Determining the appropriate selling price of products is an important decision for businesses as they look to attract customers, fuel growth and maximize profitability. While some companies may opt for dynamic pricing — which involves adjusting the price of a product or service based on external factors, such as customer demand, competition and market conditions — sometimes a simpler approach can serve a business better.
Cost-plus pricing, also referred to as markup pricing, is a straightforward pricing strategy that involves calculating the selling price of goods and services by adding a specific markup amount to the total cost of producing the items. It’s incredibly simple: There’s no need to conduct a competitive market analysis or study historical sales data. All a company needs in order to calculate its cost-plus price is a solid understanding of the total cost of producing a product or service.
However, the pricing strategy does have its pitfalls. This guide explains the cost-plus pricing formula, how it stacks up against alternative pricing strategies, when companies may want to consider using the method and best practices for getting the most out of this pricing tactic.
What Is Cost-Plus Pricing?
With cost-plus pricing, a company determines its price by adding a fixed markup to the total costs involved in bringing a good or service to market. The markup is usually calculated as a percentage of the total costs, though, in some cases, businesses will set the markup as a fixed amount.
Cost-plus pricing doesn’t typically consider market factors, such as seasonal demand, competition or a customer’s willingness to pay. As a result, the pricing strategy may not give a company the ability to flexibly respond to market trends or varying costs the way other methods, like value-based pricing, can. Nevertheless, cost-plus pricing may allow a company to set its markup percentages in line with industry norms and consumer expectations, as well ensuring a consistent margin across their products.
Cost-plus pricing is a tried-and-true method for many types of companies, both large and small. The strategy is popular with retailers, including grocery and apparel stores, as well as small mom-and-pop shops, large government contractors and manufacturers that sell products in bulk at relatively predictable fixed costs. In many cases, businesses will assign a variety of markup percentages to the different products they sell.
Companies that shy away from this strategy tend to do so if they feel that a set markup doesn’t give them the flexibility to adjust pricing to account for fluctuating demand or intense competition. Customer perception isn’t a factor in cost-plus pricing. Additionally, companies that suspect customers would be willing to pay far more for their offerings than a standard markup may opt for alternative pricing strategies.
Key Takeaways
- Cost-plus pricing is calculated by adding a markup to the total cost of bringing an item to market. The markup is usually calculated as a percentage of the costs, with typical retail markups ranging between 30% and 50%.
- Many consumers prefer the transparency of cost-plus pricing, so businesses may find that using the strategy boosts customer trust in brands.
- One of the biggest mistakes companies make when using cost-plus pricing is basing the calculation on inaccurate cost totals.
- While cost-plus pricing provides reliable rates of return, businesses may run the risk of overpricing or underpricing their products and services when using this strategy.
Cost-Plus Pricing Explained
Straightforward and easy to calculate, cost-plus pricing is a strategy that doesn’t take into account a variety of external factors, including competitors’ prices and market analytics, to determine selling prices. The price of a product is calculated by simply taking the costs of creating the product, including labor, materials and overhead costs, and adding a fixed percentage markup on top of that. That markup figure is then added to the total cost to establish the selling price.
The markup percentage can vary widely. Standard markups in retail typically range from 30% to 50%, while typical markup percentages in industries like construction are more likely to range from 10% to 20%. Meanwhile, some businesses, like specialty parts manufacturers or pharmaceutical firms, may add markups as high as 100% to 800% on some items.
To explain how a cost-plus price is calculated, let’s say a company is determining the selling price for a sweater. The company will first break down the costs to produce the sweater:
- Material costs: $10
- Labor costs: $20
- Overhead costs: $20
The total cost to produce one sweater is $50. Cost-plus pricing involves adding a markup — for instance, let’s say 30% — to the total cost of making the product to calculate the sales price. The formula looks like this: Cost of Sweater ($50) + Markup ($50 x 30%) = Selling Price ($65)
Organizations that lean on cost-plus pricing need to have a clear understanding of their costs and overall financial standing. This includes the cost of goods sold (COGS), such as raw materials and labor, as well as indirect expenses, such as marketing, administrative duties and post-sales support. Outlining costs accurately is essential for a company leveraging cost-plus pricing to ensure that its margin is set high enough to avoid selling products at an unsustainable profitability level or even operating at a loss.
