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.

 

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.

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?

 

Cost plus pricing flaws

 

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 blogs on penetration pricing strategy, low cost pricing strategy and also competitive based pricing.

 

See our blog on what is pricing.

 

Conclusion:

 

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.