the pricing approach is quite inflexible, you might have to review and adjust your prices very often just to ensure you make a profit.  

Main challenges in implementing the Cost-plus model

You researched the available pricing methods, compared the pros and cons, and finally decided that the Cost-plus model really would work the best for your needs. 

Since it’s such a straightforward pricing method, you shouldn’t face any problems while implementing it in your business, right?   

While it might seem easy, it’s still important to prepare thoroughly for the implementation so you get the results you expect. Here are a few steps from which you should start:

Identify costs 

The first thing to do is to calculate how much it costs you to develop a product or service. This will require a bit of research as besides fixed costs (such as cost of materials or labor) you should also include the overhead costs in the calculations. 

The more data you have here, the better since it lowers the risk you will underprice the product - and this way, the product sales won’t cover the costs or have transparent prices.

Determine markup percentage

Once you have the product costs written down, it’s time to define the profit margin you will add to your prices. This might be quite tricky to do though, since the markup percentage can vary wildly depending on the industry and type of product you are selling. 

A clever way to gauge how much you should add is by looking at the markup standards for your industry and then at your competitors' prices to figure out how much markup other brands from your sector are adding.

Important: Keep in mind that while a higher markup rate might bring higher profits per sale, it can also lead to lower sales volumes if your prices are too high compared to competitors. 

Can’t decide whether or not you should use the cost-plus method for your products or are worried that the price you estimated might be too low or too high? We are here to help. Schedule a meeting with us, and we can help you decide which pricing strategy would make the most sense for your brand.

Conclusion

Cost-plus pricing strategies are so popular for a reason. When done correctly, this method can ensure you will cover your production expenses and also let you build a stable profit. 

Using it to its full potential isn’t as easy as it might seem though. You need a good grasp on your production costs (both direct and variable costs) and then find the ideal markup percentage that will help you make a profit but without discouraging your customers.  For some products, using this pricing method might also be quite inefficient - so you first need to gauge whether the cost-plus pricing method will work for you. 

Here at Valueships, we’re here to help you with both - so if you’ve been pondering how to price your products and just don’t know where to start, give us a call.

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Maciej Wilczyński
Managing Partner, Founder Valueships

Expert in B2B pricing, monetization and value-based selling strategies. Over the past year, he has completed over 40 consulting projects in Europe. Prior to founding Valueships, he worked at McKinsey & Company, mainly in the TelCo, software, and banking industries. He completed his doctorate in pricing in SaaS start-ups at the University of Economics in Wrocław, where he also lectures.

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Maciej Wilczyński
Managing Partner, Founder Valueships

Expert in B2B pricing, monetization and value-based selling strategies. Over the past year, he has completed over 40 consulting projects in Europe. Prior to founding Valueships, he worked at McKinsey & Company, mainly in the TelCo, software, and banking industries. He completed his doctorate in pricing in SaaS start-ups at the University of Economics in Wrocław, where he also lectures.