Is Cost-Plus Pricing a Viable Strategy?
in Monetization and Pricing
Monetization & Pricing
September 26, 2022
Cost-plus pricing is a simple strategy. You can implement it very easily, but are you sure it’s right for your business? Here’s why it probably isn’t.
Let’s say you’re on the last few steps before releasing a new product. One of the last tasks before the launch is setting the price. How do you approach it?
Here’s a proposition. You calculate all your costs, add a markup that guarantees the profit, and that’s it. There’s your price using the cost-plus pricing strategy.
On a surface level, it may seem pretty logical. And, of course, that’s how many successful businesses work, right?
But are you sure that’s the correct move in your case? Is it the most efficient way to evaluate your product or service? In most cases, the answer is NO.
As a simple strategy, cost-plus pricing can still be implemented in more traditional businesses. But if you’re not selling snacks or t-shirts, you probably shouldn’t use it.
In this article, we’ll explain why.
What is cost-plus pricing?
The fact is, we’ve already explained the concept of cost-plus pricing in the very first sentence of this article. There really isn’t that much to add. Cost-plus pricing (or markup pricing) is a very straightforward strategy in which you calculate the expenses needed for a given product and then add a markup. And we talk about all the expenses, including the workforce and all the overhead costs, such as rent, marketing, office supplies, and taxes.
In this strategy, you focus exclusively on your business. By counting all your expenses, you figure out how much you need to charge for your product to make money.
The cost-plus pricing method is mainly used by FMCG and other retail-based businesses. And, in many such cases, it is enough to grow as a business. Most importantly, it’s easy to implement and follow, especially for companies that have very extensive product portfolios and can’t afford to analyze each and every product or category. That’s when cost-plus pricing is justifiable.
So, why can’t it work for you?
Why is cost-plus pricing inefficient in many modern businesses?
A vast majority of issues in the cost-plus pricing strategy come from its self-centered nature. By focusing on your costs, you overlook all the other crucial factors that should influence the price. Most importantly, you don’t think about your clients, their needs, and how your product or service responds to those needs. Of course, we’re not saying that costs are irrelevant. They are obviously instrumental in any company. Especially if your business relies heavily on resources prone to market fluctuations, such as energy. But you shouldn’t base your price exclusively on them.
After all, who cares about costs??
As a business owner, CFO, or manager, you surely do. And you’re not wrong to do so.
But your clients couldn’t care less.
They won’t lose any sleep over your software licenses, equipment, and staff salaries. At the end of the day, customers focus on what they get from you and how much they have to pay for it. And here’s where we have to introduce the crucial term, willingness to pay.
Willingness to pay is the maximum price that a client is ready to pay for a product or service. In its very nature, it’s almost the exact opposite of the cost-price strategy. Instead of focusing on your own business and expenses, you think about your clients, their needs, and, in the end, their wallets. This approach is much more challenging but allows you to maximize your business potential. It’s the absolute fundament of value-based pricing. By conducting research, you’re able to figure out exactly what value your product brings to your customers and how much they will be ready to pay for it. Needless to say, it’s usually a significantly higher number than you’d get using the markup pricing strategy. More importantly, it's more accurate since it’s based on actual research.
Of course, to figure out that number, you have to analyze customers' behavior, conduct surveys, and look at your competition. It’s a complex process that we describe more comprehensively in our article:
The cost-plus pricing strategy isn’t very “strategic”
To sum up, let’s take a look at two of the most significant disadvantages of cost-plus pricing.
1. Not knowing the value of your product
As we’ve just described, by focusing on the costs only, you overlook perhaps the essential aspect of your business, which is the value it brings to customers. And if you don’t understand what value your product or service brings, putting a price on it is just glorified guessing. Of course, with the costs appropriately calculated, it may keep the business running, but with the value-based approach and thorough analysis, you can earn more and keep your clients satisfied.
2. The lack of competitive analysis
This is the perfect argument against cost-plus pricing that applies to the entire service sector and pretty much every company that operates in the digital world. As a software house, SaaS, or marketing agency, you compete with many similar businesses, even across the globe. As a result, your target groups can look up and compare your offer to theirs. If you don’t do the same, you expose yourself to risks, such as:
- Your offer is similar, but the markup is too high, so customers choose the competition.
- Your offer is similar, and the markup is significantly lower, making your offer attractive but causing you to miss potential profits.
Of course, there are more possible variations. The bottom line is, not knowing your competition, their offer, and pricing, you have no idea how yours fits on the market.
However, remember that looking at competition should never be the only way of determining your prices. You can read more about the topic here:
Value as a foundation of your pricing
Tying your pricing only to costs significantly limits your perspective and possibilities. There’s no actual research, no analysis behind it, so you have very little idea of your strengths and weaknesses. Therefore, you can’t evaluate those strengths and adjust for weaknesses. That only is a good enough argument against cost-plus pricing in most modern businesses. Unless you have an extensive portfolio of products, it almost certainly will cause you to miss on business opportunities and potential profits.
So, as strong believers in value-based pricing, we’d be happy to help you figure out the best way to move forward for your company and maximize your profits using thorough research, not simply calculating costs.