Setting product or service prices is arguably one of the biggest yet most challenging decisions you can make. Some businesses use the cost-plus pricing strategy to reach a price that’s justifiable.
What is a cost-plus pricing strategy?
Cost-plus pricing is where a business comes up with prices by multiplying its cost of goods sold by the desired markup percentage. In short, look at how much it costs you to make a product and multiply that by a fixed percentage to get your selling price. Many product-based businesses (e.g., retail) use this pricing strategy for simplicity.
To use the cost-plus pricing strategy, you need to know:
How much it costs you to make the product Direct labor Direct materials Overhead associated with producing product Your markup percentage
But, you may struggle to land on a fair markup percentage that also gives you a decent profit. When choosing a markup percentage, pay attention to industry standards, such as:
Grocery stores: < 15% Restaurant: 60% (food); 500% (beverages) Retail: 50% (also known as keystone pricing)
If you use a cost-plus pricing strategy, you don’t have to use the same percentage per product. You can shake up your markup percentage.
Pros and cons
Not everyone is a fan of cost-plus pricing. Many businesses use it as their pricing strategy, but many pricing experts agree that it has its drawbacks.
Weigh the pros and cons before relying on a cost-plus pricing strategy for your products or services.
So, why would you consider implementing a cost-plus pricing strategy? Take a look at some of the most common pros of this model.
It’s easy to implement: One of the biggest advantages of using this strategy is that it’s easy to calculate … which translates to time savings. And what business owner doesn’t want that?
Cost-plus pricing doesn’t require a thorough market analysis on your competitors’ pricing or what customers are willing to spend (which is also a con that we’ll get to later). Instead, you simply need to identify how much it costs to make a product and use the cost-plus pricing formula to get your selling price.
You can justify your prices: Another reason businesses opt for this pricing strategy is that prices are justifiable. If your production costs increase, you can clearly explain why your selling prices increase, too. This could potentially boost business transparency … and help you raise prices without losing customers.
It’s a stable pricing strategy: Nothing’s worse than a long-standing price war with one or more of your competitors. But with a cost-plus model, you might be able to avoid these price wars.
Why? Because you aren’t setting prices based on competitor research, you are less apt to raise and lower your prices based on your competitors’ decisions.
Now that you know the advantages of the cost-plus method, we can turn our attention to the flip side. Here are some reasons that might make you hesitate before implementing this pricing method.
You might not cover all your costs: Depending on how good you are at estimating and allocating costs, you might end up setting a selling price that’s lower than all of your business’s costs.
Remember: product costs aren’t the only expenses you have. You may also have other costs, such as employee salaries, that are unaffiliatedContinue reading