Cost Plus Pricing: How to Use Cost Based Pricing In Marketing 🌺
Cost-plus pricing or cost-based pricing – 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 formulas such as companies that use cost-based pricing. We will also provide real-world case study examples. Also, we will evaluate a cost-based pricing approach, covering the advantages of cost-based pricing methodology and 5 valid reasons why cost-plus pricing is not the best option when making a business plan.
Table of contents for this article include:
Cost Plus Pricing: How to Use Cost Based Pricing In Marketing
Cost-based pricing definition
I work in different environments where people are strongly committed to a cost-plus pricing approach and almost a badge of honour: i.e. the appearance (false in many cases) of financial rigour and numbers or financial accuracy gives them confidence. They are 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 its 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 arrives at an initial price for the item sold. Many choose a cost-plus or cost-based pricing strategy. Let’s find out why.
The logic of cost-based pricing is very simple. We get the item’s selling price by adding an amount of money (markup) to the item’s costs.
The simplest cost-based pricing method determines the amount added to an item’s cost and then adding that amount to arrive at the item’s price. This is a cost-plus pricing formula. If (C) an item’s cost; then its price (P) 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 materials, heavy equipment, parts, etc. Fletcher Building, Brickworks, Rinker Group, Hanson, Gunns, Adelaide Brighton and Nash Timber potentially all use cost-based pricing methods and formulas to some degree. Even energy companies and medical equipment or 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 its costs to do the job first (say $56,451). Key stakeholders at the building materials company meet to discuss how much they should add to this cost by considering factors such as the number of such jobs to do in a year, overhead costs, and desired final profits. Factors indicate that $32,987 added to the job’s costs; then the 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 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 thousands of SKUs (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 the standard cost-plus formula as above). So, they often end up setting the price of an item using mark up pricing.
Another cost-based pricing method is markup pricing. It basically adds to the item’s cost some standard percentage of that cost. The percentage used could for a markup pricing formula be the same for all of the company’s products. Alternatively, there is a separate standard percentage for each type of product sold by the company. Alternatively, a company has a separate standard percentage for each type of product that they sell.
Markup is the standard percentage used. The amount added to an item’s cost (C), expressed as a percentage of that cost. Below is how we calculate a markup (M) cost-plus strategy:
M = (added amount/C) x 100
Cost-plus pricing strategy examples
To calculate a retailer’s cost-plus pricing strategy example based on 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 question 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 are governed by tradition (they have always done it this way) or simple rules of thumb (a lot of rough estimates and guessing). In a wholesaling cost-plus pricing example, a typical markup on merchandise costs would be roughly 20%.
Keystoning cost-based pricing in marketing and merchandising
In retailing, fashion, gifts and food, they have traditionally used the so-called keystone pricing (or keystoning pricing method). Keystone is when a business doubles an item’s cost to arrive at its price (i.e. applying a 100% markup).
In the restaurant industry, the typical guideline is that the price of the items on the menu should be determined by tripling an item’s food costs (i.e. applying a 200% markup) and quadrupling the costs of served alcoholic beverages (i.e. applying a 200% 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
This 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 businesses use cost-plus margin pricing because they want 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 their 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 one is to change the percent gross margin to a markup percentage because this often feels more intuitive (or easier). The second method 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 larger than the item’s price, it becomes considerably above the item’s cost. 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 the 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 customers may be unwilling to pay a higher price. This happens 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
As mentioned, cost-plus pricing is particularly common among companies. However, there are also downsides in using this strategy.
1. 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. However, we have to decide what costs we should include. 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?
In an extreme example, if the marginal cost of bear production is zero, should they give that bear away for free?
We might have heard somebody say, “I have worked in companies where average costing was not giving us a ‘low enough’ price.”
What ended up happening, they started to remove costs that deemed as “not appropriate”.
2. 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.
3. 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 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% or so to a much lower cost).
4. 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)
5. It gives customers the ability to push their prices down.
What if your clients in a B2B environment know that you are applying to 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 any more than 20%.” It is never a good idea to give your clients an incentive to start these conversations.
With cost-plus pricing strategy, you simply put a markup on your product to determine its selling price. This pricing method looks solely at the unit cost and ignores the prices set by competitors. Nevertheless, you’ll want to look at the benefits and drawbacks of this pricing strategy to determine whether it’s a good fit for your business.
Points to Note:
There’s one big flaw with a strict full cost pricing. It destroys value. This is because an input price based approach leaves a margin on the table. You will be effectively underselling your commercial strategy. Re-pricing existing products once a price 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 your 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.
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 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.
Pricing Methods: 5 Things People Say When They Do Not Get Pricing
Pricing methods. How do you remove the misconception? There is a proverb from Geoffrey Chaucer that says, “Many a true word is spoken in jest.” Meaning, a humorous remark may turn out to be true after all.
In this short blog, we take a lighter approach to highlight common misconceptions that pricing professionals often hear. This could even be thought of as a way to learn by asking questions – in the Socratic style.
