5 Problems With Cost Plus Pricing!🖐️Episode 10
In this episode of Pricing College, we have previously introduced cost-plus pricing. But now want to cover the reasons why it is a flawed pricing system. Join us as we discuss the 5 most common problems with cost-plus pricing.
TIME-STAMPED SHOW NOTES:
[00:45] We had previously discussed what is cost-plus pricing.
[01:10] How do you actually allocate costs? It’s not as easy as you might expect.
[01:30] Aidan says it tends to lead to a lack of innovation or value adds.
[02:30] Just making up a margin makes very little sense. A made-up margin goes against complex cost accounting.
[03:10] If buyers know you use cost-plus pricing, they want to push you down to your actual costs.
[03:55] Cost-plus pricing does not consider the market dynamics.
[04:20] You will likely undersell your product.
In today’s podcast, we are going to cover five reasons and problems why cost-plus pricing may not be that good.
Before we touched upon the cost-plus pricing, looking at some of the benefits that we said, it seems to be rigorous, fair, and logical. So yeah, today we’re gonna look at some reasons why maybe you shouldn’t use cost-plus pricing.
I think we picked a nice odd number like 5 which means that Joanna drew the short straw. So, she has to do three reasons and I only do two.
Let’s start off with one. Cost-plus pricing can be an overly complex cost allocation formula. It looks at both fixed and variable costs to set a cost position. That basically means that it tries to allocate all these different costs across the product portfolio. If you’ve got a hundred different products, that’s going to be very complex.
Okay, so that’s number 1. Number 2 for me is that it tends to lead to a complete lack of innovation or financial benefit to innovating. If you think about the product, let’s say you’re manufacturing a telephone, it’s a new smartphone. Then, you charge a 20% markup on that as your profit through cost-plus pricing.
In that scenario, we’ll say you find a new technology and a new method of making a telephone. Now, that means it’s half as expensive to manufacture. But does that mean that you should cut your selling price by 50%? In that scenario, innovation will actually destroy your business.
From the point I made, it’s a very complex cost allocation formula. Yet the markup on that cost formula is simplistic and the percentage markup on cost. It actually takes a lot of that hard work. Why would you do very complex cost accounting and then sort of just make up a margin on top? It doesn’t really make much sense.
Actually, I just cover a lot on that one with Joanna’s point number 3. And I think yeah, financial people love cost-plus pricing because it seems to be rigorous and factual. Then, they just make up a margin.
Yeah, that margin fundamentally means you either overcharge your customers or undercharge your customers.
I think that is point number 5. So, I’m gonna go with point number 4. Now, my point number 4 is that when you practice cost-plus pricing and your customers know about it, especially if there’s an aggressive procurement style, customers know how to drive down the price.
If they know that you practice cost-plus pricing, they’re gonna want to know. And it’s the worst thing to any salesperson when they start asking about an open book or seeing your cost structure. The warning bell should be ringing.
I remember I worked in the sales business and when the customer said we only make a 4% margin, then why should you be making 15%? We want you to make 4% as well and it’s when they know what your cost structure is. It’s real trouble for you.
The last one would be that cost-plus pricing doesn’t take into account the market. It doesn’t look at the relationship between price and volume on cost. In fact, it just focuses on that pure accountancy view in the spreadsheet. It misses out and loses the market dynamics.
Unfortunately, because of that, you can have this great innovation. A product innovation, but really if you’re using cost-plus pricing, you can often undersell the innovation. It’s because you’re not looking at the value of the offer and adding that additional price premium that you deserved, basically underselling yourself.
I think we’ll leave it there. I suppose as a final point for me is if you believed in your product and want to give value to your customers, and really improve their lives, then cost-plus is not a great way to do it.
There’s a lot of different methods now. We’ve moved on from that basic, the cost-plus markup and we’re gonna discuss those different methods in future episodes.
LINKS MENTIONED IN TODAY’S EPISODE:
Read Neil Kokemuller’s thoughts about problems with cost-plus pricing.
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