What Is Cost-Plus Pricing? Advantages, Disadvantages & When to Use It

Pricing is a very important part of building a business. There are many strategies, but their whole point is that a percentage is added to the company's costs for one product, which will be profit. In general terms, this is called cost-plus pricing.

In this article, we will analyze in more detail how it works, how to calculate such a price correctly, the advantages and disadvantages of such pricing, and some examples.

Cost-plus pricing is a fairly simple strategy in which the price of a product is made up of the cost of producing that product plus the margin.

First of all you determine the direct material costs of producing a product, then add labor costs and overhead costs, so you calculate how much the company will cost to offer a product or service on the market. After summing up all the costs of materials and production, you add a margin.

The margin in this case is an additional percentage that buyers will be willing to pay. This percentage will be the company's profit.

It is important to correctly determine how much the margin will be, namely, how much buyers will want to pay for a particular product. If the margin is too small, it will negatively affect the company's profit, and if the margin is too large, then customers simply will not want to buy the product. So it is very important to determine the right margin.

Before applying this strategy, you need to know how the price is calculated, or rather the formula.

Calculating cost-plus pricing is simple. Take your total fixed and variable costs (labor, manufacturing, shipping, etc.), and then add your profit percentage. Here’s the formula:

Cost + Markup = Price

Say you’re starting a retail store and want to figure out the pricing for a pair of jeans. The cost of making the jeans includes:

· Material: $10
· Direct labor: $35
· Shipping: $5
· Marketing and overhead: $10

Cost-plus pricing involves adding a markup—let’s say 35%—to the total cost of making your product:

Cost ($60) × Markup (1.35) = Price ($81)

Like any pricing strategy, cost-plus has advantages and disadvantages.

Simple to figure out. As mentioned above, this is one of the simplest pricing strategies. The main cost is based on your expenses, and the margin is formed depending on demand, product quality, and your industry.

Easy to justify. Such pricing is considered the most justified, since the price does not increase out of nowhere: the price increases due to the fact that production costs are increasing. In this regard, this is one of the most honest strategies.

Consistent rate of return. Cost-plus pricing can give you a guarantee that the prices of your products will always exceed the costs. With other, more complex strategies, this is not always possible to predict.

Good for testing the market. This is a useful strategy for newcomers to the market, as it allows you to determine how much the buyer will be willing to pay for the product. Thus, the margin and future profit of the company are determined.

Dependent on costs. Cost-plus pricing has a disadvantage of potential profit loss due to dependency on costs. If costs decrease, strictly following cost-plus pricing would require a decrease in selling price, resulting in revenue loss if consumers are willing to pay more.

Doesn’t take trends and external factors into account. Cost-only consideration limits revenue potential for trending products. For instance, True Religion's Super T Jeans cost $50 to make and retail for $260, which is a 520% markup.

Doesn’t take customers’ willingness to pay into account. Cost-plus pricing overlooks customer perception and competitor pricing, which can hinder sales if the price exceeds what shoppers are willing to pay.

The successful application of cost-plus pricing also depends on the industry. Usually, such pricing is most effective if the enterprise has certain costs associated with production, and the product itself is utilitarian in nature. Below, we will look at two industries in which cost-plus pricing can be successfully applied.

Manufacturing companies utilize cost-plus pricing based on predictable fixed costs (labor, machine maintenance, raw materials), allowing for a sustainable profit margin percentage. Typically, bulk manufacturing products are sold to established customers with a contract, resulting in a stable revenue stream without fluctuating prices.

Consider your recent visit to the supermarket. You were likely aware of the cost of items such as apples, cereal, and milk due to the cost-plus pricing model used by grocery stores. Honey Crisp apples are pricier than Red Delicious because of their higher purchasing cost. Grocery stores purchase products in bulk through procurement companies, which also follow the same pricing decision model as manufacturers.

Let's look at a few additional points that will make the application of the strategy more effective.

Not everyone uses cost-plus pricing. Clothing and grocery industries apply it because they offer a range of products with different markup percentages. Everlane, an apparel brand, uses it to show transparency on their website by disclosing the cost of making each garment and their profit. They apply a 2-3x markup, which is lower than the industry average of 5-6x, giving them a competitive edge while avoiding overpricing.

Elastic demand is when price affects consumer demand, causing people to buy more when the price drops and less when it goes up. Use cost-plus pricing for products with low elastic demand, like fast fashion. Trending products have higher elastic demand, so they require a different pricing strategy. Core items, such as white t-shirts, are less elastic and ideal for cost-plus pricing. Limited-edition products, like the Gucci x Balenciaga cap, should be priced based on hype and availability for maximum revenue.

Considering competitors' prices is crucial for pricing strategy. To determine cost-plus pricing, check competitors' prices for similar goods. If they sell at high margins, there's room for competition, and cost-plus pricing is easy. If they sell at low margins and your calculated selling price is high, determine if you have a competitive advantage or can produce products at a lower cost to make prices more competitive.

Cost-plus pricing is quite simple to apply, but as practice shows, pricing should be flexible and adapt to various changes and trends. There are also other equally effective pricing strategies that can be applied and combined depending on your industry.

Value-based pricing is a pricing strategy where the price of a product or service is determined by the value it provides to the customer rather than the cost of producing it. This means that the price is based on the perceived benefits and value that the customer derives from using the product or service, rather than on its production or distribution costs.

Penetration pricing is a marketing strategy in which a company sets a low price for its products or services in order to enter a new market or gain market share.

Keystone pricing is a pricing strategy where the price of a product is set at double the cost of producing it, resulting in a 50% gross profit margin.

Competitive pricing is a pricing strategy in which a company sets its prices based on the prices of its competitors, with the aim of staying competitive in the market. The company may match or undercut the prices of its competitors to attract customers and increase market share.

Manufacturer’s Suggested Retail Price (MSRP) is the price suggested by the manufacturer of a product that a retailer should charge for the product to the end consumer. It is also known as the list price or sticker price.

Cost-plus pricing is the right approach to take when a company wants to ensure that they cover their costs and make a profit. This pricing strategy is particularly useful for companies that sell customized or unique products or services, and where it is difficult to determine the market price.

It can also be effective when a company has a limited understanding of how their products or services are perceived in the market. However, it is important to consider the competitive landscape and the value proposition of the product or service when using this pricing strategy.

Cost-plus pricing can be combined with other strategies. In order to understand how to use a strategy, you need to rely on an accurate analysis of your prices. To do this, you can use Priceva’s Price Intelligence Software.

It depends on the industry and the specific circumstances. Cost-plus pricing can ensure that a business covers its costs and makes a profit, but it may not be effective in highly competitive markets where customers are price-sensitive. Additionally, if a business doesn't accurately calculate its costs, cost-plus pricing can lead to overpricing or underpricing.

Cost-plus pricing can incentivize suppliers to increase their costs, as it guarantees a profit margin on top of their costs. However, if the buyer negotiates a lower profit margin, suppliers may be motivated to reduce their costs to maintain profitability.

Cost-plus pricing is also known as markup pricing.

Cost-plus pricing is a method of setting prices based on the cost of producing a product or service, while value-based pricing is a method of setting prices based on the perceived value of the product or service to the customer. Cost-plus pricing adds a markup to the cost of production to determine the selling price, while value-based pricing sets the selling price based on how much the customer is willing to pay for the product or service.