Getting pricing right can be the difference between a business surviving and thriving. If you price your products or services too low, you could miss out on valuable profits. But if you price too high, customers may look elsewhere.
There are many different approaches you can take to find the right prices for your products, and one of these methods is cost-plus pricing. In this article, we'll define cost-plus pricing and how to use it, with an evaluation of its pros and cons, as well as alternative methods of price setting.
What is cost-plus pricing?
Cost-plus pricing, also known as markup pricing, simply comprises adding a fixed percentage to the cost of making a product to arrive at its final selling price. This percentage is added on top of whatever price you would need to break even on a single unit or product.
Knowing where you stand with your markup and cost-setting is vital, as it'll give you insight into how much profit you'll generate once costs have been met. But some businesses need greater flexibility when it comes to their cash flow regardless. The American Express® Business Gold Card comes with no pre-set spending limit and payment terms of up to 54 days¹.
How to calculate cost-plus pricing
The cost-plus pricing formula enables you to work out the final selling price, or recommended retail price (RRP), of an item or service, based on what it costs you to make or deliver it and the profit your company needs to earn. Let’s take a closer look.
Cost-plus pricing formula
To use the cost-plus pricing formula, start by adding together all the costs involved in making or delivering your products or services. This includes raw materials, labour, packaging and shipping, as well as marketing and overhead costs, such as insurance, utilities and equipment. Then divide this figure by the total number of units you produce, to work out the costs of producing a single unit of product. From here, add a markup value based on what profit your business needs to earn.
Costs + Markup = Price
Jennifer Bailey, Chief Executive of footwear company Calla Shoes, adds a markup of between 65% and 70% to her products, which she works out by calculating her fixed overheads and then looking at what markup is needed to cover these. “This is the number calculated in order to make a profit, after all other costs come out, such as fulfilment, postage, packaging, warehousing, staff, insurance and marketing,” she says.
Cost-plus pricing example
Imagine you are a clothing retailer and you need to calculate the selling price for a new jumper. Here are the costs involved in producing a single jumper:
- Raw Materials: £10
- Labour Costs: £20
- Shipping: £5
- Marketing: £10
- Overheads: £5
The total costs of producing a single jumper are £50.
Let’s now say you want to have a markup percentage of 50%, which in this example is £25. To calculate the final selling price, otherwise known as the RRP, we can use the cost-plus pricing formula as follows:
Unit Price (RRP): £50 + £25 = £75
This gives you a selling price for each jumper of £75.
What is the difference between cost-based pricing and cost-plus pricing?
Cost-based pricing is an umbrella term for two pricing models that are based on the costs of producing a product. One of these is cost-plus pricing. The other is break even pricing. Break even pricing determines the price of the product based solely on the costs involved in producing it, without the addition of markup. It, therefore, sets a price where a business won’t make any profit from its sales. Companies typically use this model to offer low prices that enable them to gain market share or beat the competition.
Advantages of cost-plus pricing
A cost-plus pricing strategy enables business owners to calculate the minimum markup needed on their products or services to generate a profit. It provides a basic price that maintains profit margins across a range of products, notes Andrew Goodacre, CEO of the British Independent Retailers Association
“Cost-plus pricing is easy to calculate and it is effective, as long as the retailer understands all the costs of running the business, such as product costs, salaries and other expenses,” says Goodacre. Bailey agrees, noting that the simplicity of cost-plus pricing is particularly beneficial for smaller businesses, while also helping to keep pricing fair for customers.
Cost-plus pricing strategy considerations
“Retail is a fast-moving market and this is where a cost-plus pricing approach has limitations,” Goodacre says. For example, factors such as the consumer, competition and other market forces should be considered in pricing, so retailers should be flexible, he adds. “For some in-demand products, it might be that a higher price and margin is achievable, even for just a short period.”
Bailey for example, says she could likely charge more on certain products, such as white trainers, which means she may be losing out on potential profit. “But this goes against our business values where we want to offer maximum value for money for our customers,” she notes.
Alternative pricing strategies to cost-plus pricing
There are many different ways to price your product. Here’s a look at some alternatives.
Penetration Pricing
Penetration pricing is typically used by a new business or a business entering a new and competitive market. It sets prices very low in order to attract customers. However, it isn’t always sustainable in the long run and tends to only be used for a short time.
Competition Based Pricing
Here the focus is to use your competitors’ prices as a benchmark for setting your own. For example, you could set your prices slightly below your competition, the same as your competition or slightly above. If you operate in a saturated market, this strategy can be useful since small price differences can be a deciding factor for customers.
'Freemium' Pricing
This is where companies offer a basic version of their product to acquire users, in the hope that these users will eventually pay to upgrade. It is often used by software companies to give users an idea of how their product works.
Premium Pricing
This is when companies use high prices to present their products as luxurious or high-value. It is often focused on perceived value, rather than the actual value of the product or the costs involved in making them.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
