When You Should Use Cost-Plus Pricing
Many companies use cost-plus pricing. In fact, I’d say nearly all hardware companies, and service companies with fixed costs, use cost-plus pricing in some way. And yet, pricing people know this isn’t ideal (or at least, they should) since it leaves money on the table.
Most of the time, cost-plus pricing doesn’t make sense. Imagine you build a product for $10, and want a 50% margin. This means you price is at $20. But what if your market would pay you $50? Shouldn’t you try to capture that? And 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 an arbitrary number, based on what you want – rather than a meaningful figure, based on your customer’s willingness to pay.
We should always, as much as possible, price based on how much our buyer is willing to pay. Easily said, hard to do.
Now, why do companies use cost-plus pricing? It’s usually because they want to cover their costs while being competitive on price. Finance set margin goals for the company, and this becomes the cost-plus price-setting mechanism. Note however, that this is not a great reason to do cost plus. It might look like you’ll meet your margin goals on paper, but it doesn’t optimize the return on your innovation.
That being said, I can think of a couple of instances when it makes sense to use cost-plus pricing:
If you have tens of thousands of products to price, it would be cumbersome and unrealistic to use value-based pricing (VBP) on every single one. Imagine you are pricing every item at a retailer, or every item at a distributor. Pure VBP isn’t practical in these circumstances.
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, for example. Those should have higher margins. The brands or product lines that tend to attract new customers should have a lower margin. Even though you are likely using a cost-plus pricing model, the ‘plus’ part doesn’t have to be identical for every product. The margin you can earn should be dependent on the product, the competition, the buyers and their buying process (especially the last two).
The other scenario where 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 margin goals. However, even in this situation, you still want to use the underlying principles of 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 feel we have to use cost-plus pricing, we should still look for ways to charge our buyers as close to their willingness to pay as possible. Don’t just accept cost-plus pricing on its own. If you do, I guarantee you’re leaving money on the table.
____
Join the Conversation!
Have a question or comment about this blog? Please share your opinion in our Champions of Value Community.
Director of Pricing
4yOn pricing 10s of thousands of products it might start at cost plus, but anything you sell regularly should be converted to value. If you don’t you’ll just see cost increases until your vendor figures out the market before you did. On commodities it might make sense for your system to be setup on a higher cost plus margin for smaller orders, overrode or qty break for large orders, and then carefully adjusting the cost basis used for the calculation when it makes sense. On commodities a lot of times it depends when you bought and how much you bought. You need to listen to customer feedback. The idea of setting up commodities pricing in an ERP is usually what one customer should pay vs another. Think of it like balancing the line’s performance. While a general pricing matrix is crafted there are often special agreements (contracts) in place for those times the regular price is too high. What about online retail? That is probably the easiest as capturing competitors prices is visible. Get a snap shot of your competitor, compare by vendor, get your costs down and then price to the value you provide vs a online competitor. Cost plus is an okay starting point assuming prices are not sticky, but mostly a temporary holding spot until the real work can be done. Thousands of products can be overwhelming but using technology and leveraging the product information of others can help get it done right. How much margin is there to be had? 1-3 on commodities 2-20 on A movers and 5-30 on other product if your system lacks a pricing analyst. Otherwise it just depends on how refined your pricing is. A lot of margin can be captured by carefully watching for opportunities to make changes and timing your actions. How to determine what should and shouldn’t be on cost plus? Is the estimated benefit greater than the analyst’s cost of time + current opportunity cost of another project? Once a line becomes value pricing managed it pays for its own maintenance and is often a fraction of the time to maintain vs setup. A lot of work should be done to manage data properly to enable the analyst to provide their best work. If just starting the work then start by hiring an experienced pricing analyst. Figure out the market prices, negotiate costs down (so you are not having to retouch the work for a bit), setup proper pricing policies/controls and then start making pricing changes. It isn’t extremely hard, but it is a refined skill.
Business Strategist | Sales | Corp. Development
4yI do completely agree. It is why we are still need to build the stories behind the brand, to avoid case cost-plus pricing since it will determine buyer's wtp level. Interesting notes for commercial thought, Mark.
Group Finance Controlling | International Finance | Finance Business Partnering | Financial Transformation | Compliance | International Tax and Treasury
4yInteresting article about the implications of cost-plus pricing. Another facet of the same concept could be applied to intercompany transactions in multinational organisations. Cost-plus pricing can lead to imbalanced profitability between companies within the same group and can attract attention from tax authorities around the world in relation to how profits are calculated and where they are recorded. Whenever possible more accurate methods to calculate a fair and arm's length price for goods and services should be used. #transferpricing
Experienced Business Strategy Professional with Expertise in Pricing Intelligence, Operations, P&L Management, and Brand Protection.
4yAgree, the goal should be to balance the portfolio to drive overall margin objectives with room for fluctuating costs. Great read as always, Mark
Pricing - Strategic Price Optimization
4yThanks Mark Stiving, Ph.D. ... very clear as always