When Cost-Plus Pricing Is A Great Method
Because of its ease of implementation, the cost-plus pricing model is a popular method across a wide range of businesses.SaaS and subscription businesses, on the other hand, swiftly derail the paradigm.
Due to the subscription model's foundation in value-based marketing, it is a great way to make money from your existing customer base.The cost-plus pricing approach ignores the value you deliver to consumers in favor of focusing only on your operational expenses.
Additionally, the physical expenses of creating a product are not often linked with subscriptions.Customers' ongoing financial support is the primary emphasis of SaaS and subscription businesses.As a consequence, most of your clients will have little incentive to value your product because of the expenditures associated in supplying it.
Cost plus pricing explained
Using the simplest approach possible, cost plus pricing, it is possible to arrive at a fair price for a product.It's a win-win situation when you create something and then sell it for more money than you paid to build it.Many organizations utilize cost plus pricing as their major pricing approach when introducing items.
It's not uncommon for corporations to figure out their manufacturing costs, figure out their target profit margin, and then place it on a few thousand widgets.That's all there is to it.This strategy requires very little market research and also doesn't evaluate customer desires and rival tactics.
Even when it's clear to the customer that the stockings are being filled by their parents, the markup is typically just a target rate of return.To put it another way, that's not quite the end of the line in unicorn world.It's still unlikely to become reality, since you'll never be able to account for all of your expenses, and an arbitrary profit margin has no bearing on how much your consumer is prepared to pay in the first place.Because of this, the dartboard is left mostly intact in the cost-plus model.
Do not be worried; it is simple!Using this approach, you may determine your cost-plus pricing
Assumption: Cost x Target Margin = Price
Cost + Desired Profit = Price
It may be a little more difficult to calculate the real cost of your product or service.In order to generate a profit, you need to consider the whole cost of running your firm while evaluating Cost Plus.
For example, if you were to base your price exclusively on the production costs of a product, you may wind up losing money.
So take a step back and think about what it will take to bring your product to market.Consider your selling expenses, not simply your manufacturing costs.
Cost Plus Pricing just requires this one piece of internal research, which is readily available.You may determine your overall cost per unit by going through your invoices and overheads.
Cost plus pricing has the following advantages:
- Simple.Using this approach, you can easily determine a product price, but you must specify the overhead allocation mechanism in order to be consistent when computing the pricing of numerous items.
- Contract earnings will be guaranteed.With this technique of contracting, any contractor is prepared to take it since they know that their expenditures will be refunded and that they will make money.Such a contract carries no danger of loss.
- Justifiable.A price rise may be justified by citing an increase in the supplier's expenses as the cause.
The following are some drawbacks of pricing products based on cost in addition to value:
- Disregards the opposition.Because of the cost plus formula, a corporation may determine a product price before discovering that its rivals are charging significantly different rates.This has a significant influence on a company's market share and earnings.In either case, the corporation loses out on the opportunity to make money by underpricing or overpricing.
- Overruns in product costs.No one in the company's engineering department has any motivation to build a product that is suited to its target market's needs under this model.Instead, the department just creates what it wants and makes it available to the public.
- Cost overruns throughout the course of the contract.Cost-plus-price contracts provide suppliers little incentive to reduce their costs, so they add as many expenses as possible in the contract in order to get compensated.As a result, the supplier should be offered incentives to reduce costs as part of the contract.
- Ignores the price of a new one.Because it is based on previous expenditures, it is subject to revision.The cost of the most imminent replacement is a better indicator of overall expenses.
In a variety of different businesses, cost-plus pricing is an effective pricing strategy to use.This approach often works best when manufacturing expenses are well-defined or when the product is just functional.Cost-plus pricing has typically been used in these two businesses.
In the manufacturing industry, cost-plus pricing is a way of life.It's simple to allocate a profit margin percentage utilizing markup pricing to their goods since their fixed expenses (such as labor, equipment maintenance, and raw materials) are reasonably predictable.
The bulk manufacturing items are sold to current clients under a contract in most of these agreements.As a result, it's far simpler to establish a steady stream of income over time without having to alter prices.
Consider your most recent trip to the grocery store.You presumably knew how much apples, cereal, and milk would cost before you went out to get them.The reason for this is because food shops adopt the cost-plus pricing model, too.Because the Honey Crisp was more costly to purchase, it will cost more to eat it than a Red Delicious.
The procurement companies that grocery shops use are likely to use the same price determination approach as our manufacturing example since they similarly purchase things in bulk.
Cost-plus pricing has the disadvantage of taking no account of how much demand there is for the product or service.In the end, the formula doesn't give a damn about whether or not buyers would really pay the listed price for the goods.As a result, some company owners have attempted to apply the ideas of price elasticity to cost-plus pricing in order to compensate.Others may rely only on market conditions, such as prices offered by competitors, trends, and general business acumen, to estimate a fair market value.
It's also possible to use value-based pricing, which is the practice of pricing products and services according to their perceived worth to customers, rather than the cost of producing them.Value-based pricing, which often delivers a greater profit percentage, may be a good match for your firm if you have specialized or unique items with highly desirable qualities.