Below are some of the common statements people say when it comes to pricing. We suggest you keep a bingo card and tick it off if you have heard of them. If you did, then you can give yourself a pat on the back. The next step and more challenging one is to try to win over the person to the side of pricing and revenue management.
How many of these statements have you heard before?
1. “You cannot just increase prices.”
This is one of the most common statements that you often hear. It is based on a fundamental misunderstanding of the pricing profession and pricing methods. Hence, we listed this one first. As if you cannot get past this one, you have no chance of getting buy-in with our implementing pricing optimisation. A good answer to this question will enable you to move on to more complex questions such as below. See our blog on premium pricing strategy.
2. “Is this some sort of pseudoscience with magic numbers?”
This one can come up or a variation on it when the concepts of psychological pricing, relative pricing, anchoring or numbers such as $5.99 are brought up. This should be viewed as a good thing as it opens the door for more discussion.
3. “Our sales force will never accept this price testing method.”
This is a great indication as to how the business is actually set up and who carries power. It can also give you great insight into why margin erosion may be appearing. At this point, it may be a smart idea to think about how sales teams are incentivised.
4. “You need to know our costs or drive our costs down more.”
This one follows directly from the one above – if not a sales-driven organisation, it may adhere loyally to a strict cost-based pricing strategy. Do the finance team have a large say in pricing strategy? This gives a great indication as to where your work should begin
5. “It will not work for us – as our industry is different.”
We left this one to last – as it is probably one of the most common comments. The funny thing is that we have not seen an industry yet where pricing improvements cannot be made.
We do not intend to belittle the common queries made by non-pricing professionals. Of course, they can be valid concerns when not answered with a clear and comprehensive solution.
Let’s explore what can be improved. Your sales team defines price as what’s on the invoice. The CFO defines price as ‘what we take to the bank’. Your customer says the price is too high. Your pricing manager says that price doesn’t match our standard terms. The distributor says they can’t make any money on your line. However, it’s still Monday morning!
So what defines and indicates price?
Can you improve net price realisation and take more money to the bank? I prefer price as what goes to the bank, after all, discounts, returns, warranties, commissions and other deductions before determining the final price.
There are several elements to price management. The first is achieving the optimal price for each good or service. The second is managing your product mix and services to achieve the optimal price for a set of customer transactions.
For many firms, the difference between what’s invoiced and what’s banked is over 10%, made up of co-op, early pay, volume rebates, freight allowances, returns and other factors, defined and imagined. The difference between list price and invoice price is often over 20%.
For a firm with a 10% operating profit, capturing a 1% price improvement falls through to operating profit and expands operating profits to 11%, a 10% improvement.
Do you spend as much time thinking about price as you do thinking about costs? We will discuss 6 things that you need to be attentive of that can help improve your pricing and profits.
Here are 6 steps to consider that can improve your pricing methods and profits:
Have a clear, executive-level pricing proprietor.
Most organisations do a great job of managing pricing execution and deals flow. Your pricing manager may be doing a good job tactically, however, they should also be thinking strategically. It is great to have a capable and experienced owner of pricing strategy who can think ahead into what to do more in the future.
According to a study published in the MIT Sloan Review, fewer than 15% of companies have any systematic pricing review.
What to do: Delegate one of your executive team, most likely the VP of Marketing or CMO, with building a pricing team and enabling them to develop a pricing improvement plan and process.
Optimise your product range.
Classify your customers and understand which ones are price sensitive. Have a basic price fighter in your range that will meet their needs without disrupting your full product line pricing.
What to do: Look at your product pricing methods vs. your user segmentation again.
Align sales compensation with profit growth.
If your reps are paid with basic wages (not for profits or price improvement), what incentive do they have to fight for the best price?
If you were selling and could make 5% commission on $1000 with little effort, or 5% commission on a $1010 sale with some effort and risk, what would you do? The 1% price lift is worth a negligible amount to them but a huge amount to your bottom line!
What to do: Consider having, at a minimum, your sales leaders receiving an incentive on the expansion of either average selling price or gross margin.
Revisit your ‘price waterfall’ annually.
Check on all price deductions made prior to the final net price.
Are programs such as co-op still pulling their weight as you’ve shifted your pricing strategy to inbound marketing, pulling away from distributors to create demand? Do customers take an early pay discount when paying after the early pay period has expired?
Once you have established your price waterfall, compare it to your leading competitors. When you do, you are pushed to match invoice price plus you have more attractive trade terms. Oftentimes, your customers and sales team aren’t discussing in a price negotiation.
What to do: Conduct a review of you and your competitors, pricing methods, selling terms and price structure annually.
Understand your customers’ value.
Do those who set your prices truly understand your customers’ value? Do you have a pricing playbook and value pricing method which continuously reinforces the value of your products What diagnostic tool did your team use to improve pricing?
What to do: Ask your customers why they buy from you. This is a value discovery program.
Set expectations of annual price improvement.
Most businesses are worried about losing market share. Therefore, creating a culture of price improvement will ensure pricing is always top-of-mind for your commercial function.
What to do: Establish an annual price improvement goal and analyse on a regular period.