Cost-plus pricing is reliable for businesses that want to ensure they’re receiving consistent margins. The pricing model is often favored by organizations in relatively stable environments where the competition is unlikely to undercut them by driving down their own prices or significantly reducing their profitability for the sake of gaining more market share.
Some organizations also rely on cost-plus pricing as a way to establish trust with consumers, as many customers favor the transparency and predictability of the pricing method. Besides, many consumers are turned off by dynamic pricing, particularly if businesses start charging higher prices when items are in high demand. According to a recent survey, more than half of consumers say dynamic pricing is a type of price gouging and only about a third believe dynamic pricing benefits consumers.
However, the main downside to cost-plus pricing is a lack of flexibility and responsiveness to market conditions. In addition, the model doesn’t tend to focus heavily on cost-cutting measures. If costs are always guaranteed to be recouped through the pricing model, organizations may not work as meticulously to trim the expenses of producing the product.
Cost-Plus Pricing vs. Other Pricing Strategies
Cost-plus pricing, which is one of the oldest and simplest methods to determine prices, is sometimes scorned for its lack of sophistication compared with other strategies, including subscription pricing models and psychological pricing tactics.
Whereas alternative strategies often take into account external forces, such as economic conditions, customer attitudes and competitor pricing, cost-plus pricing focuses more on the specific markup percentage for each product. Its champions may argue that companies can calibrate the markup margin to the price elasticity of products to assess how demand responds to price changes, yet the method is not nearly as responsive to market forces as other pricing strategies. Three main alternatives to cost-plus pricing are competition-based pricing, value-based pricing and demand-based pricing.
| Pricing Type | What Prices Are Based On | How Prices Fluctuate |
|---|---|---|
| Demand-based | Shifts in demand | Higher prices bring higher revenue when demand spikes; lower prices drive sales when demand drops. |
| Cost-plus | Production costs | After calculating the cost to produce a good or service, businesses add a markup to generate profit and cover business expenses. |
| Competitor-based | What competitors are charging customers | Lowering prices below what competitors charge can attract customers, while raising prices above those of competitors can signify premium goods and services. |
| Value-based | What customers are willing to pay | Customers are willing to pay more for unique features, premium goods and services or brand prestige. Lower quality or easily replaceable goods typically carry lower prices. |
Competition-Based Pricing
An organization using competition-based pricing sets its own prices based largely on the pricing levels of competitors, typically by matching or beating competitors’ prices. For some premium brands, this strategy is used to set higher prices than competitors to differentiate the product and highlight its added value. Frequently used in highly competitive or commoditized markets, competition-based prices are often used to gain or maintain market share. However, this pricing strategy is vulnerable to price wars, and without carefully considering cost structures, using this method could threaten a company’s profitability over time.
Value-Based Pricing
Value-based pricing is a sophisticated model that’s established by determining customers’ perceived value of the product or service and pricing items based on what they’d be willing to pay. It requires extensive market analysis, customer sentiment tracking and business metrics to provide an accurate calculation of prices customers will find favorable. Companies often go to great lengths to gather and analyze data, studying customer feedback, buying patterns, survey results and price tests to create their value-based pricing models. Value-based pricing is favored in situations where willingness to pay is disconnected from production costs, such as for innovative software-as-a-service (SaaS) products that cater to a specific customer need or market niche.
Demand-Based Pricing
Demand-based pricing is a dynamic strategy that allows for fluctuating prices based on variable customer demand. This tactic allows for adjusting prices to account for products or services that are subject to seasonal demand fluctuations or inconsistencies in demand across geographic areas. An example of demand-based pricing is the use of surge pricing by rideshare apps like Uber or Lyft, which may charge higher prices in certain areas and during periods of high customer demand. Another example would be hotels or airlines that respond to seasonal periods of high demand by hiking their rates. Like value-based pricing, demand-based pricing relies on significant analytical capabilities to effectively set prices according to demand. Companies typically use internal historical data, industry data on seasonal sales and analyst forecasting to predict demand.
When to Use Cost-Plus Pricing
Despite its drawbacks, cost-plus pricing endures because it is simple, reliable and predictable. At the end of the day, the cost-plus pricing method provides consistent rates of return for those who depend on it. Businesses use this method for a number of reasons, but the universal factor tends to be stability — of costs, customer demand and the balance sheet. Here are some of the scenarios that best lend themselves to cost-plus pricing.
