Why Use Cost Plus Pricing? Is it a Smarter Choice for Startups? ↗️
Among the most central aspects of any startup is pricing. Are you thinking about what would be the best pricing strategy for your startup? You might be considering a cost-plus pricing strategy. Why should you use it?
Plenty of founders and startup leaders face defeats, setbacks, and feelings of helplessness, despite their efforts to sustain and improve their foundation. Underpricing, overpricing, or not charging can contribute to lower revenue, unsatisfied customers, or even worse, startup failure.
Thus, you need to devise an effective pricing strategy that will not only increase your startup’s cash flow. But will also boost customer satisfaction and loyalty.
In this article, we are going to discuss the challenges that startups encounter in terms of pricing. Then we delve into what you should consider when pricing a product for your startup.
Finally, we talk about the advantages and disadvantages of cost-plus pricing. This will help us determine why and when you should use a cost-plus pricing strategy for your startup and when you should not.
At Taylor Wells, we believe that managers must always weigh their options when making pricing decisions. A cost-plus pricing strategy can become a tactical pricing method when given a proper execution.
The Cost Plus Pricing Strategy
Almost every manager will tell you that cost-based pricing is their least favourite pricing strategy. However, cost plus pricing is similar to the romance novel genre. It is widely derided yet enormously popular.
The majority of businesses carry out this pricing strategy. It is the pricing basis for everything from the simplest products, like espresso from a coffee shop, to multibillion-dollar projects.
The concept and definition of a cost-plus strategy are pretty simple. The seller considers all fixed and variable costs incurred or to be incurred in the process of manufacturing and then imposes a markup percentage. Then the buyer stipulates the markup or the manager does the decision-making.
Usually, businesses can determine the asking price by adding all the costs to the markup. What’s more interesting is some companies use markups ranging from 5% to 800%.
Common Problems That Startups Face About Pricing
1. Prices are too low and there’s not enough money to keep the business running
This can happen when startup owners set their prices far too low because they didn’t feel confident enough to raise them, and as a result, they earn very little money.
Another scenario is when the company started on a shoestring budget. Some entrepreneurs prioritise quick cash. They set up their businesses when they didn’t have much money, so they cut their prices to get the work done.
When prices are too low, owners and employees tend to overwork to make ends meet.
2. Competitors and close substitutes are easily accessible to the target market
Starting a company today poses more challenges because customers have more options now than ever. Thanks to a broader range of products and services alternatives are made available across gadgets, apps, and media entities (such as social media).
There are cases when customers visit physical stores solely to see the product in person. This allows shoppers to choose and buy from another online or in-person retailer that offers the lowest price.
3. Prices are dependent on varying economic forces
Your startup is more vulnerable to economic factors which include inflation, wages, disposable income, and government regulations compared to long-established companies. These aspects will all have an impact on prices.
Additional market elements such as customer perceptions and buying patterns will influence pricing decisions. This is why a thorough understanding of the target market’s individual needs and preferences is needed for optimal pricing in your startup.
Next, we explore different factors to examine when dealing with pricing problems. These will serve as guides to answer why you should (or not) use a cost plus pricing strategy.
Things To Keep in Mind When Pricing a Startup Product
1. Types of Customers and Their Value Drivers
Get to know the target market of your startup. Then you can classify your customers into different categories. Consumers are willing to pay varying amounts based on the psychological merit they relate to your good or service.
Hence, you must recognise segments based on similarities and purchasing behaviour because your startup will lose money unless rates are geared to these customers.
Following the identification of consumer groups, the next is to distinguish the values that drive their purchasing decisions. This will help uncover in what sense their motivations are necessary for you to establish your pricing.
2. Potential/Existing Competitors and Costs
As a startup, your competitors are not the most urgent thing that should influence your pricing. Nevertheless, it’s still something you have to consider. The overall economic valuation of your goods or service must reflect the value of your main competitor.
This will attract more attention to your product. The best approach here is understanding how you differ from them and incorporate that into your pricing model.
If you can’t find your main competitor, you can look for something related or comparable in the industry.
In pricing a startup product, you might also think about the costs. In this case, take into account both fixed and variable costs.
3. Marketing and Communications
How should a startup present its product to its customers? Of course, it is given that it should be pleasingly and appealingly. You want to convince your market about the value of your product.
One thing to take note of is that having to read through several lengthy lists of specifications to understand your product frequently irritates people.
You can earn a lot of trust when you are transparent about your prices. The same goes when it’s simple for consumers to compare and contrast your prices to those of your rivals.
Moreover, when marketing your startup product, contemplate the benefits of conveying the outcome rather than putting emphasis on product features. Ask yourself how will your brand improve your buyers’ lives?
4. Pricing Structure
Pricing is as essential to your startup’s success as to your entrepreneurial endeavours. The price you set is what will inevitably sell your goods or service. It also tells the customer a narrative about your startup and acts as a reference for assessing your costs.
The pricing structure specifies and sets up the prices for your startup’s products. The goal here is to establish a rate that is consistent with your business model to avoid overpricing or undercharging your customers.
When Is Cost Plus Pricing a Smart Option for Your Startup?
Why is the cost-plus pricing strategy criticised by pricing experts even when it is commonly practised? Is it a smarter choice for your startup? Adapting cost-plus pricing to your new business has its pros and cons. You must examine your current circumstances. Will the benefits outweigh the risks?
Cost Plus Pricing Has Reasonable Downsides
Cost-plus strategy is scorned among pricing professionals for a variety of reasons. For one, cost-plus pricing prevents efficiency and financial containment for stand-alone projects. The company’s revenue and total profit decline when lower costs are quoted. Contrastingly, a bloated cost structure will raise prices while increasing profit.
