Reasons to Use Cost-Plus Pricing

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Introduction

It is common to see in various textbooks, especially marketing ones, that the cost-plus method for setting prices has many dangers and limitations. For a full discussion of these concerns, please see the article on this website = Disadvantages of Cost-Plus Pricing

While the above article highlights all the reasons NOT to use cost-plus pricing in isolation – but rather in a collection of pricing tools – what are the main reasons that a firm should use cost-plus pricing, in full or at least in part?

Key Benefits of Using Cost-Plus Pricing

As a quick guide, below is the list of the main reasons for using cost-plus pricing, however each one will be discussed in detail below (under the diagram). And don’t forget to check out the free Excel template available on this website for calculating cost-plus pricing.

  • It’s Conceptually Simple to Use and Understand
  • It is Handy Pricing Method for Businesses with 1,000s of Products
  • Profitability is Ensured
  • Somewhat Flexible as Costs Change
  • Improved Business Planning and Forecasting
  • Faster Implementation

benefits of using cost plus pricing

It’s Conceptually Simple to Use and Understand

From an understanding perspective, cost-plus pricing is very simple. You identify the various costs associated with producing and supplying a product to a consumer – and then you markup that cost by a percentage, which is your profit margin.

For example, if all the costs of a product total $10, and you apply an 80% markup, then the retail price to the consumer is $18, where you make an $8 per unit sale profit margin. And provided you have correctly allocated and identified all the product costs, then this works very simply and is easily understood by all relevant staff and even most consumers.

However, as discussed in the article on… While this is relatively simple to explain and understand, is implementation is sometimes quite complex and challenging.

It is Handy Pricing Method for Businesses with 1,000s of Products

Adding a percentage markup to the cost of the product – assuming it has been calculated correctly as per the above article link – makes a lot of sense for large-scale businesses.

For example, a large retailer – such as Walmart – could potentially run hundreds of thousands of unique product units in its stores. Trying to set prices individually – based upon competitive position, product positioning, and customer value – would simply be an enormous task.

Therefore, the scale of the business would mean that some sort of pricing shortcut or simple approach to pricing is necessary. In this case, a large supermarket could apply generic markup percentages for different categories of products.

For example, 100% markup for canned food products, 80% markup for frozen food products, 50% markup for fresh food, 150% markup for non-food products – and so on.

While this is a relatively simple example, it does demonstrate that it is possible to 100,000s products coming into the store – particularly when there are product changes quite frequently (new brands in, and old brands out for example).

Profitability is Ensured

Again, assuming that the cost of producing and providing the product to consumers (or other partners in the channel) has been allocated correctly – then by adding a percentage markup to the resale price, then a profit margin is always built-in.

This assumes that all fixed costs and other non-variable costs have also been included in the production and supply cost of the product – not just the variable cost. This means that when the product is sold using the cost-plus method – that ALL costs are covered plus a profit margin is also delivered.

It should be noted however, that this works quite well in theory. What this means is that we still need to achieve our expected sales volumes. This is because the allocation of fixed costs is usually based upon expected sales.

For example, if we have a coffee shop paying $1,000 in rent per week, then if we sell 1,000 cups of coffee the rental fixed cost is $1 per cup (plus the variable and staff cost of the coffee itself). But if we do not achieve 1,000 sales – but only 500 in the week – then the rental fixed cost per cup is now $2.

So, provided that sales volumes are maintained, cost-plus pricing will ensure that we achieve continuous profits, and we should never experience a loss due to underestimating our cost structure.

Somewhat Flexible as Costs Change

Virtually every business will experience fluctuating costs in their operation. Most costs will go up over time, while other costs may go down. For example, the price of oil goes up and down, which would then increase/decrease the transport and logistics costs of a product.

Why we would expect short-term fluctuations, and probably factor in an average cost into our cost-plus calculations, long-term and/or permanent structural cost changes need to be built into revised prices.

Cost-plus pricing allows us to do this quite easily. In many cases we would use our systems, spreadsheets, to build a cost-plus pricing model. We could then change the cost inputs in the calculation, which would then flow onto our and price points – which we could modify.

The title of this section says “somewhat flexible”, which means that in market reality we cannot modify prices too frequently. While we often see dynamic prices in industries such as hotels and airlines, in other industries it will create customer dissatisfaction.

For example, if we have a local coffee shop and every day we change the price of our coffee as our cost structure has slightly change, then this will simply lead to customer dissatisfaction and loss of repeat business – not good!

Therefore, in many businesses and product categories, we need to be “somewhat flexible” and only change prices when there are substantial and/or permanent changes to our product cost structure.

Improved Business Planning and Forecasting

By using a cost-plus pricing method, particularly where we have an automated spreadsheet (or other mechanism) for calculating cost inputs and the resultant retail/customer price – then this gives us a good degree of certainty and price and profit management in our accounting and sales forecasts.

This means we can also scenario test changes to our cost structure. For example, using our coffee shop above, we could model the impact of a worldwide increase in coffee by 20% – what impact would that have on our prices and what impact may that have on our profit margins and sales?

Obviously, a coffee shop is a simple example, but more complex businesses (running multiple product lines) would generally invest considerable resources in profit forecasting taking into account different future marketing environment scenarios.

It should be noted that simply doing a financial forecast with potential cost changes, may not be reflective of market reality. Obviously, we should also take into account competitors, customers, different segments, and other unpredictable environmental changes.

Regardless, it is a helpful planning tool and helps the business ensure that they will not be “caught out” by unfavorable cost trends or adjustments.

Faster Implementation

When using cost-plus pricing, it is very clear what the price should be. If our product cost has been calculated at $15, and our cost structure then increases to $18 – then we apply the same percentage markup to work out the new price. This is clear to all relevant staff, and can be implemented quite quickly.

However, compared this to a different pricing method approach. For example, using relative competitive pricing. In this case, we would need to monitor competitive pricing, consider when and to what level we need to change prices (often taking into account our brand positioning) – and then, usually, we would need to seek management approval, often with a supportive business case/argument.

All of which takes time – potentially months for a large business – as opposed to a cost-plus scenario, where prices may be adjusted even on a daily basis (such as in a supermarket for example).

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