Companies and businesses use different types of pricing strategies, Cost-Plus Pricing is one of the simple yet effective strategies. However, it means adding the original cost of the product plus overhead expenses like labor cost, transportation cost, rent, and a profit margin or the markup. When you add all of these costs together, then it’ll be a cost-plus pricing strategy.
It’s not a market competitive pricing strategy. But it requires a bit of market research to put together all the different costs. This strategy is based on the simple ‘value-adding’ concept, cost of the raw material plus the value you added to make it a complete product.
Who Uses Cost Plus Pricing Strategy?
Since this strategy completely avoids customer demand, marketing trends, and competition. Therefore, companies and businesses in the retail industry usually follow this strategy like; departmental stores, grocery stores, and clothing items.
Cost-Plus Pricing Formula & Calculation
For instance, a company produces washing soaps. Its costs are as follows;
Direct raw material cost = 25
Labour cost = 10
Factory overhead = 12
Total cost = 47
Total cost is not the final price of the product, because it hasn’t included the company’s mark up or the profit ratio. Now, the company decides to add 30% on all of its products. Therefore, it’ll be like this;
Final price = total cost (1 + mark-up)
= 47 (1 + 0.30)
= 47 + 14.1
Final cost-plus price = 61.1
Advantages of Cost-Plus Pricing
The reason why companies and businesses use cost-plus pricing is because of the following reasons;
It is Simple to Use
This pricing strategy is very simple to use if you know all the basic costs, factory overhead and the percentage of profit margin. When you know all the basic figures, just add all of them step by step and you’ll the final price.
You don’t need extensive market research to find multiple figures. You just have to go through the company’s record to know production cost, and other relevant incurring costs. You’d also know what percentage of profit margin the investor is looking for in its investment. When you put all of them together, then you’ll have your product price. That’s why this strategy is popular among small businesses because they can easily calculate it.
Cost Coverage and Rate of Return
When you’re calculating and working on multiple figures, then cost plus help you to include all of those basic and add basic investment return rate on it at the end. But sometimes some other indirect costs aren’t included in the costing process. Consequently, they make the profit margin lower.
However, if you start with increasing figures of profit margin, then it would cover up all the fluctuating, indirect and uncalculated costs. You can also calculate the estimated revenue based on previous history.
It is Justifiable
Companies can defend and justify their products’ prices because they print a complete pricing mechanism on the packing. As a result, customers are satisfied with the pricing that what they are paying is right.
When you’re new in the market or launching your product for the first time; then you’d have limited information about many things. Like you’re uncertain that how the market would respond, and you don’t even have direct price competitors that would give you the idea about the price.
In such circumstances, cost-plus pricing helps you to focus on all the basic costs; add company profit margin and enter the market with the final price.
Disadvantages of Cost-Plus Pricing
The reason why big companies are careful while adopting this pricing strategy, some of its disadvantages are as follows;
It Ignores Competitors
When a business starts pricing based on cost-plus formula by utterly avoiding the competitors’ prices in the market, then it would end up charging either too high or too low. People won’t buy a company’s product if the price is too high, or it would cost the company if it’s too low. Either way, it would very badly impact the market share of the company. In other words, it’ll be a lose-lose situation for the company.
When a company doesn’t do market research on competitors’ pricing scheme, then losing market share is one thing. It would also lose the customer’s perceived because some customers value the product based on its price.
For instance, if you’re offering a high-quality product; but you’re charging a less competitive price, then you’re losing the perceived value of the product. Customers would perceive your product cheap.
Product Costs Dominate
Companies that normally follow this pricing method, their graphic designers and engineers usually don’t have sufficient resources, budget or R & D plan to come up with some unique features. Instead, they develop and produce whatever is available or come to mind, and then they launch the product.
Sometimes, small businesses and companies are so much busy calculating their costs that they avoid customer’s paying capability. Whether they’re comfortable with the price or not; if the company keeps focusing on making a profit, then it would lose sight of valuing the customers.
Customers don’t care about the pricing methodology of the company. All they know that the company charges what good for its business. However, what customers care about is the value of the product contrasting with the price. If the product is adding more value to their lives, then they would happily pay for it regardless of its costs. If the product isn’t adding any values, then they’ll be reluctant to pay even a less price.
Charging less ensures investors that they would at least receive the minimum return on their investment, instead of risking their entire capital by pricing more. However, it makes businesses and stakeholders lazy. The government usually follows this strategy of offering a minimum guaranteed return on their investment to individuals and private businesses. It results in poor quality of working conditions of workers, and a lot of money and resources are wasted under the table deals.
Examples of Cost-Plus Pricing
For instance, if a company manufactures a product and its production cost is $5. Labor cost, overhead, indirect, calculating and fluctuating cost is $5. Now, the markup or the profit margin of the company depends on multiple factors. Like the demand, economic conditions of the country, and customer’s ability to pay.
If the demand is high which means customers can pay, then the markup rate would be higher. On the other hand, if the economy of the country is down, less demand in the market, then the profit margin rate would be lower because the target market has less capacity to pay for the company’s product.
Cost-plus strategy could be ideal for some businesses, but it’s not for most businesses. The mistake most companies make while pricing is that they don’t give importance to market demand, and competitor’s prices. Therefore, whether customers would perceive its value too high or too low, it’s not good for the company either way.
On the other hand, cost-plus and value-based pricing strategy should be on the same level. Only then customer would be happily and willingly pay for the product whatever you’re offering.
Image by Gerd Altmann