Cost Plus Pricing: How to Use Cost Based Pricing In Marketing
Cost plus pricing or cost based pricing is a pricing method where a fixed sum or a percentage of the total cost of creating a product is added to it’s selling price.
In the pricing and revenue management community, the term cost plus pricing has increasingly come to have a very negative connotation. Some view it as a backward looking approach (see premium pricing strategy for a polar opposite).
In this article, we will discuss cost based pricing in marketing and financial analysis. We will cover: various cost based pricing formula. Companies that use cost based pricing. Real world case study examples. Finally, we will evaluate a cost based pricing approach, covering the advantages of cost based pricing methodology and 5 very valid reasons why cost plus pricing is not the best option when making a business plan.Click here to improve your pricing capability
Cost based pricing definition
I have worked in numerous environments where people are strongly committed to a cost plus pricing approach – and almost see it as a badge of honour, i.e. the appearance (false in many cases) of financial rigour and numbers / financial accuracy gives them confidence that they are being hard nosed business people. However, often it can be a sign of anything but.
Numerous surveys of pricing teams and price diagnostics from consultants for both goods and services consistently show that the most commonly used starting point for an item’s price is its cost.
A cost based pricing definition is when the setting of a product or service initial price begins with a consideration of the it’s costs.
There are many situations when a business may consider using cost plus strategy examples to set or review their prices. They may need to come up with a new price for a product that does not already have a price or review prices for products that do have prices. In all of these situations, management must arrive at an initial price for the item that is being sold and many choose a cost plus or cost based pricing strategy. Why?
What is cost based pricing
The logic of cost based pricing is very simple. A typical cost based strategy example is when an item’s selling price is calculated by adding an amount of money to the item’s costs. There are many ways in which cost plus strategy example can be done.
Cost plus pricing example
The simplest cost based pricing method involves determining the amount to be added to an item’s cost and then adding that amount to arrive at the item’s price. This is referred to as a cost plus pricing formula. If (C) is an item’s cost, then its price (P) is calculated as follows:
P = C + added amount
Companies that use cost based pricing
A cost plus pricing example is particularly common among companies that sell customised products, like construction companies, material handling, heavy equipment and parts etc. Fletcher Building, Brickworks, Rinker Group, Hanson, Gunns, Adelaide Brighton, Nash Timber potentially all use cost based pricing methods and formulas to some degree. Even energy companies and medical equipment / technology companies generally use cost plus pricing strategy examples.
Cost plus pricing construction
A cost plus pricing example would be when a building materials business gives a price estimate for a job, by calculating it’s costs to do the job first (say $56,451). Key stakeholders at the building materials company would then meet to discuss how much they should add to this cost by considering factors such as the number of such jobs it is likely to do in a year, its overhead costs, and is desired final profits. If these factors indicate that $32,987 would have to be added to the job’s costs, then company would set the price of doing that job at $89,438.
Cost plus pricing methods
Another form of cost plus pricing example is mark up pricing. Mark up pricing is generally used by businesses who buy lots of different goods and resell them at a fairly consistent pace like a distributor / wholesaler or retailer. They’ll have thousand of SKU’s (Stock Keeping Units), products and many different product categories. Many commercial teams find it difficult to calculate the additional amount separately for each product (i.e., using standard cost plus formula as above). So, they often end up setting the price of an item using mark up pricing.
Mark up pricing
Mark up pricing essentially is another cost based pricing method. Mark up pricing basically adds to the item’s cost some standard percentage of that cost. The percentage used, could for a mark up pricing formula be the same for all of the company’s products. Alternatively, there could be a separate standard percentage for each type of product sold by the company.
The standard percentage used in markup pricing is called markup. It is the amount added to an item’s cost (C) expressed as a percentage of that cost. A markup (M) cost plus strategy example could be calculated as follows:
M = (added amount/C) x 100
Cost plus pricing strategy examples
To calculate a retailers cost plus pricing strategy example based on a markup, the markup must first be converted into a proportion (by dividing it by 100) and then multiplied by the cost. The result of this multiplication is then added to the cost. This method of calculating a cost plus price formula is written as follows:
P = C [(M/100) XC]
For example, to set your initial prices on a line of luxury biscuit boxes for Christmas, a retailer might apply a 200 percent markup. If the retailer pays $8 for a particular brand of luxury biscuit box selection, it would use the following calculations to set a price of $24 for this line of luxury biscuit boxes:
P = $8 +[(200/100) X $8]
P = $8 + (2.0 x $8)
P = $8 + $16
P = $24
Cost plus pricing method
A good questions that I am sure you now have after reading this formula is what makes up the markups that companies use? (A question so many procurement teams also ask these companies..). For many distributors and retailers markup levels tend to be governed by tradition (i.e., they have always done it this way) or simple rules of thumb (i.e., a lot of rough estimates and guessing). In a wholesaling cost plus pricing example, a typical markup on merchandise costs would be roughly 20 percent.
Keystoning cost based pricing in marketing and merchandising
In retailing, fashions, gifts and food have traditionally used with is called keystone pricing (or keystoning pricing method). Keystoning is when a business doubles an item’s cost to arrive at its price (i.e., applying a 100 percent markup).
In the restaurant industry, the typical guidelines are that the price of menus items should be determine by tripling an item’s food costs (i.e., applying a 200 percent markup) and quadrupling the costs of served alcoholic beverages (i.e., applying a 200 percent markup).
