How do you use cost-plus pricing?
Cost-plus pricing is a simple way to set prices. It involves determining how much a good or service costs and then adding a fixed amount as a markup.
To give you an idea, if your total costs are $100 and you want to make a 20% profit, you would add $20 to the price to make it $120.
This method, also called “markup pricing,” is used by many companies to set prices because it is easy to understand.
Not only does cost-plus pricing guarantee a profit at the end of the day, it doesn’t guarantee that customers will like the price.
Synonyms
- Cost-plus pricing model: The most straightforward model for setting prices—businesses take the cost of producing a product or service and add a fixed percentage to arrive at the selling price.
- Markup pricing: Adding a markup percentage to the total cost of goods sold (COGS) to arrive at a product’s selling price.
Why Should You Use Cost-Plus Pricing?
Businesses can figure out how profitable they will be with cost-plus pricing, making it easy to set prices without changing them as market conditions change.
When businesses can quickly figure out unit economics, they can also make intelligent choices about growing and entering new markets.
The straightforward approach of the cost-plus pricing method makes it simple to use. However, it only makes sense to use in these situations:
- A business needs a quick and straightforward way to set prices.
- Costs of production stay the same and can be predicted.
- Prices are not very sensitive to changes in the market, so customers are willing to pay more. The objective is to cover costs and make a small profit.
- This way of setting prices is often used for government contracts because it is fair and easy to understand.
- Grocery shops and other stores that sell a lot of goods often use cost-plus pricing because the amount of goods they sell more than makes up for any margins they might lose on lower-priced items.
Price Formula Based on Cost-Plus
Businesses need to use this method to figure out prices using the cost-plus model:
1. Figure out the total price.
Companies using this approach need to keep a detailed record of their expenses to make accurate cost estimates.
This means keeping careful records of all costs to get a complete picture of all costs, such as those for goods, labor, overhead, and marketing.
2. Split the total cost by the amount that was made.
The “output” could be goods, skills, time, or all three.
The company needs to split the total cost of production by the number of units made to put a number on these factors.
This number is called unit cost, which stands for cost of goods sold (COGS).
3. Figure out the markup rate.
Then, companies must choose how much profit margin (a “markup percentage”) they want to add.
To find the markup percentage, take the intended price and subtract the unit cost. Then, divide the result by the unit cost.
4. Figure out how much it will sell for.
- Lastly, companies can use this formula to figure out how much their goods will sell for:
- The selling price is equal to the cost plus the markup percentage.
- Price Based on Cost: Positives and negatives
- It almost seems too good to be confirmed how easy the cost-plus method is to use. That’s because it is a lot of the time.
Why cost-plus pricing is good
The best thing about cost-plus pricing is that it ensures you make money on every sale. Some other benefits of cost-plus prices are:
- Thoughts of fairness. People usually think that cost-plus pricing is fair because it shows the seller isn’t charging too much for the good or service. The markup may even be agreed upon by both parties, which adds to the impression that everything is fair.
- Stable competition in some areas. Cost-plus pricing can help keep prices stable in markets where companies’ production costs are close. Businesses can focus on other parts of their products to make them stand out if they don’t have to compete aggressively on price (like in price wars).
- It’s easy to change the price. Businesses can easily change their prices when the cost of production increases or decreases with cost-plus pricing. This helps the business keep the profit margin it wants and also helps customers understand why the price went up.
- It’s suitable for people who don’t know much about the market. Cost-plus pricing is valuable for setting prices based on actual costs when competitive intelligence is hard to find or unavailable. Shops that sell things, like clothing and grocery shops, often use this method.
- It makes people agree to the deal. Cost-based pricing works well when a seller has to agree to a deal with unknown costs or when the costs make up a big part of the seller’s income, like in research and development deals. Sellers can reduce risk and get a fair return on their investment by putting the price on what the item costs.
Cost-plus pricing has some problems.
Even though cost-plus pricing has some benefits, it also has some problems:
- Ignores an order. When you use cost-plus pricing, you don’t have to think about what customers want, so you might price a product too high or too low. This could mean losing sales, making less money, or not being able to compete with competitors whose prices are based more on demand.
- There is no reason to keep costs down. Businesses aren’t as motivated to keep costs down when they use cost-plus pricing because they can pass on any price increases straight to customers. This could cause waste and higher prices, hurting the company’s and the market’s ability to compete.
