Let’s create a simple imaginary product and market. The product, a widget, costs $10 to make. The CFO has determined the company needs 50% margin to keep the investors happy. What price should we charge?
The obvious answer is $20. That’s also the easy answer. It just isn’t the best answer. To find the best answer we need to know how much our buyers are willing to pay.
In our simplistic market, we have three potential buyers. Buyer A is willing to pay $15, Buyer B is willing to pay $25, Buyer C is willing to pay $50. Does that information change your price? It should!
If we only get to set one price, there are three obvious choices.
Price at $15, sell 3 units, make profit of 3*($15 – 10) = $15 and margin of 5/15 = 33%.
Price at $25, sell 2 units, make profit of 2*($25 – 10) = $30 and margin of 15/25 = 60%.
Price at $50, sell 1 unit, make profit of 1*($50 – 10) = $40 and margin of 40/50 = 80%.
By the way, the number of units we sell is determined by counting the number of buyers who would pay the recommended price or more.
If we use cost-plus pricing, we price at $20, sell 2 units, make profit of $20 and 50% margin. Not the best choice by far. Both $25 and $50 yielded more profit and higher margin percentages.
The optimal answer in this scenario would be to charge each buyer exactly what they are willing to pay, which would result in 3 sales, $90 in revenue, $60 of profit and 66% margin. But that’s not the point of this blog.
The point of the blog is to say: The reason companies use cost-plus pricing is they don’t know their buyers’ willingness to pay. Any rational company, given this information, would price based on willingness to pay, not costs. Cost-plus is just easier.