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Cost-Plus Pricing

Disciplines > Marketing > Pricing > Cost-Plus Pricing

Description | Example | Discussion | See also

Description

Price your goods and services by first working out how much it costs to make, then adding your profit margin to get your desired end price.

The cost to make something is made up of direct costs and indirect costs. Direct costs are those that can be attributed directly to the product, including materials used to make the product. Indirect costs are those which are the company incurs but which are harder to allocated on a per-product cost. For example lighting and rental costs. Indirect costs can be allocated by proportionately allocating them to products, for example with some formula that takes into account such factors as time to manufacture and holding costs.

Some costs such as the salaries of people involved in producing the product may be allocated either as direct or indirect costs, depending on how easily their time can associated with product production activity. For example a person working on an assembly line may have their wages allocated as direct costs. This is harder to do with people such as marketers or designers, for who an approximate proportion may be allocated as indirect costs.

Example

A software development firm prices their work based on the hours they work for customers, where the hourly price is calculated from the salaries of software engineers plus a contribution towards overheads.

A carpenter sells his tables based on the price of wood, his time and a percentage mark-up for the business.

Discussion

Some costs are easy to allocate to products, such as the material costs to make them and distribution costs in getting them to market. Other costs, such as electricity, the company Christmas party and the cost of the HR department are much more difficult to connect with individual products. And yet these other costs have to be covered through the price that you set.

In many ways, cost-plus is an honest way to determine prices, as it simply says 'I will charge what it costs me, plus a modest profit'. This may be acceptable when this is traditional, such as lawyers charging by time spent, or where there is little price competition. However, in many markets, customers have plenty of choice and base their 'value' decisions on a review of the prices that competing companies charge.

Using 'cost-plus' can also lead to inefficiencies within the company being ignored as any increase in cost is automatically passed on in the price that customers pay. In any case, if you plan on using cost-plus, do pay close attention to what your competitors charge and how your customers view and act upon your pricing.

See also

Types of Reasoning, Competitive Pricing, Expectation Pricing