When you produce a product, it costs your company a certain amount of money.
When it comes to pricing, this “cost” serves as an anchor point for most pricing strategies. Because it costs money to produce a product, retailers and brands, understandably, want to have an end price that is more than that cost. If the end purchase price is lower than it costs to produce a product, the retailer or brand will lose money every time they sell that product.
This is where cost-oriented pricing comes into play, most notably a cost plus pricing strategy. In this article, we’ll cover cost-plus pricing and show you when it makes sense to use this strategy.
What is cost plus pricing?
Cost plus pricing is the most straightforward pricing strategy out there. Sometimes called a variable cost pricing strategy, variable cost pricing model, or even full cost pricing, this price method guarantees that you never lose money in a sale.
Cost based pricing is the foundation for any smart pricing strategy, and is both easy to calculate and apply to your assortment. There are only three steps involved in the cost plus pricing formula: determine how much it costs to produce a product, determine how much margin you want to make (also called the “markup,” meaning how much you mark the price up above the costs), then calculate the final price by combining these two figures.
“Markup” another word for the amount that you add onto the cost of a product in order to achieve your desired margin. Markups are expressed in percentages and currency amounts.
How to calculate markup percentages
Markup percentage is the percent amount that you add to the price for markup. To calculate a markup percentage, there is a markup percentage formula. All you need to do is subtract the cost of the product from the end price. Divide that number by the cost of the product, and multiply the result by 100 to find the markup percentage.
The retail markup calculation, also called markup pricing formula
Pros and cons of a cost plus pricing strategy
The biggest pro of a cost plus pricing strategy is that it’s simple: just calculate your costs per unit, decide how much margin you want to make and calculate a price based on this information. But this simplicity means that cost plus has a few major disadvantages in the world of variable pricing.
To start, it only considers internal variables in calculating a price, but doesn’t account for larger market influences in the pricing equation. Imagine you are selling a hair dryer, which costs you €10 to make. Say you want to make a 50% margin, in which case you’d add a €5 markup to the item on the market.
This is a great strategy, and you’re guaranteed to always make that €5 with every sale. But if you looked at other products on the market, you may discover that you can raise that price a little more. Below are the first two results that appear when searching for a hair dryer. The first is from Philips and is listed at €22.49 at MediaMarkt. The second is from Hema, and is listed at €20.
Even if you want to be the lowest price out of these three hair dryers, you’re still missing out on margin by only pricing yourself at €15.
Related: Price: The Most Important P in the Marketing Mix
The second major disadvantage to cost-plus pricing is that it isn’t flexible enough to keep up with the current dynamic market (especially if you are selling on Amazon or other fast-paced market places). If you only use cost-plus, your prices will never change with market dynamics. So, if the two hair dryers in the above example drop price unexpectedly, you may accidentally end up as the highest-priced option on the market, which can damage your price perception and lead to a reduced number of sales. Cost plus pricing also makes digital investments in things like electronic shelf labels, dynamic pricing, and pricing data like Pricewatch useless.
Finally, a cost plus pricing strategy doesn’t account for the times where you may WANT to sell items at a loss. Some examples of these kinds of strategies include end-of-season sales, clearance sales, Black Friday sales, penetration pricing strategies, or even times when global pandemic fundamentally alters retail.
Related: How the Coronavirus will Affect Retail
What to think about when using a cost plus pricing strategy
When you consider the cons of a cost plus pricing strategy, it’s easy to see why we at Omnia don’t advise cost-plus as the only strategy you use. Determining markup varies from retailer to retailer and category to category. There’s no standard markup pricing, and there isn’t any sort of markup pricing “formula” that can fit every retailer’s needs.
Instead, retailers and brands need to think about markup within the context of their market. There are two main considerations: stock rotation and strategic positioning.
Stock rotation
Let’s start with stock rotation. If you are in an industry that has fast stock rotation, you can get away with having lower margins on the products you sell. This is because you’ll sell a high volume of these products, meaning you’ll still make profit even if there isn’t a high margin.
If you produce or sell a slow moving product though, you’ll need to think about your markup differently: because you won’t sell a high volume of products (and because your products will take up valuable shelf or warehouse space for longer periods of time), you need to recoup the loss with a high margin. This is why luxury goods — like a timeless Rolex — come with high prices.
You’ll have to think about where your products sit on this spectrum when determining your markup.
Strategic positioning
Beyond thinking about stock rotation though, you also have to think about the product’s strategic positioning. In some cases, you may want to sell a product at a LOSS instead of a gain, in which case the cost-plus pricing strategy may not be relevant for you.
“Diapers are a great example of this strategic loss,” says Sander Roose, CEO of Omnia. “It’s well known within retail that diapers are not a profitable product. But smart retailers use this knowledge strategically. In many cases, they may run a sort of high runner strategy and sell the diapers at a loss, but with the ultimate goal of pulling families into the online shop. These families have bigger budgets, so retailers can easily make up for the loss on the diaper with other products.”
When to use a cost-plus pricing strategy
“I think a cost-plus pricing strategy makes sense for non-comparable products or own-brand products,” comments Sander. “If you can’t compare your product to anything in the market, or don’t have price elasticity data, then you can use cost plus to arrive at sensible prices for your products.”
A cost plus strategy may also be good as a fallback strategy or a “last resort” pricing strategy within your dynamic pricing engine. Cost oriented pricing can be an effective way to figure out the pricing floor for your dynamic pricing strategy. When you account for a certain amount of margin as your lowest price, you can still ensure that all sales will be profitable.
Final thoughts
The cost plus model pricing is easy to apply to your assortment, but it does have a few major disadvantages. That said, it’s a great starting point that you should use as your price floor in any dynamic pricing strategy you create.
Curious about other pricing strategies? Check out our series of different strategies, all linked below.
What is Value Based Pricing?: A full overview of how price and consumer perception work together.
What is Charm Pricing?: A short introduction to a fun pricing method
What is Penetration Pricing?: A guide on how to get noticed when first entering a new market
What is Odd Even Pricing?: An explanation of the psychology behind different numbers in a price.
Here’s What You Need to Know About Psychological Pricing (Plus 3 Strategies to Help You Succeed): Modern day pricing is so much more than a numbers game. When thought about correctly, it’s a powerful way to build your brand and drive more profits.
How to Build a Pricing Strategy: A complete guide on how to build a pricing strategy from Omnia partner Johan Maessen, owner of Commercieel Verbeteren.
