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Cost-Plus Pricing

What is cost-plus pricing?

Cost-plus pricing (also known as markup pricing) is a method to determine the selling price of a product in which a fixed percentage is added to the unit cost of a product. The unit cost of a product is defined as the cost of manufacturing one unit of a product.

Despite the popularity of the cost-plus pricing model, it might not be the best way to determine the selling price of all kinds of products. This pricing method takes only the unit cost of the product and your desired profit margin into account. Unlike the value-based pricing model, it does not emphasize other external factors such as the product’s perceived value, market conditions, or competitor prices.‍

Cost-Plus Pricing Strategy

A cost-plus pricing strategy is a method where you add a fixed markup percentage to the unit cost of a product to obtain its selling price.

Many different types of industries use the cost-plus pricing strategy.  Ideally, this method works best when the products are utilitarian in nature. For example, retailers, such as grocery stores, clothing shops, etc., use this method of setting prices. These stores offer a range of products to their customers. Hence, the seller can fix different markup percentages for other products. This pricing strategy is unsuitable for Software as a service (SaaS) businesses because it doesn’t consider the product's perceived value. Generally, the added value of SaaS products is much more significant than the production cost of the product.

This strategy works well for businesses trying to establish a cost-leadership strategy. A business can share its pricing strategy as a unique value proposition (UVP) with its customers. ‍

Cost-Plus Pricing Formula‍

To determine the selling price of a product using the cost-plus pricing formula, you need to follow the steps mentioned below:

  1. Determine the product’s total cost equal to the sum of fixed cost (for example, labor cost) and variable costs (for example, material cost). You also need to add in the operational costs required to manufacture a product (known as overhead costs).
  2. Fix the markup percentage of the product. Markup is defined as the percentage difference between the selling price and the unit cost of the product.
  3. Multiply the total cost by (1 + markup percentage) to get the selling price of the product.

Selling Price = Total Cost (1 + Markup percentage)

Let us understand the cost-plus pricing formula with an example. Suppose you are the owner of a business that sells mattresses, and you are tasked to determine the selling price for one mattress.

First, you need to note down all the costs associated with the production of one mattress:

  • Raw material cost: $30
  • Labor cost: $50
  • Overhead costs: $20
  • Total cost: $100

Let’s assume that the markup percentage is fixed at 40%; then the selling price can be determined using the formula:

Selling Price = $100 (1 + 0.40)

Selling Price = $100 (1.40)

Selling Price = $140

Therefore, the selling price of one mattress is $140.‍

Advantages of Cost Plus Pricing:‍

The advantages of using the cost-plus model are as follows:

  1. It is simple to understand and use. You need to analyze the production costs and factor in the markup percentage to determine the selling price of a product.
  2. You do not have to conduct any market research for competitors or potential customer base. The pricing solely depends on the production cost and markup percentage.
  3. This strategy brings in a guaranteed profit per unit item sold.
  4. Implementing price increases for products is easier price increases products if the production cost increases.
  5. It is easier to justify the pricing decision and the increase in product prices to the customers in case of a cost-plus pricing strategy.‍

Disadvantages of Cost Plus Pricing:

The disadvantages of using the cost-plus model are as follows:

  1. If the production costs of the products fluctuate a lot, it will also cause frequent changes in the selling price.
  2. Since this strategy doesn’t factor in the product’s perceived value, you might be selling products for less.
  3. This strategy is prone to external risk factors such as competitor price, consumer demand, etc.
  4. This strategy doesn’t promote cost analysis or innovation of a product.
  5. There is a chance that you may forget to consider some aspects of production costs to calculate the selling price. This might cause a critical financial loss if the markup percentage is low and only a small number of units are sold.

Examples of cost-plus pricing strategy

Below is an example industry that relies on the cost-based pricing strategy to determine the selling price of their products:

Saas products

A cost-plus pricing strategy could be an easy method to set a price for your SaaS product. However, this method is not exactly compatible with the subscription-based SaaS business model. Generally, SaaS products are priced depending on the value it provides to their customers and the competitor's price. The cost-plus model doesn’t take both these factors into account.