If you don’t have the resources to properly gauge consumer demand or there are too many different competitor prices in the market, the cost-plus pricing model may be the ideal choice for your business.
Chances are, you’ve probably encountered a product and have wondered how much the actual cost of that product was to manufacture, and why the markup was set the way it was. There is a good chance that the product you were analyzing was leveraging the cost-plus pricing method.
Cost-plus pricing, also known as markup pricing, is a simple pricing model that involves adding together a few key elements: direct material cost, direct labor cost, and overhead costs, then adding a markup percentage to get your final price amount.
Let’s say that your direct material cost is $10, the labor cost is $5.00, and the overhead is $8.00. You decide that you want to drive a 50% markup to your product, so that percentage gets added to the formula as well. Here is what the cost-plus pricing equation would look like:
As seen in the formula above, this pricing model only takes into consideration your internal unit costs, and it completely disregards external factors entirely such as competitors and your target audience.
This is a commonly used pricing method when it comes to the retail industry specifically (but not exclusively), because there are often so many different types of competitors that offer similar products at dramatically different prices. In that sense, trying to price your product based on a competitor’s using a value-based pricing model would not make much sense. If your business is in a similar situation, you may want to consider taking this approach.
Alternatively, if you’re offering a software or a SaaS product, where direct material costs are not something you can easily determine or put a price on, the cost-plus pricing model may not be the best option. This is primarily because your offering is often providing much more value than what the costs of producing it are.
If you still feel like the product or service, you’re providing is a good potential fit for cost-plus pricing, there are some additional strengths and weaknesses with the model that you’ll want to fully be mindful of before unveiling your final price to the market. These are as follows:
Simple to Identify: Unlike other pricing techniques, cost-plus pricing is really quite simple. No external research is required to determine your price.
Justifiable: Because the price of your product is directly associated with the costs that go into producing it, this is one of the most justifiable pricing methods. If the labor or manufacturing costs increase and you find yourself needing to increase the final price, your customers are more likely to understand. Only the markup portion can be put into question.
Profit per Sale: As cost-plus pricing uses your internal costs as a key part of determining your final price, every time you sell that product, you’re making a profit.
Lack of Competitive Foresight: While this type pricing approach is simpler to identify due to exclusion of competitor data, this could also come back to bite you - especially if your markup is too high and a competitor lowers their price to steal a portion of your market share.
No Guarantee of Return: Despite the fact that every time you sell a product you’re making a profit off of the costs associated with that individual item, if you didn’t forecast sales correctly and priced your product too high, you run the risk of not breaking even when taking into account total production, labor, and overhead costs.
Customer Neglect: Due to the fact that you won’t be relying on customer research to inform your pricing decisions, you run the risk of missing out on valuable data that could help better align your price with consumer needs. In some cases, customers might actually be willing to pay more for your product, but you wouldn’t know because there was no due diligence done beforehand.
While the cost-plus pricing model may not be suitable for all businesses, there is a case to be made for adopting it, especially if your business is the type to leverage transparency when it comes to the costs associated to build your product, as it’s a powerful way of building consumer trust so long as your markup rates aren’t too heavily inflated.
Still, as is the case with all pricing models, there is no clear-cut winner. At the end of the day, you need to analyze the core values and the resources available for both your business and your products and services. If the above deterrents aren’t intimidating you, and you don’t want to be bothered with a bunch of competitor and customer analysis, you should consider deploying a cost-plus pricing tactic.