Cost-Plus Approach

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When considering pricing strategies for your small business, you might consider the cost-plus approach as a simple method to help ensure a profit on products and services sold. This method simply takes into account your relevant costs and markup percentage and is useful when you lack other details about the market for your product. However, this pricing strategy may not work effectively in a competitive market and ignores some financial risks. Understanding the cost-plus approach and some alternative strategies can help you decide what works best for your situation.

Basics of Cost-Plus Pricing

When your small business uses the cost-plus approach, it considers only the relevant costs (direct labor, direct materials and overhead) associated with producing the product or service along with a desired markup percentage to determine an appropriate price. The intention for the cost-plus pricing approach is for the company to end up with a price that will assure a predictable profit for each sale. This pricing formula doesn't consider other factors like competition, value, location or bundle discounts that other pricing strategies do.

Direct labor includes costs such as wages for production workers and quality control inspectors, while direct materials include costs such as fabric, nails and lumber. Examples of overhead costs include rent, insurance, utilities bills, advertising and taxes. The markup percentage your business sets refers to how much the company wants to receive from sales after the costs incurred, such as 20% or 30%.

Once you know your costs and markup, you can calculate the price to charge for your product or service. The cost-plus pricing formula to get the sale price is (direct labor + direct materials + overhead costs) * (1 + desired markup), where you convert the markup percentage into decimal form.

Exploring a Sample Price Calculation

To see the cost-plus formula in action, consider a small business that makes wooden furniture. The business wants to determine the right price for a new type of wooden stool.

Direct labor for making the stool totals $15, and the direct materials costs are $40. The overhead allocated to make a single stool is $10. The desired markup percentage is 20%.

Plugging these values into the cost-plus pricing formula, you get ($15 + $40 + 15) * (1 + 0.20), which simplifies to ($70 * 1.2). This comes out to a target product selling price of $84.

Benefits of the Cost-Plus Approach

Some benefits that the cost-plus pricing strategy can offer your small business include the following:

  • Easy to calculate: Small business owners usually find the cost-plus approach the simplest method to use when they start out with pricing products. After all, you can get a desired price with a straightforward formula that you can plug into a spreadsheet or even do by hand rather quickly. The work needed beforehand to determine the relevant costs and markup is also minimal, so you'll have more time to focus on other business areas.

  • Ensures transparency in pricing: Whether you're negotiating with a supplier or trying to explain your pricing decisions to someone inside your company, the cost-plus approach makes it easy to justify your reasoning. You can simply show documentation with your costs and share your markup percentage to prove that the price charged is fair based on that information.

  • Simplifies planning: When used properly, the cost-plus pricing method can make it easier to plan goals for number of goods or services sold since you have a clear idea of what your profit will be. This helps avoid some of the risks of other pricing strategies as long as your costs don't change from what you had calculated.

  • Good for situations with limited knowledge: Since you only need to know your markup percentage and costs, this approach to pricing works well when you have little knowledge of the market, customer preferences and your competitors. It sets a good foundation for generating some sales and leaves the option to tweak your strategy later if you learn you need a higher markup rate.

  • Can help you lead with a low-cost strategy: If your company decides to focus on charging a low price to get a larger chunk of the market share, then the cost-plus approach's focus can make your job easier in boosting demand for your product or service. You can work with a low markup percentage to compete with other companies and gain customers who focus on getting the best price.

Disadvantages of the Cost-Plus Approach

While the cost-plus approach to pricing can be convenient for you to use, you should be aware of these drawbacks:

  • Disregards competition: A problem with the cost-plus approach comes from not considering the pricing of competitors. This can lead to prices that are either way too high for customers or that are too low and don't get the company the maximum profit it could. Both can cause your business to struggle financially.

  • Ignores customer perception of value: This strategy also disregards how customers might feel about your product and how much they'd be willing to pay for it. When you focus on only costs, you might ignore factors like the product's prestige or effectiveness. This can cause you to set prices that don't reflect your product's actual value with those who would likely purchase it.

  • Can hinder efficiency: The intensive focus solely on costs can cause your business to become inefficient and not put much effort into improving productivity or quality. Your business also might not be prepared to adapt to the changing market and may be less innovative with this approach.

  • Ignores important risks: Your costs may actually not get covered if sales don't go the way you expected. At the same time, your costs for making your product could go up before you adapt your pricing, causing you to see less profit.

Exploring Other Pricing Strategies

Cost-plus pricing can help busy new small business owners begin selling their products and services quickly. However, you'll likely find it lacking when you sell a product or service that many other competitors do since you also need to consider market factors, customer perception and competition.

Therefore, you might find it helpful to explore some of these alternative pricing strategies:

  • Market-plus pricing: Also known as price skimming, this method involves setting high prices in the beginning and then lowering them later on for more economical customers. For example, you might produce an expensive cell phone model and later make a "light" version for budget-minded customers.

  • Demand pricing: When you use this pricing strategy, your prices can go up and down based on how much customers demand your products or services. For example, you might charge more for shovels in the snowy winter than you do in the summer.

  • Competitive pricing: This method considers your competitors' current prices and allows you to make some small adjustments based on your product's value in comparison. An example would include taking your top competitor's price for smartwatches and charging 10% more since your watch offers a slightly improved design.

  • Economy pricing: When you have a generic product of which you sell a lot, you might use an economic pricing method to give customers a very low price. If you make loaves of white bread or other generic foods to sell, you might use this method.

  • Price bundling: This involves giving customers a lower price when they purchase a set of products versus a single one. For example, you might have noticed you usually pay less for a two-pack of toothpaste than you would if you bought two of the same size separately.