Another significant flaw of the cost-plus pricing strategy stems from the misconception that a cost-plus price will cover costs. This belief can lead to managers becoming overconfident and complacent. You should avoid this if you’re leading a startup.
Sales volume is frequently approximated ahead of time and fixed costs are allocated to each unit based on that estimate. Furthermore, the cost-plus price can easily be too high or low. This often leads to a terrible miscalculation. Using cost-plus pricing also does not promise the coverage of costs or the generation of profit.
Lastly, the cost-plus pricing strategy ignores both the customer’s willingness to pay and the prices of competitors. A price strategy can be completely inaccurate when these considerations are overlooked.
For example, the startup’s cost plus price will be too high to be potent if a competitor has a significant cost advantage. On the other hand, the cost-plus price will be far too low when a consumer is willing to pay much more. This allows profit to slip through the cracks.
Value-based pricing is popular and well-regarded by many executives because it accounts for these factors.
Despite these constraints, why use cost-plus pricing? Because cost-plus pricing strategy can be used for smart and tactical reasons. Cost-plus pricing can increase customer trust and reduce the risk of price wars when implemented with careful thought and caution. In return, we can expect consistent and predictable profits for your startup.
What Are the Tactical Advantages of Cost Plus Pricing Strategy?
When and why should you use a cost-plus pricing strategy? Here are the primary reasons why you should implement cost-plus pricing in your startup. We enumerate the benefits and look into how other firms embed this pricing method into their business strategies.
1. Cost-plus pricing is easy to communicate or explain.
Customers benefit from cost-plus pricing because it is fair and impartial. There is no more sensible explanation for a price increase than stating that your input costs increased by 7% this year, so you will raise your prices by 7%.
Let’s take Everlane, a clothing retailer, as an example. Everlane takes it a step further by employing cost-plus pricing to bring its value proposition of “radical transparency” to life.
The company provides a detailed cost breakdown for each garment sold which includes materials, labour, duties, and transportation, as well as its markup.
Customers easily verify Everlane’s emphasis on paying fair wages to garment workers and actively participating in environmental initiatives. You are endorsing this company’s values by purchasing its products.
2. Cost plus strategy is completely contradictory to value-based pricing.
Value-based pricing attempts to identify and focus on differences in customers’ economic valuation. Consequently, it promotes customising prices to cater to customer preferences.
Take into account the customer frustrations caused by Uber’s surge pricing, Coca-Cola’s dynamic vending machine pricing depending on outside temperature, or electric utility variable rate pricing.
In these cases, the management had to justify their pricing by identifying the value drivers of customers.
This factor does not exist for those who use cost-plus pricing strategy. They may underprice their products for some customers. But they worry less knowing that their prices are considered reasonable by their customers.
Learn more on how to use cost-plus pricing in marketing here and check out the podcast below.
3. Another asset of a cost-plus strategy is its ease of implementation.
All front-line retail workers with a calculator can apply a markup percentage to wholesale costs and calculate the asking price. Small stores and business owners appreciate this about cost-plus pricing. Your startup may also find this as an advantage.
Moreover, price levels tend to stabilise when the major players in a market use cost plus pricing. The amount of risk associated with pricing decisions shrinks for all traders.
Prices remain relatively stable when the market’s higher-cost providers offer higher-quality products and lower-cost sellers offer lower-quality products. In addition, companies that base their prices primarily on costs rather than rival companies’ prices are much less likely to participate in price wars.
4. Cost plus strategy motivates shoppers to consider factors other than price when making purchasing decisions.
Most of us expect to find low prices and low service quality when we walk into a discount store. Conversely, high-end shops make us anticipate a higher quality of service as well as more posh and costly products.
It is necessary to make consumers believe that prices reflect the cost. Especially for a startup, you want to be noticed despite the tough competition. One way to capture your customers’ interests is to make them think of quality rather than simply buy anything that is comparatively cheap.
5. Finally, a significant upside of a cost-plus strategy relies on the execution of cost leadership.
A company with distinct competencies will allow a lower cost structure in comparison to industry rivals. It can use cost plus strategy to design and develop the most appealing value proposition of all.
It also establishes itself as a price leader as low costs result in low prices. While superior customer valuation becomes an inherent element of the brand image.
Costco utilises this principle. As a result, the brand continuously holds market leadership. How? Nothing in the company’s stores has a markup of more than 14% (15% for its private-label products).
Costco publicises this pricing policy widely. The label’s cost plus strategy delivers a powerful impression that its customers are getting great excellent deals. A “no-frills” store atmosphere, limited assortments, and bulk purchasing also complement their strategies.
Cost-plus pricing strategy has a grittier common sense and logic that is difficult to refute. This is true even with all the criticisms it receives. It is a useful and meaningful tool for companies that have a cost advantage or want to use price transparency as a differentiator.
Furthermore, a cost-plus strategy is a good option for sellers who want to convey that their prices are reasonable to build customer trust. Startup managers and CEOs must analyse and weigh their options though.
There is no need to rush and adapt value-based pricing when it is not suitable for your new business. What’s more important is to solidify its foundations. One method to do that is to have an effective pricing strategy. Cost-plus pricing strategy offers outstanding potentials that startup companies shouldn’t ignore.
For a comprehensive view on maximising growth in your company,
Are you a business in need of help to align your pricing strategy, people and operations to deliver an immediate impact on profit?
If so, please call (+61) 2 9000 1115.
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