Small business owners tend to like cost-plus pricing because it is simple and straightforward.
Just take the cost of the product (including labor and overhead), add the desired profit margin (e.g. 20%) and the price of the product magically appears.
However, the simplicity of the cost-plus approach can also disguise an assortment of pricing pitfalls for unsuspecting business owners. At a minimum, it's worth examining the pros and cons of cost-plus pricing before you decide whether it's right for your business.
The Pros of Cost-Plus Pricing
- Ease of use. By far, the biggest advantage of cost-plus pricing is that it's easy to calculate and easy to apply to all of your products and services. Since it doesn't require a complex pricing formula, everyone in your operation can be taught how to price merchandise and you are always guaranteed a profit on the sale of your products -- provided you've correctly calculated your overhead costs.
- Consistency. Cost-plus pricing protects business owners from the fluctuations that occur in other pricing strategies. Changes in demand or short-term price wars don't faze cost-plus pricing advocates because they are confident about their costs and they know exactly how much profit can be earned from the sale of their product.
- Fairness. Consumers prefer cost-plus pricing over other methods because it is based on actual costs plus a moderate profit for the business owner. If it can be tactfully communicated, a cost-plus pricing approach can be leveraged to boost loyalty in your customer base.
The Cons of Cost-Plus Pricing
- Inefficiency. Unfortunately, cost-plus pricing strategies are hotbeds of inefficiency. Since the profit margin is treated as an add-on, there is no real incentive for cutting costs. Cost only becomes an issue when competitive forces pressure business owners to radically reduce prices.
- Competitive Blindness. Further complicating the problem of inefficiency is the fact that cost-plus companies are often blind to competitive pricing until it's too late. Instead of keeping an eye on the marketplace, cost-plus businesses plug away at their pricing structure until they experience catastrophic declines in demand.
- No Compensation for Intangibles. Even though consumers like cost-plus pricing, it's not necessarily the best deal for business owners because it doesn't compensate for intangibles like brand recognition and strategic positioning. It would be nice to achieve a ROI for the time and energy you've invested in building your company, but there's no provision for it in a cost-plus pricing approach.