- They are not being different enough. With cost-plus pricing, the only goals are to meet costs and make a certain amount of profit. This makes it hard for companies to set their prices apart from their competitors, which could be necessary in some markets or industries.
- There is a chance of price wars. Price competition is less likely to happen if all companies in a market use cost-plus pricing. Price wars can happen when one or more competitors raise their prices too quickly, which could hurt all the businesses concerned.
- 5. Notvaluable for markets that change quickly. Cost-plus pricing might not work where prices change quickly or demand is hard to predict. When this happens, it can be challenging for businesses to keep up with the changes, and they might miss chances to set their prices in a way that makes them the most money.
Examples of the Cost Plus Pricing Model
Let’s look at two real-life examples from two businesses to better understand the cost-plus pricing model: physical goods and business-to-business software as a service (SaaS).
1. Physical Goods: Furniture made by hand
Think about a small shop that makes wooden furniture by hand.
The owner figures out how much each piece of furniture will cost in terms of direct labor costs, overhead costs (like rent, utilities, and marketing), and the cost of raw materials (like wood, paint, screws, etc.).
Let us say that making a dinner table costs $500 altogether. The owner chooses to make a 30% profit, meaning the price has increased by $150 ($500 * 0.3).
It would cost $650 to sell the dinner table, which is $500 plus $150.
The owner ensures that the business covers its costs and makes the proper profit on each item sold using the cost-plus pricing plan.
2. B2B SaaS: Tool for managing projects
Now, look at a B2B SaaS company that sells project management tools to companies.
In this case, the costs of making software are different from the costs of making physical goods.
Instead of direct material costs, a SaaS company has overhead costs like any other business and costs for software development, computer infrastructure, customer support, and marketing.
The business costs $50,000 monthly and has 1,000 regular users. Then, it would cost $50 per user ($50,000 divided by 1,000).
The business plans to use a cost-plus pricing model to make a 40% profit. This could be done by adding $20 per user cost ($50 * 0.4), making the end price $70 per month ($50 + $20).
For every new customer, the business makes enough money to meet the cost of the product and make a profit.
Cost-plus pricing can be done with technology.
Businesses can use and handle cost-plus pricing strategies better with the help of technology. The software makes it easier to figure out fixed and changeable costs, apply margins, consider external factors, set prices, and make decisions by giving you helpful information.
Enterprise Resource Planning (ERP) tools help companies handle their finances, operations, and supply chains with all-in-one software programs.
ERP systems give businesses correct information about how much their physical products cost by combining functions like managing inventory, buying things, and planning production.
So, it’s easy for them to use cost-plus pricing models and make changes as needed based on how much money they want to make or how much their costs change.
Set up, price, and quote (CPQ)
CPQ software makes it easier to quote and set prices by setting up complicated products instantly, applying pricing rules, and making quotes for possible customers.
CPQ connects to ERP, CRM, and other data sources to gather up-to-date cost data. This makes it easy for businesses to use cost-plus pricing methods.
Businesses can set prices for different types of customers, areas, and channels with CPQ software, ensuring they make the profit they want in all sales situations.
The tools for business intelligence (BI) and analytics
Business data and analytics tools can help you understand how prices work, how much things cost, and how the market changes.
Businesses can improve their cost-plus margin to reflect market conditions better and stay competitive by looking at past cost data and observing how costs change over time. It can also help them find ways to cut costs, like making process changes or renegotiating contracts with suppliers (though they may not want to use these ideas).
Software for optimizing prices
Pricing optimization software uses complex formulas and machine learning to determine the best way to set prices, considering fixed costs, competition, and what customers want.
These tools aren’t just for cost-plus pricing; they use cost data in their models so that companies can find a good balance between cost-plus pricing and other price factors.
This makes pricing strategies that make the most money possible, even in a competitive market, more successful.
Tools for managing money
FinOps teams use accounting and billing software and other financial management tools to keep track of their transactions, budgets, and income projections.
Financial software gives businesses specific information about costs at different stages of the production process. This lets them make bills of materials, figure out how much they cost, and use cost-plus pricing models.
Financial management software helps businesses make intelligent decisions about their pricing by streamlining financial data management and giving them powerful reporting tools. They can then see how these choices affect their overall profits.
