Cost-Plus Conundrum

conundrumWhen you lower your cost of goods sold (COGS), do you make more profit?

Not necessarily if you use cost plus pricing.

Imagine your company prices using cost plus (the horror).  Your formula is simple, your price is 3 times your cost.  You make product A at a cost of $100 so you sell it at $300.  66% margin is not bad if you can get it.  You make profit of $200 on each unit and since you sell 1000 units, you make $200,000 in profit.

A brilliant engineer figures out a way to make product A at half the cost.  Wow!  Your costs go down to $50.  The marketing team gets out their calculators and say, “Hey, 3 times 50 is only 150.  We should lower our prices to $150.”  You’re still making a nice 66% margin, but you’re only making $100 profit per unit.  In order to maintain the same profit dollars, you now need to sell twice as many units.  Is that even possible?  What will your competition do?

You see, cost plus pricing means as you lower your costs, you lower your prices, but more importantly you lower the overall dollars of profit contribution.  In our example, we went from $200 of profit per unit to $100.

What if instead of cost plus pricing, the marketing team used value based pricing and said, “Hey, customers are already paying $300 per unit.  They obviously value our product at least that much.  Let’s not change the price.”  Now your profit goes to $250 per unit, you sell the same 1000 units and you make $250,000 in profit.  In other words, you let the cost savings go to profit, not to lowering prices.

This cost-plus conundrum is simple, elegant, and obvious once you hear it.  I heard it for the first time last week at the Professional Pricing Society’s spring conference.  (I don’t recall who said it, but if anyone has the original source please share it with me and I’ll post it here.)

Your lesson?  Don’t use cost plus pricing.  Use value based pricing.  But of course if you regularly read this blog, you surely already use value based pricing.

 

Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author

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Photo courtesy of Villanova University Digital Library.