Cost Plus Pricing: 5 Problems With A Cost Based Pricing Strategy
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 come to have a very negative connotation and can be seen as a backward looking approach (see premium pricing strategy for a polaropposite).
In this blog, we will cover 5 very valid reasons why cost plus pricing is not the best option when making a business plan.
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. deviding 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 – so they just started removing 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 that in the teddy bear factory – a bright employee comes up with a way to reduce costs by 80% without reducing quality. The management should logically reject this innovation as through cost plus pricing – their profits would also drop by 80% i.e. as 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 – if you have a really hot product or service, it would be foolish to ignore this when setting prices – i.e. 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 – if clients in a B2B environment know that you are applying say a 50% markup when their business only achieves 25% margins may use this to negotiate a price decrease. i.e. 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.
The biggest flaw with using a strict full cost pricing or input price based approach to your commercial strategy for price of a product – is that you will inevitably leave lots of value on the table.
A price model that does not look at issues such as price competition in the market, what value your product actually offers (and any differentiation) – will almost always be less profitable.
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 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.
The next time your finance team is talking about full cost pricing, which cost is added or direct labour applied – you will realise you have a serious pricing problem.