Price optimisation is not about selling less at a higher price. It’s about eliminating the leakages and practices that enable you to capture improvement in a systematic way in your net price realisation. How much time do you or your team spend thinking about these questions? How much time is it worth thinking about to get a 10% expansion in operating profit?
In a very competitive business environment, companies need to capture the full value of their products. They can do it using different distribution channels in order to be successful. The good thing about focusing on the steps mentioned above is that they are very easy to implement and can start making profits almost right away.
Cost-based pricing strategy: Communication skills vital for pricing leaders
Why is communication a prerequisite for pricing leaders?
At Taylor Wells, we are often involved in the implementation of pricing teams and functions in businesses. Where they were previously or where they have not been seen as core to the commercial proposition of the business. This can be when the dreaded adherence to a faulty cost-based pricing strategy or cost-plus can be very strongly defended.
Among pricing, experts revile the cost-plus pricing for some legitimate reasons. For stand-alone projects, in particular, cost-plus pricing discourages efficiency and cost containment. When lower costs quoted, the company earns lower revenue and total profit. A bloated cost structure, on the other hand, will raise prices and boost profit.
Another is the cost-based pricing formula ignores both the customer’s willingness to pay and the competitors’ prices. Ignoring these factors would make pricing decisions entirely off base.
In this blog, we do not intend to cover any of the well-known weaknesses of a cost-based pricing strategy but instead touch on some of the pitfalls that can happen when a new pricing lead or revenue manager seeks to buy-in for a pricing optimisation program or movement towards value-based pricing. At Taylor Wells, we are ardent believers that a pricing leader is also a business leader, i.e. not a segmented function such as purely finance, risk or legal. If you really want to transform pricing in a large company, you need to win buy-in from sales, marketing, finance, the C-suite, operations. In other words, all departments. It’s not certainly easy to do this. We feel underappreciated sometimes with the task at hand.
How to broach the elephant in the room? Cost-based pricing strategy may not be the best way forward!
I was chatting to a friend the other day from a company where I used to work at. I was asking about the commercial strategy and who is setting a pricing strategy. He said, “How can they set prices when they do not even know the costs?” At that point, I do not have enough time to go down the road of explaining value-based pricing. Also, I do not want to criticise my friend who seems so committed to cost-based pricing strategy. Opinionated people exist. They stick to what they believe in. They see it as a form of hearsay or a lazy/shady marketing waffle when they hear anything different.
It can be an exhausting experience – winning buy-in from multiple functions for a move to value-based pricing. However, it is vital to build any pricing transformation. In fact, we view it as laying a solid foundation for the transformation. Otherwise, you are sure to find the optimisation program will flounder as if on quicksand.
There are sometimes strategic and tactical reasons to use cost-plus pricing. When implemented with forethought and prudence, cost-plus pricing can lead to powerful differentiation, greater customer trust, reduced risk of price wars, and steady, predictable profits for the company.
No pricing method is easier to communicate or to justify. Cost-plus pricing is inherently fair and nondiscriminatory to customers. That is if the business is 100% sure of its cost position. Most are not, however, and the cost base of products are often guesstimating rather than precision.
Cost-plus pricing is the very antithesis of value-based pricing, which seeks to discover differences between customers’ economic valuations and to exploit them by customizing prices.
Providing useful and understandable explanation and evidence on Cost-based pricing strategy
Taylor Wells commits to an education-based form of marketing pricing and pricing recruitment. We strongly believe in the ability of pricing to deliver sustainable profit and revenue boosts to even the most established business. When you are a pricing professional, the benefit of value-based pricing is almost self-evident. Still, we sometimes need to remember how we discovered the profession in the first place.
Usually, a light-bulb moment when value-based pricing becomes clear to us. The challenge in spreading the word to others is helping them have their own light-bulb moment. More often, the trick can be making them believe that they thought of it themselves!
Companies that use cost-based pricing stabilises price levels. These companies are less likely to engage in price wars if they base their prices mainly on costs instead of competitors’ prices.
Cost-plus pricing can encourage shoppers to use factors other than price in buying decisions. When consumers believe prices reflect cost, they are more likely to factor quality into their decision instead of just buying whatever is cheapest.
When the company has unique competencies that allow for an advantageous cost structure relative to competitors, it can use cost-plus pricing to create and deliver the most enticing value proposition of all.
For companies with a cost advantage or an interest in using price transparency as a differentiator, cost-plus pricing is a powerful strategic tool. Companies are less likely to engage in price wars if they base their prices mainly on costs instead of competitors’ prices.
When implemented with forethought and prudence, cost-plus pricing can lead to powerful differentiation, greater customer trust, reduced risk of price wars, and steady, predictable profits for the company.
Undeniably, there are disadvantages to cost-based pricing such as it ignores demand and competitive situations. Nonetheless, companies find cost-based strategy attractive because it is simple and predictable. It is the most popular pricing method for service-based businesses. It ensures that production and overhead costs are covered. In addition, it assures a steady rate of profit for the business. This is a pricing strategy that guarantees profit.
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