Choosing a price for your products is a big decision; it determines your ability to attract customers, what products you sell, and, ultimately, how profitable you will be.
By developing a strong pricing strategy, you can enhance your business' competitiveness and earn more sales.
The simplest approach to product pricing is the cost-plus model. To determine a selling price, you add a percentage markup to the total cost of your product. While this strategy can preserve a nice profit margin per sale, it has some drawbacks as well.
Find out if cost-plus pricing is right for you by analyzing the pros and cons, considerations, and real-life examples in this article.
Table of Contents
What is cost-plus pricing?
Cost-plus pricing, also known as markup pricing, involves calculating total costs, then applying a markup percentage to those costs to reach an asking price. Retail brands aim for a 30 - 50% profit margin.
How to calculate cost-plus pricing
Before you can successfully implement a cost-plus pricing strategy, you need to understand the cost plus pricing formula.
Cost plus pricing formula
Calculating cost-plus pricing is simple. Take your total fixed and variable costs (labor, manufacturing, shipping, etc.), and then add your profit percentage. Here’s the formula:
Cost + Mark up = Price
Cost-plus pricing example
Say you’re starting a retail store and want to figure out pricing for a pair of jeans. The cost of making the jeans includes:
- Material: $10
- Direct labor: $35
- Shipping: $5
- Marketing and overhead: $10
Cost-plus pricing involves adding a markup–let’s say 35%--to the total cost of making your product:
Cost ($60) x Markup (1.35) = Selling price ($81)
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Advantages and disadvantages of a cost-plus pricing strategy
Cost plus pricing has its share of pros and cons. Let's look at the advantages and disadvantages of this pricing strategy.
Advantages of cost-plus pricing
- Simple to figure out. You already track production costs and labor costs. Setting the price is just a matter of adding a percentage for profit.
- Easy to justify. No price gouging here. The cost-plus pricing system is fair and non-discriminatory. If you must apply a price increase, it’s only because the cost of production and/or direct materials went up.
- Consistent rate of return. When costs stay the same, you can ensure that every sale covers your costs. Revenue and profit can be estimated easily.
- Good to test the market. Cost-plus pricing is a great way to determine how much a customer will pay for your product. When starting a retail business, you don't have enough data to determine your pricing strategy. You can start with cost-plus, get a feel for the market, and refine your pricing strategy from there.
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Disadvantages of cost-plus pricing
- Dependent on costs. One drawback of cost-plus pricing is potential profit loss. If you switch suppliers or get cheaper materials, your costs will get lower. Strictly cost-plus pricing would require you to lower your selling price. If consumers are willing to pay more for the product, you’d be missing out on revenue.
- Doesn’t take trends and external factors into account. If you sell a trending product, you can charge more. If you're only considering cost, you're limiting your revenue. For example, True Religion's Super T Jeans, a popular upscale denim pant, cost $50 to make, and retail for around $260— a 520% markup.
- Doesn’t take customer willingness to pay into account. If shoppers don’t think your product is worth the set price, you won’t make sales. Cost-plus pricing doesn’t respond to competitor prices or consumer demand.
Alternative pricing strategies
Your pricing strategy, then, is based on your target audience, their willingness to pay, and what your competitors charge for similar products. Retailers often test and change their pricing over time, depending on variables such as demand and market conditions.
Other pricing strategies to try include:
- Value-based pricing. With value-based pricing, customer opinion, rather than the product’s cost, determines a product's price. Value-based pricing works best for companies that sell unique, high-value products, rather than commodities like groceries.
- Penetration pricing. Retailers will launch a new product at a lower price to gain market share. To get people in the door, brands are willing to trade off a certain amount of profit for increased customer awareness.
- Keystone pricing. You arrive at keystone pricing by simply doubling the wholesale price of the product. Retailers use it because it's easy to implement and creates a healthy profit margin.
- Competitive pricing. By using competitor pricing data as a benchmark, you can intentionally lower the price of your product. This tactic works well in industries where price is the only differentiator, and you rely on it to win customers. It can work well if you negotiate a lower unit cost from suppliers, thus cutting costs, and promote your special pricing.
- Manufacturer suggested retail price (MSRP). The MSRP is what a manufacturer recommends retailers charge when selling a product.
Top considerations for cost-plus pricing
- Elastic demand
- Competitive landscape
Let's examine each of these considerations individually.
Cost-plus pricing isn't for everyone. Clothing and grocery industries often use it since they sell a variety of merchandise, and each product can have a different markup percentage. For apparel brands, it’s an easy way to communicate transparency with potential customers.
Clothing retailer Everlane takes transparency to a new level. Its website shows exactly what it costs to make each garment and how much profit they make.
Notice how the brand only applies a 2-3x markup, compared to the industry average of 5-6x. Everlane doesn’t price gouge customers and uses cost-plus pricing as a competitive edge.
When a good's price affects consumer demand, it's called elastic demand. When the price drops, people buy more. When the price goes up, they buy less. If you’re using a cost-plus pricing strategy, you want to apply it to products with low elastic demand.
Fast-fashion clothing, for example, has low elastic demand. There are many types of clothing people will wear, and they can jump from one brand to another at the slightest change in price. Trending products, however, have more elastic demand because consumers will spend more for them than for out-of-trend products.
If your product is less elastic, such as a white, regular fit t-shirt, you might consider a cost-plus pricing strategy. The price of core items like this is unlikely to change, so you won't lose revenue. Other items that are less elastic include polo t-shirts, jeans, and socks.
Products that are trending or limited-edition, on the other hand, require a different pricing strategy. Say you're reselling the Gucci x Balenciaga The Hacker Project Cap, you can earn more revenue by pricing based on hype and availability.
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Considering competitors' prices is an essential part of any pricing strategy. The best way to determine cost-plus pricing is to see what your competitors charge for similar goods.
If they sell a high-margin product, there's room for competition; there's no evidence that competition drives prices down. Using a cost-plus pricing strategy here is easy, because you can charge less than your competitors and still make money.
The opposite is also true: If your competitors are selling at low margins and your calculated selling price is high, you must decide if you have the competitive advantage to charge more. Alternatively, determine whether you can produce products at a lower cost to make your prices more competitive.
Is a cost-plus model right for your business?
A cost-based pricing model is clearly beneficial for small retailers. By adding a simple markup to your total costs, you can determine a selling price for a product that yields your desired profit margin. While the cost-plus method has a few drawbacks, a little market research will tell you if it's the right pricing strategy for you.
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