All successful businesses know that adopting specific strategies will allow them to operate well and improve their sales. However, some businesses don’t understand the need for a plan or strategy, especially when it comes to pricing.
Pricing strategies are important as they help a business attract customers, drive off competitors, and maximize profits. However, not every strategy is suitable for all businesses. It is always a good idea for any business to first research the pricing strategy they want to implement and evaluate whether it would be good or bad.
This post focuses on a pricing strategy known as cost-plus pricing. Continue reading on as we’ll cover the definition, the advantages and disadvantages of cost-plus pricing, and share a few examples for better understanding.
What is Cost-Plus Pricing?
Another name for cost-plus pricing is markup pricing. This is the process in which a business determines the cost of a product and adds a percentage on top of it to set the final selling price. This is a simple and easy-to-implement technique for setting the price of the goods and services compared to other methods.
First, a business determines the overall cost of a product/service. The factors influencing a product’s cost in this strategy are direct labor costs and overhead costs. After adding the production cost, the company adds a markup percentage to the total cost. This helps the business to determine the final selling price that would be reasonable for a customer.
The markup percentage or the add-on is a direct profit for the business when a customer buys the item. Therefore, a business must always know the overall business’ costs, including the products’ costs before selling it to the customers.
When and Why Should a Business Use It?
Cost-plus pricing is an effective method that benefits a business operating on a large scale as it is aware of the cost of producing one particular product individually. This allows the business to understand the current financial situation it is in and determine the selling pricing according to the right markup percentage.
This markup percentage is the amount a business will earn as a direct profit. The amount will only vary if the cost of production increases or decreases. A business that is selling goods at high prices may see that customers are opting for alternatives instead. Therefore, decreasing overall sales, and leading to less profit generation. This strategy will help the business set the right price; whether the profit is low or high, the price will be just right, and customers will be willing to pay for it.
A business that operates in competitive markets has to look at and evaluate their costs precisely. However, this method doesn’t consider the prices set by competitors. Instead, it focuses only on the unit cost, i.e., the overall cost to produce one unit of a particular product the business offers. This strategy helps the business set the right price that is not only reasonable for the customer but also beneficial for the business.
Examples of Cost-Plus Pricing
Here is a simple example of how cost-plus pricing works and how businesses benefit from it. Let’s suppose a company sells a product for $3, and this includes all the costs, including production and marketing costs. Now, the company can add a markup percentage, which depends on the company and factors such as current market conditions and economic conditions.
Therefore, if the demand for a product is low, the business will add a lower markup percentage to attract the customers. Similarly, if the demand is high, the company may set a higher markup percentage for its product.
Usually, manufacturing companies and grocery stores rely on the cost-plus pricing strategy. For instance, the products a manufacturing company offers have predictable costs, including labor, raw materials, maintenance, etc. So, they can easily add a profit margin or markup percentage to their product.Do You Know Your Competitors Prices? Click Here to Start Tracking Them Today!
Advantages and Disadvantages
This pricing strategy has its fair share of advantages and disadvantages. Therefore, it is important for a business to weigh in the pros and cons to evaluate whether it is a good method.
- It’s an easy and simple method to use
- Helps you allocate the cost of production
- It helps companies create stronger contact with suppliers; this is because cost-plus pricing guarantees the return of the initial investment made. Suppliers will be happy to know they’ll get the money back
- An easy way to increase prices once the production cost goes up. Therefore, informing clients or customers won’t be an issue.
- The price does not depend on the competitor’s pricing. This means the price set could be higher or lower; it can have a bad impact on the financial situation of the business.
- Costs could keep increasing as suppliers have no control over the production costs
- The business may find it difficult to change the product’s price when necessary
- The strategy alone may have adverse effects on the operations of the business. Therefore, more strategies together could be helpful.
Should a Business Use It?
Well, there are some key benefits of using this method. But, it depends on the type of business as well. A business with too many competitors may find this strategy useless if its product’s price is higher than the competitors. It will lead the manufacturer to lose existing and potential customers.
However, a business that operates in a niche market could benefit from cost-plus pricing as the product itself won’t have cheaper alternatives. Therefore this method could be quite helpful for such businesses.
Businesses can choose a method from numerous pricing strategies. In the end, it all comes down to what the company prefers. It is always beneficial for the stakeholders of a business to calculate and examine the possible outcomes of a certain pricing strategy. This will help them in determining the best method that will benefit the business in the long-run.Do You Know Your Competitors Prices? Click Here to Start Tracking Them Today!