The Advantages and Disadvantages of Cost-Plus Pricing

The cost-plus pricing model has long been hugely popular across all business sectors. Like all pricing models, it offers various benefits but has some potential drawbacks. With that in mind, here is a quick guide to the advantages and disadvantages of cost-plus pricing.

What is cost-plus pricing?

The cost-plus pricing formula is very simple:

Cost of item + desired profit margin = price

Where costs are variable, the price may be adjusted to reflect these changes. Alternatively, the costs may be averaged over a time period (e.g. a year) and the price set to reflect the average cost.

Advantages of cost-plus pricing

The cost-plus pricing strategy is popular for a reason. Here are its main advantages.

Easy to calculate

This may be the single, biggest reason why the cost-plus pricing strategy has become so popular. The cost-plus pricing formula can be used by literally anybody with a basic knowledge of maths. In the modern world, that means it can be easily programmed into computers.

Clearly sustainable

Another major advantage of cost-plus pricing is that it keeps the focus firmly on costs. It therefore ensures that they are always covered. This may seem like an obvious point. In reality, however, there are many instances where companies choose to make a loss on products or services. 

Generally, this is intended as a relatively short-term strategy. It’s usually to gain market share either in established markets or in new ones. This is often known as penetration pricing. Over the longer term, this approach can be worthwhile. It is, however, inevitably higher risk than straightforward cost-plus pricing.

Easy to explain to customers

For many customers, it’s important to feel confident that they’re getting a fair deal for their money. They understand that products and services cost money to create. They understand that the businesses that create them need to make a profit. It’s therefore very easy for them to understand cost-plus pricing.

Straightforward way of testing new markets

Unlike many other pricing models, cost-plus pricing can be implemented without any in-depth market knowledge. For example, you don’t need to know anything about your customers or competitors. It can therefore be useful for testing the waters in new markets.

Disadvantages of cost-plus pricing

Costs-plus pricing does not work for every business type. In particular, it’s highly unlikely to be the best option for SaaS businesses. Here are its main drawbacks.

Can get complicated if you want to apply different margins to different products or services

This isn’t a huge obstacle to cost-plus pricing. Even so, it’s worth thinking about. Firstly, you need to decide how to make sure that the correct margin is applied consistently to each product or service. Secondly, you need to think about customer perception. They may be very interested to know why your profit margins are higher on some products and services than on others.

May miss out on opportunities to maximise revenue

Sticking to the cost-plus pricing strategy can cause businesses to miss out on opportunities to maximise their revenue. It can also discourage people from driving for greater efficiency. 

In a true cost-plus pricing strategy, lowering costs would also lower prices. This could deliver a competitive advantage. If, however, there is no (immediate) competitive threat, there is no (immediate) clear benefit to this.

May not reflect the true value of the product/service

This is probably the single, biggest reason why cost-plus pricing is avoided in certain business areas, particularly SaaS. When products and services can deliver significant value, customers are generally perfectly willing to pay for them. 

They may, however, also want to be given recognition for the value they are offering the business. For example, if a customer is willing to make a large up-front payment for a service to be delivered later, they may expect a substantial discount. Many businesses are perfectly willing to recognise this.

Does not necessarily reflect market conditions

The cost-plus pricing strategy is a very inflexible one. In particular, it does not acknowledge customer sentiment or changes in demand. For example, with cost-plus pricing, turkeys would be priced the same all year round. This would cause turkey farmers to lose out significantly over the Christmas period.

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