Cost plus pricing seems to be the most commonly used pricing technique in business today. After all, cost plus pricing is easy to implement, it ensures you are making a reasonable margin, it makes competing predictable and it’s fair to all of your customers. Unfortunately, it leaves a lot of money on the table.
Easy to implement – Once you’ve decided on your desired margin, you simply multiply your variable costs times a markup to get your price. For example, if you want 50% margin, you multiply your variable costs times 2. If you want 66% margin you multiply costs times 3. This is especially beneficial when you have many different products and don’t have the people to set individual prices.
Ensures a reasonable margin – By using the same markup on all products, you know that you are getting a specified margin. Firms with more complex pricing mechanisms can have discounts applied after discounts and be surprised by margins that are much smaller than expected.
Competition is predictable – If both you and your competitors have a lot of products, it can be very difficult to know how to price relative to your competition on every part. However, knowing that your competitor uses a standard markup enables you to also use a standard markup and remain consistently priced relative to your competition.
It’s fair – Many businesspeople are uncomfortable charging different customers different prices or even charging different markups for different products. They feel it is not fair. Cost-plus pricing is exceptionally fair.
There are probably other benefits to using cost plus pricing, but COST PLUS PRICING DOES NOT MAXIMIZE YOUR PROFITS. In past posts we have spent a lot of time talking about pricing according to how much our customers are willing to pay. That is how to maximize our profits. Price to our customers willingness to pay.
We should know the minimum margin we are willing to accept, but this isn’t cost plus pricing, it’s really a cost plus floor. If our customers are not willing to at least pay an amount equal to our variable costs plus our margin then we should not be selling the product.
Are you currently using cost plus pricing. Why? Do you think the benefits of using cost plus pricing are greater than the extra profit to be gained by pricing based on value? Or are you unsure how to move away from cost plus pricing?
Let me suggest you start with a modified cost-plus approach. Keep your current process, but find one customer segment who is willing to pay more and charge a higher margin to those customers. Or, if you have a good, better, best product family, raise the margin on the best. You will quickly see that there is a lot of money to be made by pricing based on customer value rather than your costs. Slowly add more segments or more techniques and soon you will not be looking back at cost-based pricing.