One of the most straightforward pricing strategies for the sale of goods and services, cost-plus pricing is a pricing model where a fixed percentage is added to the cost of producing or purchasing the product. It’s also known as cost-based pricing and markup pricing.
A simple example of, “What is cost-plus pricing?” is: Regardless of whether you purchase a bottle of juice or a hybrid vehicle, the price you pay is often much higher than what it actually costs to produce or purchase the item.
An Introduction to Cost-Plus Pricing
Focused on unit cost rather than demand or competitor pricing, cost-plus pricing ensures all costs are covered and a predetermined percentage of profitability is achieved.
Using a formula that includes total costs such as material costs, labor costs, and overhead, businesses typically use cost-plus pricing for the introduction of new products or services, when entering a new market, or when the company’s price and demand elasticity is low.
Calculating Cost-Plus Pricing
The question then becomes… how to know what the optimal profit margin should be? Determining your markup doesn’t need to be a guessing game. To calculate cost-plus pricing simply talk the cost of the goods, and multiply it by 1 plus the percentage profit you’d like to achieve. For example, let’s assume it costs $25.00 to produce the product and you want to achieve a 40% profit margin.
$25.00 x (1 + 0.40) = $35.00
Through this calculation, we can determine that your selling price should be $35.00. However, before delving into how to set the right profit margin for your business, let’s look at gross profit margin and net profit margin.
Gross Profit Margin: Expressed as a percentage, this financial metric measures the profitability and operational efficiency of a company’s revenue that exceeds the cost of goods sold (COGS).
Gross Margin (%) = (Revenue – COGS) / Revenue
Net Profit Margin: Again, expressed as a percentage, this financial metric indicates a company’s profitability after accounting for expenses, including COGS, operating expenses, taxes, interest, etc.
Net Profit Margin (%) = Net Profit / Revenue
When calculating markup in cost-plus pricing, SaaS companies should include costs like server maintenance, ongoing development, and customer support in their calculations. For example, a cloud-based project management tool might determine that its per-user cost is $5 and apply a 200% markup, resulting in a $15 per-user subscription price. Markups in SaaS often vary depending on factors like market competitiveness and customer value perception.
What industries use cost-plus pricing?
Depending on your industry, there’s a wide variance between average profit margins – both gross and net. For instance, on the lower end of the scale are oil & gas refining companies and marketing organizations (9.9% average gross profit margin). Regional banks are the undisputed leaders when it comes to high gross profit margins (99.8% average gross profit margin). This is why calculating markup correctly is key.
With such a significant variance, where does your industry fall?
Utilities rank midway, ranging from 40.2% to nearly 55% gross profit margin. On the other hand, food distribution and auto manufacturing rank around 14%, whereas the average gross profit margin for electronic gaming & multimedia is 70.7%. Want to know the average gross profit margin and average net profit margin for your industry? Check out this article.
Achieving Peak Profitability
While the article provides insights into industry profit margin averages, the following tips and guidelines will further help you achieve your desired profitability.
- Determine all costs: Account for all direct and indirect costs, including materials, labor, and overhead costs such as rent, utilities, administrative expenses, etc. Be sure to regularly review and update the data.
- Consider your industry: Cost-plus pricing is more suitable for some lines of businesses than others. For example, retail companies like clothing, grocery, and department stores can apply different markups to their goods depending on the product’s direct and indirect costs. Additionally, with relatively predictable costs, manufacturing companies can easily determine their markup to ensure sustainable profitability.
- Know price and demand elasticity: Price elasticity refers to the sensitivity of demand to price. Elastic demand is the relationship between product demand and other variables, such as the income of your target market, the availability of similar products, etc. Cost-plus pricing works best for lines of businesses that are less elastic, like when demand remains high regardless of the price.
- Understand the competition: The straightforwardness of cost-plus pricing enables you to make an educated decision on whether you want to charge more or less than your competition. If you charge less than the competition, be sure to consider whether you’ll be able to cover costs and make a profit. If you charge more than the competition, does your business have market dominance and/or do you sell a product that is widely desired, innovative, or considered a luxury item?
- Implement a reasonable markup: While a high profit margin may initially be good for business, if your competition offers a similar product at a lower cost, you risk customer churn. Setting a reasonable markup requires you to understand market demand, your sales pipeline, and your competitors’ pricing strategies.
Cost-Plus Pricing: The Advantages and Limitations
Regardless of the pricing strategy, there are advantages and disadvantages to consider. While cost-plus pricing may suit your industry and profitability goals, there are some pros and cons that you should take into consideration.