Stable Cost Environments
Stable cost environments where costs don’t tend to fluctuate wildly due to factors like supplier issues or inflation make cost-plus pricing a simple and attractive choice. However, if costs are regularly in flux, a cost-plus organization would have to constantly adjust prices accordingly.
Customized or Unique Products
Businesses that produce customized or unique goods will often struggle to find the appropriate historical sales data, competitor pricing or customer sentiment information to leverage alternative pricing schemes like competitor-based or value-based pricing. Cost-plus pricing makes it easier to tailor different markups to specific products or services. In addition, the cost-plus pricing model can reduce the risk of losing money on experimental or bespoke offerings by building in a guaranteed profit margin from the get-go.
Government Contracts and Public Sector Projects
Construction projects, including those initiated by government agencies, may call for a variety of contracts, including fixed price contracts, time and materials contracts and cost-plus contracts. Businesses that build out large government contracts or other public sector projects often find that cost-plus pricing offers the advantage of transparency — and in some cases, a government may require such a pricing scheme of its contractors. Doing business with government agencies and local municipalities brings a level of public scrutiny that makes open and transparent pricing a must. In many cases, government contracts won’t pay a percentage-based margin and will instead pay costs plus a fixed amount that’s agreed on in the contract.
When Cost Recovery Is Crucial
One of the biggest drivers of cost-plus pricing is cost recovery and profit assurance. Fiscally conservative organizations that are more concerned about the health of the balance sheet than growth will frequently gravitate to cost-plus pricing for its reliability. The caveat here is that the organization must have a very clear picture of its actual costs. If markup is determined based on flawed or incomplete cost data, this advantage is lost.
Low-Competition Markets
Cost-plus pricing tends to work best in marketplaces with a relatively low level of competition, either because pricing is fairly stable across a few established competitors or because the product or service is unique to the market. The danger in the latter case especially is that a business may leave money on the table if customers are willing to pay a lot more than the cost-plus price for a one-of-a-kind product.
How to Implement Cost-Plus Pricing
Cost-plus pricing is straightforward to calculate, but several nuances can be applied to successfully use this strategy over the long term. Successful businesses rarely set and forget cost-plus pricing. Best-in-class organizations strive to get the most accurate picture of their total costs to make their calculations, seek customer feedback and keep prices responsive to costs while finding ways to drive expenses down. Here are five steps organizations can take to successfully implement cost-plus pricing.
1. Calculate total costs.
Truly profitable margins require a complete picture of the total costs that go into bringing an offering to market. Businesses will start by adding up the full range of direct costs incurred to create a product or service, such as labor, materials and manufacturing supplies. Then they’ll add indirect costs to this sum, including rent, utilities and general office expenses.
2. Determine the markup percentage.
Choosing a markup percentage is one of the trickiest aspects of cost-plus pricing and the step that is the most likely to make or break the competitiveness of a firm’s pricing. Organizations need to consider industry norms, price elasticity and even regulatory requirements when determining the markup. Some businesses may set appropriate margins based on past experiences in a particular market, while others will turn to market research and historical sales data when setting or adjusting their margins for cost-plus pricing.
3. Set the selling price.
Once the business has figured out its markup percentage, calculating the selling price is a simple affair. For service contracts, multiply the margin percentage by the total cost, then add the two figures together to determine the markup amount. Manufacturing or retailing operations that sell by the unit would first establish the total cost and divide that amount by the units to be sold to determine a per-unit cost. The markup would be determined by multiplying the percentage against the unit cost. Then that per-unit markup would be added to the cost per unit to come up with the selling price.
4. Evaluate customer perceptions.
Smart businesses keep close tabs on customer perceptions with regard to their pricing, no matter which model they use. As organizations move forward with their cost-plus pricing strategy, they may find that it helps them build a solid reputation and engender trust with customers who appreciate the transparency involved. In this case, the organization may choose to align its marketing messaging to highlight that it is committed to keeping its prices at a certain level so it can charge customers less. Alternatively, customer feedback and market research may show that customers are willing to pay more for a product. In this case, the company may want to consider adjusting margins or even moving toward a value-based pricing strategy in the future.
