Cost-plus pricing is the most basic form of pricing. Most people, who sell products or services, use the cost plus method to price their goods or services. So what exactly is cost-plus pricing?
Mathematically speaking, cost --plus pricing is summing all the costs for a particular product, and adding up a markup percentage (how much profit you want to make), to determine a price for the product. Typical costs include the cost of the goods, the cost of labor, and overhead costs (rent, utilities, insurance, and other fixed and variable costs). An example of cost-plus pricing is:
XYZ Company has designed a new widget that has the following cost:
Direct cost of goods = $25.00
Direct labor cost = $15.00
Overhead = $10.00
The total cost for the product is therefore $50. If the company decides it wants to make 30% profit per widget, then it simply marks up the $50 cost by 30% (or multiplies $50 x 130%*) for its price. The price will be $65. By charging $65, XYZ Company should get a 30% return (or $15 profit) on each widget.
The Lure of Cost-Plus Pricing
Cost-plus pricing is attractive to many business owners, because they have information about their direct costs. Therefore, it is easy to implement. The alternative (and more recommended) method of demand-based pricing is difficult for most business owners, because most do not have information about demand. However, using cost-plus pricing creates problems for business owners as well.
Why to Avoid Cost-Plus Pricing
These problems mainly include: (1) indirect costs (or costs they may not be aware of), and (2) pricing too low in the marketplace. No matter how carefully a business may determine its direct costs, there are always unexpected external factors (strikes, natural disasters, events, and changes in the supply chain) that may significantly affect costs. If XYZ relies on a unique supplier for widgets, and that supplier were to go out of business, then XYZ would have to expend resources (and cost) to find new suppliers. Several changes like this, that would impact the price in the cost-plus method, would mean that prices would be unstable.
The second problem could be equally damaging. The business owner, by relying on cost to price products, could price lower than competitors. This doesn't mean that it would necessarily benefit by taking the other business' customers. Most markets for product are large enough to give customers several choices, so a lower-priced good isn't the only deciding factor in a purchasing decision. Some businesses take this lower-priced strategy to get ahead of the game but adversely lower their profits instead. By matching other business' prices, all the businesses are better off in a marketplace with several sellers. They all get a higher price for their product at a consistent volume and cost, than if they were to accidentally price lower. By using the cost-plus method, a seller would be incurring a "loss" in not profiting as much as it could with higher prices.
What's the Alternative to Cost-Plus Pricing?
So, when deciding how to price your products, the cost-plus method would be easiest, but would also have pitfalls. Other pricing methods exist, that are a hybrid of both cost and demand, and require research into the advantage and disadvantages of each. Business owners who want to maximize their profit should explore several pricing strategies, and choose the one that best meets their business model, industry, and market for customers.
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