Cost plus Pricing (CPP) is probably the most suited pricing strategy for most small business startups. It’s also the most widely strategy used by businesses all around. This is so, because CPP is the simplest method of determining price, and it embodies the basic idea behind doing business.
That is, “you make something, sell it for more than you spent making it (because you’ve added value by providing the product)”, according to Vivian Guo, of Price Intelligently.
The Balance Small Business defines Cost plus Pricing as follows: “Cost-plus pricing, also called markup pricing, is the practice by a company of determining the cost of the product to the company and then adding a percentage on top of that price to determine the selling price to the customer.”
How do you calculate Cost plus Pricing?
Rosemary Carlson explained in The Balance the steps needed to calculate a cost plus price for your products:
- Determine the total cost which is the sum of the fixed and variable costs. A fixed cost is a cost that does not change with an increase or decrease in the amount of products you produce or sell. An example of a fixed cost is rent. On the other hand, variable costs change as the quantity of products you produce or sell changes. An example of a variable cost is packaging.
- Divide the total cost by the number of units to determine the unit cost. A unit cost is the price incurred by you to produce, store and sell one unit of a particular product.
- Multiply the unit cost by the markup percentage to arrive at the selling cost and the profit margin of the product. Here an amount of money is added to the unit cost price of the product that will be your profit. You may decide to use your target profit margin to determine your selling price. In other words, if your target profit margin is 30%, you’ll multiply your unit cost price with 1.3 to arrive at your selling price.
The advantages and disadvantages of Cost plus Pricing
The main advantages for using CCP are according to The Economic Discussion the following:
- It offers a price stability for your business if your costs stay stable over prolonged periods;
- The cost-plus formula is simple and easy to calculate;
- CCP helps you to guard against making losses. Indeed, if you find that costs are rising, you can take appropriate steps by variations in output and price.
- You can use CCP when you’re unable to forecast the demand of your product;
- If you find it difficult to gather market information for the product, using CCP will be a good starting point;
- If you don’t know how many competitors you have, or how big they are, the using Cost plus Pricing is the answer.
The disadvantages of Cost plus Pricing (Accounting Tools):
- PPC ignores competition. As a result, you may end up pricing too low and giving away potential profits, or pricing too high and achieving minor incomes;
- Product cost overruns. Using PPC, there is no incentive for a business to design a product that has the appropriate feature set and design characteristics for its target market. Consequently, they may simply design high cost products that the market doesn’t want.
- Contract cost overruns. For example, if you hire a supplier under a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures. Unfortunately, this many times leads to ‘loading’ the cost unnecessarily – that you have to pay. Therefore, a contractual arrangement should include cost-reduction incentives for the supplier.
- PPC ignores replacement costs. This pricing strategy is based on historical costs, which may have subsequently changed. However, the most immediate replacement cost is more representative of the costs incurred by the entity.
Although the Cost plus Pricing strategy ignores mostly what is happening outside the doors of your business, it’s a logical starting point. At the very best CPP will prevent you selling your product at a lost. Sadly, at CCP’s worst, you won’t sell a single product – because your competitors know better what consumers in the market are willing to pay for the product.