Pricing is challenging. Doing it well often blends concepts from diverse fields such as psychology, finance, marketing, statistics, and even calculus. Facing such complexity, some managers use an outdated, yet convenient approach called ‘cost-plus pricing.’
While ‘cost-plus pricing’ quickly generates an answer, it’s like a frozen TV dinner. Microwavable meals are convenient, taste fine and may even include frozen peas so you can cross ‘eating vegetables’ off your to-do list. However, its processed salty ingredients are far from the ideal staple of a balanced diet. Like TV dinners, ‘cost-plus’ pricing offers an alluring convenience while falling short of the mark.
What is cost plus pricing?
Cost-plus pricing is the approach of calculating price by starting with costs and adding a desired profit margin. For example, if I’m selling frozen microwavable dinners (this metaphor is working overtime!) and they cost me $2 to make, a cost-plus pricing approach adds a margin to my costs. Maybe I’d solve for a 50% margin and add $2 to my costs to price the product at $4.
Easy frozen peasy! Not so fast…
Why you shouldn’t use cost-plus pricing
While cost-plus pricing solves for the profit margin you want, it doesn’t consider customer perception of value. This method can lead you astray by causing you to unknowingly charge more than what a customer is willing to pay. The customer won’t change their mind about your high price simply because you called shotgun on your preferred margin. If your ‘cost-plus’ price is above a customer’s willingness to pay, you’ve lost the sale.
Second, what if your cost-plus price is far below a consumer’s willingness to pay? While consumers will likely still buy, you’re leaving money on the table. Even worse, research shows that low prices can cause some customers to question the quality of your product. This not only risks lost profits, but it can hurt the long-term value of your brand.
Lastly, cost-plus pricing is playing checkers when you should be playing chess. Pricing offers a valuable strategic tool when leveraged to its full capacity. For example, you can estimate how a customer values your product, target different priced packages to different customer segments, and use price to signal where your product sits in the marketplace. While these levers only scratch the surface, cost-plus pricing provides an inadequate framework to address them.
Use value-based pricing
The better approach is value-based pricing. Value-based pricing starts with the value your product creates for customers and builds from there. It entails understanding customer segments, their alternatives, and forecasting the relationship between price and quantity.
While value-based pricing doesn’t start with profit margin, you can and should reconcile customer willingness to pay against your margins and financial strategy. The difference here is that you’re starting with customer value and then aligning price against your financial goals, versus focusing exclusively on your margin.
So put down the pricing version of a microwavable frozen burrito and consider a more fulfilling, delicious financial diet of value-based pricing.
