Although many professionals continue to ridicule cost-plus pricing, this simple and efficient model has its place in business. Companies use fixed and variable costs and add markups of their choice, determining the price of their goods. Doing so can increase customer trust and result in steady, predictable profits.
We’ll evaluate the pros and cons of cost-plus pricing models to help you determine if it’s right for your business.
The Benefits
Despite its infamy, cost-plus pricing can be beneficial. Its pros will help you determine whether or not to use it, so let’s look.
Pro 1: Easiest to Communicate
Since cost-plus pricing is inherently fair and does not discriminate against customers based on buying power, it’s the easiest to justify.
Especially during times of high inflation, where cost increases are inevitable but also the worst received, cost-plus pricing enables companies to raise prices with little friction. If your costs go up by 10%, the justification for raising prices is simply, “our costs went up by 10%!”, an explanation easy for customers to digest.
Many sustainability companies take this a step further with radical transparency in prices. They’ll provide a detailed breakdown of their costs and explain to customers how their prices enable sustainability and ethical wages. Doing so increases customer trust and loyalty.
Pro 2: Simple to Implement
Cost-plus pricing can save the day if your company doesn’t have the resources to dedicate substantial time to pricing strategy.
Consider cost-plus pricing when your business’ resources are stretched thin. Ensure you keep tabs on it and monitor costs relative to your markups.
Although simple to implement, cost-plus models have drawbacks that may result in profit loss (more on this later in the article). Before you decide to take the easy way out just for the sake of it, evaluate your company’s resources and do what you can to strategize pricing as effectively as possible.
Pro 3: Stabilizes Price Levels When Widely Adopted
If major competitors in your industry also use cost-plus pricing, these models stabilize price levels and eliminate the need for price wars. Collectively, this lowers all companies’ risk.
Prices remain incredibly stable when higher-cost suppliers offer higher-quality products and vice versa.
Inherent in this is that you research your competitors, although their pricing is a factor ignored by the cost-plus model. If price stabilization is critical to your affinity towards cost-plus pricing, ensure the competition uses the same model.
Pro 4: Encourages Other Buying Considerations
When customers understand that prices reflect actual costs, they begin to consider more than the lowest price when it comes time to buy.
While some will always go for the bargain deal, many other consumers will purchase more expensive products with the understanding that the quality is better.
Pro 5: Creates The Opportunity For Cost Leadership
Companies that can use their unique competencies to lower costs without significantly sacrificing quality will quickly become cost leaders. This balance is difficult to achieve, but it’s massively appealing to customers if you can pull it off.
Costco is the best example of cost-plus pricing leadership. Their average markup is 11%, compared to Walmart’s 24% and Home Depot’s 35%, and Costco promises not to mark up prices by more than 15%.
Despite this, Costco products are known for their quality and generous warranty and return periods. Customers get the best of all worlds, making Costco exceedingly popular. If you can do the same in your industry, you’ll also reap cost leadership benefits.
The Drawbacks
Although there are times when cost-plus pricing works, it comes with some drawbacks. Let’s take a look at those.
Con 1: Deflates Profits
By its very nature, cost-plus pricing limits how much you can profit. Since this model determines the sale price by evaluating all fixed and variable costs, then adding a markup, there’s only so much a company can make.
While it’s up to companies to set their markups, consumers will only accept so much, so there is a ceiling. Generally, if you’re basing your structure not on value but on the costs associated with production, it’s harder to pitch a hefty markup to customers.
Although there’s no official standard, markups are typically in the range of 10-20%. If you’re instead basing the price on value, markups can easily be 100% or more of the actual cost.
Con 2: Doesn’t Always Cover Costs
While cost-plus pricing exists to cover costs, some estimation is required. As a result, this model may only sometimes cover the totality of expenses.
Since sales volume must be estimated, with fixed costs allocated based on that, and because variable costs are, well, variable, cost-plus prices can be too high or low. This miscalculation can result in hefty losses.
As such, it’s essential never to be complacent with cost-plus pricing. Continually evaluate the changing costs of goods and overall sales volume. Never set it and forget it!
Con 3: Ignores Other Key Factors
By its very nature, cost-plus pricing is simple. While this makes it easy to calculate and implement, it also means other essential factors are ignored. Such factors include competitor prices and customers’ willingness to pay.
These other factors often significantly impact prices and profitability. For instance, if a critical competitor has more efficient production than you and is pricing 30-40% lower, customer acquisition will suffer, and profit will go uncaptured.
Without evaluating the many variables that impact price, companies can miss out significantly.
Is Cost-Plus Pricing Right For You?
Considering the pros and cons of cost-plus pricing, it’s up to you to determine if it’s an appropriate pricing strategy.
If you decide a more complex model is necessary, you’ll want to leave that to pricing experts. Pricing strategy leaders can be challenging to find because the field is new, but Jennings Executive has decades of experience matching companies with pricing talent. Let us help you build your pricing team and maximize profits! Learn more today.
