The Certainty of Cost Plus Based Pricing Can Limit You
Many small businesses deploy cost plus based pricing as a key pricing strategy in their business. It is an easy, simple to understand pricing strategy but just like every pricing strategy it has its pros and cons.
So, what is cost plus based pricing? Simply, cost plus based pricing, is where you take your actual costs, whether that be materials, subcontractors, labour, equipment, etc. to build a product or provide a service and once you have that cost, you apply the margin on top and that is the price you give to the customer.
So, let’s start with the pros of this pricing strategy:
- Easy to understand – It’s the least time-consuming pricing methodology for businesses, as you don’t need to do extensive market research or collect data before setting your prices. You can simply add your costs and mark up the price by a certain percentage (or even add another fixed amount). This makes Cost Plus Pricing perfect for small businesses that don’t have much time or money on their hands–and it’s easy enough for customers who aren’t familiar with more complex pricing methods like Margin-Based Pricing or Break-Even Analysis.
- Guarantees a full coverage of costs – This pricing strategy ensures that a business is able to cover their actual “out of pocket” costs, in providing the product or service and guarantees at the end of it, they will make a profit on the work they have performed. There is little risk assumed by the business in that one transaction, so it can appear to be a desirable strategy.
- Avoids the risk of unknown information – In some situations, it can be difficult to provide a price if there is unknown information prior to starting the work. Examples of unknown information can be; opening up a structure in doing a renovation, volatility in a supply market, volatility in the weather, etc. When there is too much uncertainty in providing a firm price, a cost-plus based pricing strategy can take the risk away and can be the most advantageous approach for both parties.
Of course, there is generally the flip side of the coin, so lets now look at some of the cons:
- It can make you inefficient – With a guaranteed rate of return, there is little incentive to drive a level of efficiency and in fact, the more you cost, the better your margin on a job. In the short term, that guaranteed margin can be a good thing, however without the drive to be competitive, before long you may find it difficult to be competitive in the marketplace.
- Lost opportunities – In some cases, the customer is not looking for a cost-plus price where they take the risk to “trust” you to make sure you are doing the work as efficiently as possible, with the lowest cost. They want you to share in the risk and therefore they want a firm price. Back to the previous point, to be able to provide a price on those opportunities, you need to know you are competitive with the market or not bid on that type of work. Either way, there can be lost opportunities.
- Ignoring the value to the customer – Cost plus based pricing does not take into account the actual value of a product or service to the customer. In various situations, the customer is willing to pay far more than simply the cost of product or service. They are willing to pay a premium for things like reputation, schedule certainty, experience and with a cost-plus based strategy, these things are ignored and so are the profits that can be earned in leveraging these.
Cost plus based pricing is a great tool for businesses to use, but it does have its drawbacks. If you are looking for a way to price your products and services that will provide you with the most profit as well as give customers what they want, then you might consider looking at the other strategies available.
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