5. Monitor costs and adjust prices as necessary.
If pricing is tied to costs, an organization must keep a close eye on its cost structure to ensure that prices keep pace with major changes to company expenditures. If costs change regularly, an organization may need to beef up its accounting capabilities to keep tabs on these expenses and consider price adjustments accordingly.
Cost-Plus Pricing Challenges
What businesses gain with the simplicity of cost-plus pricing, they often lose in the strategy’s lack of flexibility and responsiveness to changing market conditions. Here are some of the biggest challenges that businesses face when they depend on cost-plus pricing.
Potential to Ignore Market Demand and Competitor Prices
Due to the inward focus of cost-plus pricing, it can be easy for a business that uses this strategy to ignore external forces like market demand and competitor prices. This could potentially drive customers to competitors with better prices, ultimately damaging sales volumes and market share.
Risk of Overpricing or Underpricing Products
When cost-plus pricing decisions are made in isolation from other market factors, an organization runs the risk of overpricing or underpricing products. For example, a competitor with better cost containment measures could price products drastically lower than where the cost-plus organization has set its levels, and other competitors could follow suit. This leaves the cost-plus organization the odd one out. On the flip side, a company selling a unique or innovative service — such as a new SaaS service — with relatively low costs could be charging significantly less than customers would be willing to pay.
May Not Encourage Efficiency in Cost Management
Cost-plus pricing can breed a level of complacency that leads to lax cost management. When pricing is designed to always recoup losses, the organization may lose its incentive to streamline expensive processes or contain the cost of materials. This may inflate prices for customers and reduce profit opportunities for businesses in the long run.
Can Lead to a Lack of Innovation
That same sense of complacency instilled by cost-plus pricing can also prevent the business from looking at innovative ways of bringing products to the market. If the company has always stuck to the simple method of cost-plus calculations, they may not be thinking of new ways to bundle products or repackage services to bolster profitability.
Best Practices for Effective Cost-Plus Pricing
Despite these challenges, cost-plus pricing remains a tried-and-true method of setting prices in certain situations. Businesses that engage in the following best practices will be able to reap the most benefits from cost-plus pricing, while minimizing the risks.
- Ensure that all costs are accurately calculated: Cost-plus pricing can pose a threat to the business if pricing leaders fail to accurately tally all of the costs related to delivering a product or service to the market. The most fundamental best practice in cost-plus pricing is ensuring that costs are properly tracked and calculated.
- Regularly review and adjust the markup percentage: Brand loyalty is at an all-time low and inflation has impacted prices, so price sensitivity is becoming a factor in even the most stable markets. Organizations can’t afford to set-and-forget their markup percentage. It’s crucial to review market dynamics and adjust markup percentages to keep sales volumes and market shares stable.
- Stay aware of market demand and competitor pricing: Big shifts in competitor prices may signal to the business that it needs to adjust its markup percentages or engage in cost containment efforts to maintain competitive pricing and keep a solid hold on market share.
- Use tools to automate the tracking and calculation of costs: The faster an organization can adjust its cost calculations, the more easily it can maintain accurate cost-plus pricing. And the closer to real time that an organization gets to tracking and calculating costs, the more responsive its pricing will remain. This is particularly crucial during times when inflation, supply chain disruptions or other economic factors are causing costs to fluctuate in normally stable cost environments.
Cost-Plus Pricing Examples
Cost-plus pricing is a highly prevalent pricing strategy used by businesses to simplify the pricing process, meet bidding or regulatory requirements, aid in cost recovery and uphold transparency commitments to loyal customers. Here are examples of specific companies and industries that regularly engage in cost-plus pricing:
- Costco: Discount wholesaler Costco offers a classic case of using cost-plus pricing to bolster brand trust and customer loyalty. The company stipulates that branded items will be priced with a markup of no more than 14%, and store brand Kirkland items will be priced at no more than 15% above cost.
- Pharmaceuticals: According to the American Hospital Association, cost-plus drug pricing models are starting to take hold in response to regulatory pressure on the industry to deliver more transparent pricing and lower-cost drug options. The pharmaceutical industry has been led by disruptive businesses, such as Cost Plus Drugs, which are using the model to pressure big pharmacy brands to create more stable and predictable pricing for customers.
