Cost Plus Pricing Strategy

In the series of articles, we are going to cover different pricing strategies one of which is Cost+ pricing.

What is pricing strategy? Pricing strategy is a business procedure that is applied when selling a product or a service. It determines the price business set for their products. To pick the right strategy, the company's pricing segment, pricing capabilities, pricing position and many other aspects has to be consider. Price defined by pricing strategy reflects different goals of the company such as the amount of profitability to be achieved (usually we are trying to maximize it), increase in market share, defending of existing market from competitors be it already established competitors or the ones entering the market. Pricing strategy could be a double-edged sword, though. Define it correctly and the business is going to flourish. Define it poorly and the business could be on its knees in a long run. It's imperative to choose the right strategy and have a tool where different strategies or combination of the strategies can be algorithmically defined and executed by the business people. Ideally in free style manner with ability to execute different pricing strategies at different points of time.

Let's get back to Cost plus pricing method.

It is a pricing strategy that in ideal world ensures that costs are covered while providing profit for the business. It is often determined by adding a fixed mark-up to unit cost of production or average costs of production, hence sometimes called markup pricing as well.

Cost of a product is a sum of direct material cost, direct labor cost and overhead cost that the business is paying for offering the product. Let's oversimplify and assume we are in the car industry and producing the cars. The direct materials or raw materials are materials such as steal, glass, rubber, plastic. Direct labor can be tracked down to individual units of the production of the car. Overhead are all costs that are not direct material costs or direct labor costs. For instance indirect labor costs are wages and benefits paid to employees who do not get into direct contact with the product itself, supervisors, managers, security personnel or even research and development or marketing. Indirect material may be part of the product, but cannot be directly traced to particular product and as such is allocated evenly across all cars produced; for instance glue for smaller parts.

Having the total unit cost of the product we can add the mark-up. Markup is a percentage we are adding to the total unit cost of a product and it represents gross profit margin. It's the difference between what are the costs of the producing the product and the final price that is accepted by the customer. The percentage can be set freely, but don't forget there is competition on the market and the mark-up is to some extent standardized per industry sector. In restaurant industry mark-up is about 60 percent with some beverages going as high as 400-500%. Retail grocers are around 10-15% , clothing can go as high as 100-300%. Pharmaceuticals can have as much as 5 000% mark-up which for a lot of people is too much and pharma companies are being criticized for it (highly effective hepatitis C drug Sovaldi at $84,000 per treatment course as example with unit cost of hundreds of dollars)

Break-even point is an amount of money the product has to be sold for to cover all costs of providing and manufacturing of the product. Indirect costs (fixed) have to be paid no matter of what the sales volumes are. They remain typically consistent regardless of volume of items produced.

Example:

Car glass producer has following costs associated with manufacturing of the front windscreen glass.

Cost of material: 90$

Direct labor: 140$

Cost per glass panel: 230$

Total fixed costs: 3 500 000$

For 10 000 windscreens, the break-even price is:

BEP = (3 500 000 / 10 000) + 230 = 580$

For 20 000 windscreens, the break-even price is:

BEP = (3 500 000 / 20 000) + 230 = 405$

For 30 000 windscreens, the break-even price is:

BEP = (3 500 000 / 30 000) + 230 = 346$

For 40 000 windscreens, the break-even price is:

BEP = (3 500 000 / 40 000) + 230 = 317$

Break-even price declines as the volume of product units goes up.

It makes sense to watch the break-even costs for different volumes and adjust price strategy accordingly. One strategy that can be used to repulse new competitors in the market, or drive the current competitors out of the market is to set the price of the product at break-even or a little bit higher above it.

Cost+ pricing advantages:

- simplest method for setting up the selling price of the product

- suppliers love it as it essentially guarantees sales with agreed profit percentage

- as the costs change, it is easier especially for suppliers to justify increase in price of delivered products

Cost+ pricing disadvantages:

- it might not encourage suppliers to optimize product costs

- it might be problematic to keep the costs down

- it's not considering competition

- it doesn't consider any measure of demand for products. That's where price elasticity is sometimes being applied