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Cost plus pricing is one of the many pricing strategies employed by companies in an attempt to increase their revenue and profit.
The basic idea behind cost plus pricing is to base your prices on the cost of production plus your desired profit margin. This makes it a very simple and safe pricing strategy. Using this strategy, you simply identify a price that you know will be above your cost of goods sold.
However, while it may be simple and safe, and you can justify it to your team, whether customers will pay that price or it is the highest price you could charge is a different conversation.
In this article, we will look at cost plus pricing, the rationale behind cost plus pricing, how to calculate a cost plus pricing price, and the pros and cons of cost plus pricing.
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The rationale behind cost plus pricing
In a perfectly competitive market, prices are generally set by the market at the point where the short-run marginal cost equals the marginal revenue. However, in the long run, the marginal cost (i.e., the cost of the last unit produced) tends to overlap the unit cost (i.e., the average cost of all units), so in that case cost plus pricing tends to reach the same price point as the one found in a competitive market.
Where cost plus pricing is found commonly is in larger one-off contracts. For example, a car mechanic might use cost plus pricing for replacement parts when doing work on a car, while a general contractor might use cost plus pricing when drawing up a contract for a house renovation.
This is because, in cases where the cost structure is transparent to customers—for example, where you can find the contractor price of lumber at a local hardware store—the cost plus structure is seen as fair and reasonable.
The price has two main elements: the cost to the supplier and the supplier’s markup. This leads to simple negotiations where the basement price is baked into the negotiable range—the supplier isn’t going to accept cost-minus pricing—and the ceiling is the supplier’s desired markup.
For example, if a supplier is offering a cost plus 30% pricing scheme, instead of broad price negotiations, the customer is already restricted to the 30% portion of the price. If the customer manages to knock 20% off the margin, they’ve only actually reduced the price by less than 5%. While the customer may feel like they’ve gotten a big win, the final price is still acceptable to the supplier who is guaranteed a positive margin.
In markets with a lot of competition, especially where every company is seen as essentially the same, companies do not have a lot of room to increase prices or set prices using a different pricing strategy.
In these cases, a company can essentially collude with its competitors by following the industry standards when choosing its desired markup. Without putting too much time into researching the potential customers’ willingness to pay, the market structure, etc., a company can choose a safe, reasonable, and fair price.
The Cost Plus Calculation
The cost plus calculation has two parts. First, you need to figure out the cost of your product. Second, you need to multiply that cost by your desired margin. We will take a look at an example below, but first let’s go through the mechanics behind these calculations.
Mechanics
The cost plus pricing system can be broken down into three steps: calculate the total cost, calculate the unit cost, and add the markup.
Step 1: Calculate the total cost
There are two types of costs: fixed costs do not change based on the number of units produced, while variable costs do.
Total cost = fixed costs + variable costs
Step 2: Calculate the unit cost
The unit cost is simply the total cost divided by the number of units produced:
Unit cost = total cost/number of units
Step 3: Add the markup
The markup is the amount you wish to earn on each product or service sold. It is usually considered a percentage, but here this needs to be made a dollar value:
Markup = unit cost × markup percentage
This is then added to the unit cost to come up with the final selling price:
Selling price = unit cost + markup
Note that the markup percentage needs to be converted to a decimal for the first half of this step. You can also combine them by adding 1 to the value of the markup percentage expressed as a decimal. For example, a 30% markup can be written as 0.3, and plus 1 it is 1.3.
Example
Your company has fixed costs of $20,000, variable costs of $4,000, and sells 2,000 units. Your desired margin is 50%.
Your total cost is $20,000 + $4,000 = $24,000.
Your unit cost is $24,000/2,000 = $12.
Your selling price is $12 × 1.5 = $18.
In SaaS, the cost structure is generally broken down a bit differently. CAC (customer acquisition cost) and ACS (average cost of service), how much it costs to get a customer signed up (the marketing and advertising costs) and how much it costs to provide their service monthly, respectively, tend to be how costs are calculated.
Both can have fixed and variable costs. For example, ACS includes the variable costs of hosting and maintaining the platform as well as the amortization of the cost to develop and test the platform, which is a fixed cost.
The cost plus pricing system can still work, but you’ll need to figure out the average lifetime of your contracts, calculate the total cost, then figure out a desired markup, and finally get to a LTV (lifetime value) that matches the cost plus strategy.
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The pros and cons of cost plus pricing
As with all pricing strategies, cost plus pricing has its pros and cons.
1. Advantages of cost plus pricing
The following are some of the advantages to using the cost plus pricing method.
i. Simple
Since you should already have a handle on what your expenses are and the margins you need to maintain a growth trajectory, cost plus pricing is an easy way to set your prices.
ii. Assured contract profits
Since costs are built into the pricing structure, every contract will be profitable.
iii. It takes few resources
This strategy doesn’t require anything in the way of market research or a review of competitor prices, so it is a cheap way to set prices.
iv. It provides a consistent rate of return
Since you put your desired margin at the heart of your pricing decisions, you know your approximate rate of return will remain stable.
2. Disadvantages of cost plus pricing
The following are some of the disadvantages of using the cost plus pricing method.
i. Ignores competition
Without consideration of competitors’ prices, there is a good chance you are charging way too much or way too little. While the former will leave you with no customers, the latter will be robbing you of higher profits and the cash flow needed to expand.
ii. Contract cost overruns
Suppliers have no incentive to work efficiently, so, while cost plus pricing might look reasonable to start, overruns often occur and the final price ends up higher than anticipated.
iii. It’s inefficient
Since all expenses are built into the price directly, your company is unlikely to operate lean. There is no reason to reign in unnecessary expenses.
iv. It doesn’t consider consumers
If your consumers aren’t privy to your internal cost structure, then cost plus pricing means little to them. A consumer would rather pay based on the value you give them than the cost you incur during production.
Evaluation of Cost Plus Pricing
While cost plus pricing is popular in certain markets, in others it won’t work. For SaaS, it is a reasonable way to internally define the minimum price you are willing to accept, but your customers will care little about the cost of providing your services.
Baremetrics is the obvious choice for SaaS businesses seeking to better track their revenue while making major pricing strategy changes.
If you’re looking for a smarter way to approach your SaaS business’s revenue performance, get in touch or sign up for the Baremetrics free trial today.
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