When You Should Use Cost-Plus Pricing

So many companies use cost-plus pricing. I’d venture to say that almost all hardware companies and services companies with hard direct costs use some form of cost-plus pricing. Yet, pricing people know this is wrong. It leaves money on the table.

In the majority of situations, cost-plus pricing makes no sense. Imagine you build a product for $10 and want a 50 percent margin. That means you price at $20. What if your market would pay you $50? Shouldn’t you get that? What if your market would only pay you $15? At $20 you either leave money on the table or you don’t sell. It’s just an arbitrary number.

 

Instead, we should (almost) always price based on how much your buyer is willing to pay. Easily written. Challenging to do.

First, why DO companies use cost-plus pricing? It’s mostly because they want to cover their costs while being as aggressive on price as they can. Finance people set margin goals for the company, and that often becomes the cost-plus price setting mechanism. This is not a great reason to do cost plus. It may assure that you meet your margin goals, but it doesn’t optimize the return on your innovation.

I can think of a couple reasons when it makes sense to use cost-plus pricing. (If you think of more please let me know.)

If you have tens of thousands of products to price, it is challenging to use value-based pricing (VBP) on every one. Imagine you are pricing every item at a retailer or every item at a distributor. Pure VBP isn’t practical. However, in these situations we can and should use VBP for portfolios of products. There may be brands or product lines where you have no competition. Those should have higher margins. The brands or product lines that attract new customers should have a very low margin. Even though you are likely using a cost-plus pricing model, the plus shouldn’t be identical for every product. The margin you can earn should be dependent on the product, the competition, the buyers and their buying process.

The other time cost-plus pricing makes sense is when your costs fluctuate dramatically. For example, in the chemical industry, it is common to quote prices as a function of the price of a raw material. Buyers see this as fair and it helps finance people maintain their margins. However, even in this situation you still want to use VBP to determine what margin you should charge different types of customers or situations.

So yes, cost-plus pricing can make sense some of the time. However, blanket cost plus never makes sense. Even when we use cost-plus pricing, we should still look for ways to charge the right buyers closer to their willingness to pay. Don’t accept cost-plus pricing.