Cost-plus pricing is a lot like the romance novel genre, in that it’s widely ridiculed yet tremendously popular. Almost every manager I know will claim they hate pricing based only on costs. Yet cost-plus pricing remains the most widespread pricing method, used to price everything from a bottle of beer in a bar to multibillion-dollar infrastructure projects.

The idea behind cost-plus pricing is straightforward. The seller calculates all costs, fixed and variable, that have been or will be incurred in manufacturing the product, and then applies a markup percentage to these costs to estimate the asking price. The markup is stipulated by the buyer, as is often the case with government contracts, or it can be chosen by the manager. (I have seen companies use markups ranging from 5% to 800%.)

Cost-Plus Pricing Has Justifiable Drawbacks

Among pricing experts, cost-plus pricing is reviled for some legitimate reasons. For stand-alone projects in particular, cost-plus pricing discourages efficiency and cost containment. When lower costs are quoted, the company earns lower revenue and total profit. A bloated cost structure, on the other hand, will raise prices and boost profit.

A second important deficiency arises from the fallacy that a cost-plus price is guaranteed to cover costs. This notion can make managers falsely complacent. In reality, because sales volume often has to be guesstimated beforehand, and fixed costs allocated to each unit based on that forecast, the cost-plus price can easily be too high or too low, resulting in a devastating miscalculation. Cost-plus prices provide no guarantee of covering costs or earning a profit.

Third, the cost-plus pricing calculation ignores both the customer’s willingness to pay and the competitors’ prices. When these factors are ignored, a pricing decision can be completely off base. For example, a competitor may enjoy a formidable cost advantage, in which case the company’s cost-plus price will be too high to be effective. In another case, a customer may be willing to pay far more, in which case the cost-plus price will be too low, letting profit go uncaptured. Value-based pricing, which explicitly accounts for these factors, is in vogue and is esteemed by many managers.

The Strategic and Tactical Benefits of Cost-Plus Pricing

Despite these limitations, there are sometimes strategic and tactical reasons to use cost-plus pricing. When implemented with forethought and prudence, cost-plus pricing can lead to powerful differentiation, greater customer trust, reduced risk of price wars, and steady, predictable profits for the company.

No pricing method is easier to communicate or to justify. Cost-plus pricing is inherently fair and nondiscriminatory to customers. What can be a more reasonable explanation for a price increase than to state, “Our input costs went up by 8% this year, so we are raising our prices by 8%”? Clothing retailer Everlane goes even further, using cost-plus pricing to make its value proposition of “radical transparency” come alive. For every garment it sells, Everlane provides a detailed breakdown of costs for materials, labor, duties, and transport, along with its markup. This way, customers can easily verify Everlane’s emphasis on paying fair wages to workers manufacturing its garments and actively endorse this company value by buying its products.

Cost-plus pricing is the very antithesis of value-based pricing, which seeks to discover differences between customers’ economic valuations and to exploit them by customizing prices. Just consider the consumer outrage generated by Uber’s surge pricing, Coca-Cola’s dynamic vending machine pricing based on outside temperature, or the variable rate pricing of electric utilities. In all these cases, many customers saw the seller’s value-based pricing moves as nothing more than gouging. Cost-plus pricers don’t face this risk. Sure, they may underprice their products for some customers, but they will sleep peacefully at night knowing customers consider their prices to be fair.

Another pragmatic benefit of cost-plus pricing is that it is simple to implement. Every frontline retail employee or bartender with a calculator can apply a markup percentage to wholesale costs and calculate the asking price, something that many mom-and-pop stores and bars appreciate.

If the major competitors in a market use cost-plus pricing, it stabilizes price levels. The amount of risk associated with pricing decisions is lowered for all players. Prices remain relatively stable, particularly when the higher-cost suppliers in the market offer higher-quality products and when lower-cost sellers offer lower-quality products. Companies are less likely to engage in price wars if they base their prices mainly on costs instead of competitors’ prices.

Cost-plus pricing can encourage shoppers to use factors other than price in buying decisions. When most of us walk into a discount mega-store, we expect to find low prices with lower service quality to match. By contrast, we expect higher service quality and more upscale and expensive products in high-end stores. When consumers believe prices reflect cost, they are more likely to factor quality into their decision, instead of just buying whatever’s cheapest.

A final and significant virtue of cost-plus pricing lies in executing a cost leadership strategy. When the company has unique competencies that allow for an advantageous cost structure relative to competitors, it can use cost-plus pricing to create and deliver the most enticing value proposition of all. It becomes a cost leader, and its low costs, the resultant low prices, and superior customer value become an integral part of its brand identity. Costco has maintained market leadership for decades by using this principle. The company mandates that nothing in its stores will be marked up by more than 14% (15% for its private-label products). It widely publicizes this pricing policy. When coupled with other cues such as a spartan store environment, limited assortments, and bulk buying, its cost-plus pricing creates a powerful image that the customer is going to get great deals at Costco.

Despite the ridicule heaped on it by managers, there is a gritty common sense and logic associated with cost-plus pricing that is difficult to dispute. For companies with a cost advantage or an interest in using price transparency as a differentiator, cost-plus pricing is a powerful strategic tool. For sellers interested in conveying that their prices are fair and building customer trust, cost-plus pricing is an effective tactic. In the herd-driven frenzy to adopt value-based pricing, managers shouldn’t throw out the cost-plus baby with the bathwater.

from HBR.org https://ift.tt/2uzCPCb