Episode #0004 - What Is Cost Plus Pricing?

In this episode of Pricing College - Aidan and Joanna discuss what cost plus pricing really is?

We do not focus on the weaknesses or potential negative impacts of cost plus pricing but introduce the topic.

Cost plus pricing can be as simple as adding a mark up or margin to your costs.

It can be as simple as buying an apple for a dollar and selling it for two dollars.

Cost plus pricing can be very appropriate for simple trading or arbitrage style businesses or for simple retail businesses.

Cost plus pricing tends to be popular with finance professionals as it is easily understood and gives the appearance of common sense and financial rigour.

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In today’s episode we want to cover that seemingly,  very simple question but something fundamental in pricing; What is cost-plus pricing?

A lot of businesses used cost-plus pricing. It’s a very common price-setting method and technique. We won’t go into a lot of detail about the weaknesses of cost-plus pricing but we will discuss what it is.

I think certainly the obvious flaws or problems potentially with cost-plus pricing is something we’ll cover in not one future episode but I assume many. But what we’ll cover today is the pluses of it, how it’s done, and why this is seemingly very efficient and make sense to so many people. 

I supposed in a very simple way it’s a mark-up on your cost; fixed and variable cost. 

Some people say a mark-up, other people try to capture a certain margin but fundamentally it means if you buy an apple for $1 you sell it for $2. You make a profit on each item you sell and at the end of the day, that’s a very sensible business. As you get more complex in business you may not want to make the same profit on every apple but, if you’re selling a thousand apples on average you want to make a profit on each one you sell 

Yes. If you’re pretty confident about your cost position then cost-plus makes sense. It’s just perhaps when markets change, it becomes a little bit more tricky but we won’t get into that right now. 

Fundamentally, cost-plus pricing makes sense in a very simple business that could be a trading business; An arbitrage style business when you buy a commodity and sell it with very limited value add. In that context, if you’re a price taker from purchasing it can make perfect sense. Especially if you have limited ability to influence the price you are selling it out. 

I supposed it’s not about a technique to use. It may be in a retail business as well. In a small retail business you've got relatively few products that you’re selling,  you know your cost. It’s not about approaching your first step into setting prices. 

I think also in this episode, we’d like to cover why is it so popular and why is it so accepted in the business community, and often if you talk to people who are not pricing professionals cost-plus pricing is what springs to mind. I’ll go first in this one because I am an accountant patriot previously and it does appeal to accountants and financial professionals who love looking at cost, P&L and balance sheets. 

In many regards, I think it’s used because it was the first pricing method that ever existed. Makes 99% of the businesses use cost-plus pricing. That’s what people are used to and maybe it’s used because it’s a tradition; a management convention, and some people don’t know that there are other things out there too. I don’t know. Aidan, you’re the accountant, what do you think? 

Thanks for reminding me and I supposed in accountancy people, there is a real dedication to numbers and the seeming solidity that numbers give. So if I see your grills, the CFO wants to know why decisions are being made and basing things on a cost-plus method gives a solidity that makes it seem sensible. Certainly to people who do not have a marketing sales approach or mindset and of course without trying to bash certain professions here. Certain professions are more focused on you know value marketing sales and others; and yeah I think that’s fundamentally it. 

What appears to be quite a rigorous logical approach, is that what you’re saying?

It’s the appearance of a rigorous approach whether that makes sense or not I don’t think matters but, I think we’re straying into some negative territory which I think we leave for a future episode. 

It’s good to find out where this convention started and why people are so dependent on it and I don’t think that’s a negative