30 October 2021
Cost Plus pricing is the simplest and least sophisticated pricing method. The price offered is the cost price plus a profit margin.
All pricing strategies begin with the fundamental question - what is the cost of the product or service? Rarely will the sell price be knowingly less than the cost to make it.
The simplest pricing method is to add a margin to the cost price (profit) and there is your price. The amount of profit should be sufficient to achieve three things...
- Provide a sufficient return to shareholders that is greater than passively investing their funds and takes account of the business risk.
- Provides funds for future growth and expansion
- Covers losses made on other products or projects delivered at a loss.
Cost Plus pricing is considered "simplistic" and "inadequate" when it takes little account of market forces.
For example, a low cost producer (a manufacturer or service provider who due to technology, scale, or some other means, is able to produce at a lower cost compared to peers) should be able to charge the same price as competitors but may not do so because their standard mark-up is +40%. It's not that they have adopted a penetration pricing strategy, it's likley they haven't thought about it.
Further, the market leader (highest market share and strongest brand) should be able to command a price premium and maintain higher profit margins.
Many organisations trundle along applying the same historical margin without proper review of market forces.
Consider overhead recovery
Cost plus pricing should include a cost component for overhead recovery. In a standard costing system, the direct inputs to manufacturing (or service delivery) are made-up of direct costs and indirect (or fixed) costs.
A company manufacturing widgets still spends money even if it stops the manufacturing line and makes nothing. The direct costs (materials and other variable costs) may stop but the factory rent, administration costs, and the original cost of plant and machinery don't go away. Hence, why they are called fixed costs.
Generally speaking, the simplest method of including overhead (or fixed costs) in products is to simply allocate them to each product based on expected volume. Thus, if you make 1,000 widgets in a year, the total fixed overhead costs are divided by 1,000 and this amount is added to the variable cost.
Another method is to allocate fixed costs by building it in to the hourly labor cost rate. This method is more often used when the items being produced have varying rates of work needed depending on complexity. This method would be used i a jobbing shop for example.
Another method is to apply the overhead to the cost of a significant consumable that is used in all projects or reflects the costing method. For example, a flooring contractor may cost based on square metres + material cost. The overhead cost would be applied to the square metre rate.
Cost plus pricing in mature markets
However, the reality is in many mature industries (long established competitors, mature technology, and stable customer base) industry players have very similar cost structures, similar profit margins, and customers have a well developed understanding of price. There is often little opportunity to adopt any other pricing strategy.
A typical industry example is civil construction. Construction machinery fleets, cost of labor, diesel, and materials are similar for all players.
Often after winning a project the first thing the winning contractor asks themselves (particularly if they are the lowest bidder) is "hang on, did we estimate that properly?"
However, when costing a competitive bid there are other considerations
- Probability of winning
- Current size of the order book
- Relationship with the customer
- Project risks
- Bid strategy
Cost-plus-pricing should only be considered a starting point for establishing a benchmark price. External market forces, long term business strategy, and short term tactical considerations should be applied to tweak the price to maximize business success.
The main risk in cost plus pricing methods is leaving money on the table. Growing a business requires surplus profits. If the market is willing to pay more, unless you charge more your business may be doomed to staying the same size and fail to break out from a hand-to-mouth existence.
The main reason many businesses charge no more than the standard cost plus price is the mistaken belief that the customer has intimate knowledge of the costs and can check your price against their own calculations. This is only true for very competitive and mature industries like basic steel fabrication.
But, what if you have a highly productive workforce, superior equipment, and work methods? You should pocket the savings.
Further reading
Other pricing strategies:
Penetration Pricing
Price Skimming
Premium Pricing
Price Bundling
Discriminatory Pricing
Yield Pricing
Pricing strategy overview:
Pricing Strategy