An interesting point to note..When goods are passed hands more than once before reaching the consumer, successive markups are applied. A typical distribution channel for the biscuit example would have a markup story like this:
Manufacturer ($8 Manufacturer’s price)
Distributor ($8 cost to acquire + $1.60 (which is a markup of 20%) = $9.60 (final wholesale price)
Retailer $8 cost to acquire + $9.60 (which is a markup 100%) = $17.60
Which means the major retailer (like Coles and Woolies) is making $6.40 additional profit contribution dollars on every box of luxury business they sell; representing 80% of the manufacturers price.
Cost plus margin pricing
Another form of cost based pricing is cost plus margin pricing or gross-margin pricing. Many business use cost plus margin pricing because they want the the process of calculating a price to be heavily influenced by the profit goals of the organisation. Many managers want to keep margins at a certain level of percentage so they meet their targets. Consequently, they set they product margins at a certain level aligned with their profit goals and work from there.
In contrast to a markup, which is the amount added to an item’s costs as a percentage of that cost, a percent gross margin (or cost plus margin pricing) is the amount added to an item’s cost written as a percentage of the item’s price. Cost plus margin pricing (or sales margin formula) looks like this:
%GM = (added amount/price) x 100
There are two ways to use a percent gross margin to set a price
The first way is to change the percent gross margin to a markup percentage because this often feels more intuitive (or easier). The second methods is to calculate the product’s price directly from the gross margin percentage which would look like this:
P = C/[1 – (%GM/100)]
When the gross margin percentage is large the item’s price becomes considerably above the item’s cost and when it is small the item’s price is only a little above the item’s cost. It is little wonder then, that you’ll hear many managers discuss high percent gross margins (+30 – 55%) as the guideline they generally expect prices to conform to even in margin constrained businesses.
Big gross margin percentage means higher prices and more profit contribution dollars
Although the use of gross margins in pricing setting helps to bring to pricing the influence of the selling organisation’s profit goals, the cost plus margin pricing method makes price review time a scary prospect. Many customers will ask for gross margin – markup equivalents to understand how you calculated your price rise. Some customer may be unwilling to pay a higher prices. Especially, if you have cost plus pricing or a rule of thumb to back up your margin percentage calculations.
5 potential flaws with cost plus pricing for your business
How can you work out your costs? – In the classic case of cost plus pricing, prices are set by adding a margin to the “costs”. The first real issue is a simple one – how can you calculate the costs.
This may seem a simple question – but we have to decide what costs we include i.e. is it total average costing, marginal costing etc.
Think of a cost based pricing example where a company sells 100 teddy bears (it is interestingly a teddy bear company – here is an example of a luxury branded teddy bear – Steiff.)
If someone doubles the order to 200 bears – what would the cost of the bear be for the calculation?
Should they set the price for the new bears at the average cost – i.e. dividing the factory, rentals, machinery costs etc across the new bears?
Also – should they reduce the cost for the original 100 bears – as the same factory is producing more bears.
Or should it just be the marginal cost of the bears?
If, in an extreme example, the marginal cost of a bear production was zero – should they give that bear away for free.
I have worked in companies where average costing was not giving us a “low enough” price
What ended up happening was they just started to remove costs that were deemed as “not appropriate”.
What margin should you add? – If it is hard to work out costs, working out the margin or mark up to add is even harder in price setting. What is a good number i.e. 10%, 20% or 600%. Honestly, it can be whatever you want it to be.
Cost based pricing gives a logical reason to not innovate.
This is a slightly funny way of looking at things but highlights the inherent flaws in this approach.
Imagine if you will, a teddy bear factory. There is a bright employee there who comes up with a way to reduce costs by 80% without reducing quality. The management should logically reject this innovation if they are using cost plus pricing.
Why? Because their profits would also drop by 80%. The markup percentage would still be the same (they would just be adding 10 percent or so to a much lower cost).
It does not recognise the value customers place on the product or service. What if you have a really hot product or service. Wouldn’t it be foolish to ignore this when setting prices? The price of a beer would be almost the same in a dive bar as in the Ritz – or the price of a business class seat on a flight would only be slightly higher than an economy seat (see blog on revenue management)
It gives customers an ability to push your prices down. What if your clients in a B2B environment know that you are applying say a 50% markup when their business only achieves 25% margins? They are likely going to use this to negotiate a price decrease.
I have been in meetings where customers have said – we make 20%, so you are part of our supply chain and so you should not make anymore than 20%. It is never a good idea to give your clients an incentive to start these conversations.
See our blog on what is pricing.
A big flaw with a strict full cost pricing is it destroys value. This is because an input price based approach leaves margin on the table. You will be effectively underselling your commercial strategy. It is harder to re-price existing products once a price is known. Make sure you get it right first.
A price model that doesn’t consider issues like price competition will tend to be less profitable
You must consider what value your product actually offers (and any differentiation). Then calibrate with you market price positioning versus your competitors. Things like monitoring price value differentials by product and segment are key here.
Whether you are in the Government Contracts game – or B2B sales, understanding the value your customers place on your product or service is key.
As a closing cost plus pricing example..
If you are the sole provider of a differentiated product – the cost to produce the service should really have no impact at all on the price you sell it at.
Value based pricing is not about charging a higher price – but pursuing a profit maximising pricing strategy.
Ask why the team is talking about full cost pricing at meetings. Especially if you are reviewing prices. Ask which cost is added or if direct labour applied. Especially if you are trying to price a new product. You will soon realise you have a serious pricing problem.
Don’t waste another dollar on the wrong pricing team strategy.
Arrange a confidential meeting.
Did you know that…
How you set up and recruit strategic pricing managers and analysts is a key determinant of how fast you can accelerate earnings growth. With the right pricing team strategy and implementation in place, incremental earnings gains can begin to occur in less than 12 weeks. After 6-12 months, the team is often able to find additional earnings. They identify more complex and previously unrealised revenue and margin opportunities.