What are the benefits of cost-plus pricing?
There are many to consider, but here are some key benefits of adopting a cost-plus pricing strategy.
- Straightforward and Simple: Since cost-plus pricing doesn’t require extensive research, it’s quick and easy to implement. This method simplifies the pricing process and is easily understood throughout the organization.
- Fewer Resource Needed: Given that there’s not a need for extensive research and the formula is straightforward, staff can be utilized for profit-generating initiatives.
- Pricing Certainty: With an understanding of all costs associated with the production of the product, you’re better able to implement stable and predictable pricing policies, while ensuring all costs are covered.
- Pricing Justification: Unlike many other pricing strategies, cost-plus pricing is easily understood by customers, even when increases are necessary due to rising production or purchasing costs, helping to build brand trust.
- Pricing Adjustments: This pricing strategy provides the ability to quickly adjust prices to meet changes in production or purchasing costs.
- Consistent Rate of Return: As long as all costs are accounted for and correctly calculated, every cost will be covered, and the markup will ensure a consistent and positive rate of return.
- Financial Forecasting: Given that this pricing strategy leverages price stickiness, you can easily estimate monthly revenue.
- Pricing Guidance: This pricing strategy is especially useful when there are limited competitors or incomplete knowledge of the target market’s budget, such as in a new or developing market.
SaaS companies can benefit from cost-plus pricing in subscription tiers where cost-per-user metrics (e.g., hosting or licensing fees) are predictable and scalable. It’s particularly useful for calculating baseline pricing for enterprise SaaS contracts where cost control and transparency are valued by clients.
What are the cons of cost-plus pricing?
Can relying solely on cost-plus pricing affect your competitive edge? SaaS companies may find cost-plus pricing inadequate in markets where value (e.g., software features, integrations, and ROI for the customer) determines willingness to pay more than raw costs. For example, an advanced analytics tool might be undervalued if priced solely on development and hosting costs rather than the business insights it offers.
Here are more cost-plus pricing disadvantages to consider:
- Inflation: If costs increase and are not accounted for, these increases can lead to financial losses.
- Costs Not Covered: Aside from using inaccurate data when determining the markup, projected sales volumes may be inflated. This results in a lower markup, fewer sales and ultimately financial loss.
- Incomplete Knowledge of the Competition: This pricing strategy doesn’t require extensive competitor research and prices are set solely on the cost-plus formula. Therefore prices can vary substantially between competitors, significantly impacting market share and profitability.
- Inadequate Customer Consideration: This pricing strategy doesn’t take into consideration the customer’s willingness to pay. While customers understand that there’s a cost associated with producing the item, they care more about the value than the business’s cost. Since customers are central to the success and profitability of virtually every organization and every industry, inadequate customer consideration creates a black hole that over time drains profitability.
- Operational Inefficiency: Given the consistent and positive rate of return, this pricing model does not provide the incentivization for businesses to lower costs through operational efficiency.
- Limited Market Intelligence: Since the cost-plus pricing strategy doesn’t rely on competitive knowledge or customer consideration, lack of market research can negatively affect product pricing, as well as result in the company not knowing the perceived value of its offerings – both of which can negatively affect the company’s profitability.
Is Cost-Plus Pricing Right for Your Business?
It’s fair to say that cost-plus pricing isn’t right for every business or industry. This pricing strategy is geared towards certain lines of businesses, but it’s less suitable for other industries like software-as-a-service (SaaS) businesses and tech companies. The reason that these two industries aren’t the right fit for cost-plus pricing is that the value their offerings deliver is significantly higher than the production cost.
For this reason, these two industries typically gravitate to other pricing models, such as value-based pricing. Rather than solely focusing on production costs, value-based pricing is a customer-focused pricing strategy that aligns prices with the customer’s perceived value of the product or service. However, like every line of business and every company no two are identical, which is why there is an abundance of pricing models.
From flat-rate pricing to tiered pricing through dynamic pricing strategies and everything in between, BillingPlatform has the knowledge and platforms that enable you to effortlessly deploy and manage pricing for physical or digital products, services, metered usage, or recurring revenue offerings. Regardless of the pricing strategy you embrace, we can help you unlock new revenue streams, maximize operational efficiency, and deliver frictionless customer experiences.
Whether cost-plus pricing is right for your business or not, it provides a starting point in understanding how much revenue is needed for your business to become and remain profitable. Do you need help in determining the pricing strategy that is right for your business? Our team of experts is waiting to answer your questions!
