Cost Plus pricing strategy is the most rudimentary of all the pricing strategies. It is probably the first one that we intuitively learn even before formally learning about pricing. And we do have numerous cost plus pricing strategy examples as well.
Our minds are hardwired to think of how much money it took us to buy something, how much money we want to make from it and therefore how much should we sell it for.
Also Read: How to Price Your Product – The Fundamentals
Now, as a marketer, pricing is one of the critical factors that you will not only have to understand but appreciate. Most of the time we interact with pricing predominantly when discussing the marketing mix but forget about the central role that pricing plays in the profitability of a business.
Business is, after all, a venture that you and I would get in for the specific purpose of making a profit.
Interestingly, there are numerous pricing strategies that you will come around, or that you have already become acquainted with over your Bachelors and now your MBA course.
If you remember correctly, we tackled the topic of price-quality based positioning sometime in July and went into some length on how price affects the perceived quality of a product and profitability.
In this article, we will explore the most rudimentary of pricing strategies – the cost plus pricing approach. Further, I will take you through some cost plus pricing strategy examples.
First, let us look at some of the examples of industries or products which have used cost plus pricing.
What is Cost Plus Pricing Strategy?
Let us start with a very basic example. Suppose that the cost of a sandwich that you want to sell is ₹100 to you. This price includes all the costs that have been involved in making this sandwich, everything that you can think of.
So, even if you had spent some rupees in printing pamphlets to distribute it in your locality, even those marketing costs are included in this. (How you would attribute the price of marketing per sandwich is topic of another discussion).
As the seller, you can decide to add a percentage on top of this ₹100, say 50% of the total costs. The added potion of ₹50 will then be your profit.
And hence you are said to have followed a cost plus pricing strategy while arriving at this list price of ₹150 for your sandwich.
Basic Intuition behind Cost Plus Pricing Strategy
The notion behind the cost plus pricing approach is simple; basically, you will calculate the entirety of costs involved in the manufacturing of the product. You will then decide on a markup percentage of these costs which you will then add to the cost to determine the selling price.
It is quite an interesting approach to make sure that you earn a pre-decided profit. In the subsequent articles, however, we will see that it may not always be as straightforward. And that your calculation of the profits that you will get from this approach may not always be correct.
Now let us taken a look at one of the practical cost pricing strategy examples to show where can cost plus pricing strategy work.
Cost Plus Pricing Strategy Examples and Where Does it Work
Let say that you have been hired in the sales and marketing department in say, Reliance Industries Limited.
Suppose that Reliance Industry Limited has recently been the beneficiary of a 10-year contract for the government, for the supply of electricity to key government infrastructure, which has become vulnerable due to power outages.
In order to achieve its goals, Reliance Industries will need to set up a small power plant, which it will operate and maintain over the ten years period of the contract.
Reliance Industries is contractually entitled to monthly reimbursements for what it incurs per each unit of electricity that it provides for consumption, plus a 20% profit on the cost of supplying the electricity (cost plus pricing approach).
Accordingly, Reliance Industries incurs labor costs of $20,000 per month for employee costs, an additional $20,000 per month for costs of diesel consumed in a single month, $15,000 from the depreciation of plant per month and $10,000 for the management’s fee.
Using the cost plus strategy, Reliance Industries will take the sum total of costs which is $65,000, and add 20% of the cost, which will be the profit of the company.
The invoiced amount for the first month will, therefore, be $78,000.
While all the figures used in the cost plus pricing strategy example quoted above are figurative, the idea is to explain you to the crux of this pricing strategy.
Moreover, it is also to make you understand that government contracts, large infrastructure, power, and such engineering contracts are a few areas where cost plus pricing strategy is still used.
Ideally, as seen above, the cost-based pricing can be very easily applied to have a predetermined percentage as profits.
Yet, while arguably one of the most popular pricing approaches today, this approach has both been lauded and criticized, particularly in pricing literature.
Is Cost Plus a Good Way to Price?
There are quite a few reasons as to why cost plus pricing strategy is not the pricing strategy that you should use as a marketer. And one of my next posts is going to be about that.
But, let’s just see here one of the smaller and easier to understand examples of why it could turn out to be a bad idea.
Later on, I will build upon from this very thought that what could be a better a pricing strategy i.e. the Value-Based Pricing strategy.
Say you have manufactured a product which has cost you ₹300. Let us now imagine that you want a margin of 50% on this product, which in turn means that you will price this product at ₹450.
Now assume that the market is willing to pay up to ₹650 for your product.
This means that with the cost plus pricing approach you will lose out on your optimal profit. It could have been much more than just ₹150.
Now let us assume that the market is instead only willing to pay ₹375 for the same product.
What happens now?
This means that you will be tempted to leave the money on the table and not sell your product because your margin is not met.
In both of these examples, we see that pricing is based on a random number or figure, as opposed to being supported by the amount of money that the consumer is willing to buy.
Which means the cost plus pricing doesn’t capture the essence of the value that the product is to the customer.
As you have observed, the cost plus pricing method is one of the most basic methods of pricing and it is no surprise that it is also one of the more popular methods. However, it does have some major merits and demerits that you may have to consider before you select this approach.
On the next article, we will go into depth on the efficacy of this costing approach and why it may be or may not be the best fit for your company.