- Construction: Cost-plus pricing is extremely common in the construction industry, as contractors use cost-plus contracts as a way to guarantee their cost recovery for materials and labor. The “plus” negotiated on these contracts sometimes amounts to a percentage markup or an agreed-upon fixed fee.
To break down how cost-plus pricing is calculated, here are two examples of companies putting the strategy into action.
Construction Firm Cost-Plus Pricing Example
A construction firm with a 20% markup percentage is pricing a remodeling job:
| Costs | Markup Calculation | Final Price |
|---|---|---|
| Raw Materials: $6,000 Labor: $3,000 Fixed Overhead: $1,000 |
Markup Percentage: 20% Markup Calculation: $10,000*.2 |
Cost-Plus Pricing Calculation: $10,000+$2,000 |
| Total Costs: $10,000 | Total Markup: $2,000 | Final Price: $12,000 |
Manufacturing Firm Cost-Plus Pricing Example
A manufacturing firm is pricing widgets that have variable costs based on the volume manufactured. The markup percentage is 50%. Here’s a pricing comparison of two different production volumes.
| Size of Production Run | Total Costs | Cost Per Unit | Markup Calculation | Selling Price |
|---|---|---|---|---|
| 1,000 units | Material and Labor: $5,000 Fixed Overhead: $5,000 |
Calculation: $10,000/1,000 |
Markup Calculation: $10 *.5 |
Cost-plus Pricing Calculation: $10 + $5 |
| Total Cost for 1,000 units: $10,000 | Cost Per Unit for 1,000 units: $10 |
Markup Per Unit for 1,000 units: $5 |
Unit Selling Price for this run: $15 |
|
| 2,000 units | Material and Labor: $8,000 Fixed Overhead: $5,000 |
Calculation $13,000/2,000 | Markup Calculation: $6.50 *.5 |
Cost-plus Pricing Calculation: $6.50 + $3.25 |
| Total Cost for 2,000 units: $13000 |
Cost Per Unit for 2,000 units: $6.50 |
Markup Per Unit for 2,000 units: $3.25 |
Unit Selling Price for this run: $9.75 |
Manage Your Pricing Data and Financials in One Place: NetSuite
No matter what kind of product or service an organization supports with cost-plus pricing, the success of this strategy depends on collecting accurate financial data to determine sound cost calculations and appropriate markup decisions. NetSuite’s Financial Management solution provides real-time visibility into a company’s financial performance, allowing businesses to track every transaction. And NetSuite Pricing Management gives businesses the power to centrally manage, control and update pricing, layering in important customer and market data to drive profitable pricing decisions. The platform makes it easy to leverage multiple pricing strategies, enabling cost-plus pricing organizations to pivot to other strategies like competitor-based pricing for products or lines of business that need to take a different approach.
Whether your business is fully established or just breaking into the market, cost-plus pricing can provide a simple strategy for setting prices, allowing a company to reliably recoup costs and experience a steady rate of return. While some companies avoid the strategy because it doesn’t provide the flexibility to adjust pricing based on fluctuating market conditions or intense competition, the tactic is popular with retailers, including grocery and clothing stores. The key to success is ensuring that the total costs used to determine the markup are calculated as accurately as possible. By automating the collection of financial data, many organizations gain predictable profitability and strong financial health by using cost-plus pricing.
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Cost-Plus Pricing FAQs
What is cost-plus pricing, with example?
Cost plus pricing is a pricing strategy that sets the selling price based on the cost of an item plus a markup. For example, if a sweater that costs $20 is sold using cost-plus pricing with a 50% markup, that sweater would be priced at $30.
What are cost-plus pricing payments?
Cost-plus pricing payments are payments made on goods or services sold with a price that’s derived from the total cost plus a set markup.
How is cost-plus pricing calculated?
Cost-plus pricing is calculated by multiplying a markup percentage by the total costs of a product or service. The selling price then equals the total cost, plus the calculated markup.
What are the advantages of cost-plus pricing?
Cost-plus pricing can provide transparency to customers and is easy to calculate without any complicated market or competitive pricing data necessary.
What are the biggest challenges of cost-plus pricing?
Cost-plus pricing is frequently calculated without considering external business factors, which could lead to a company’s overpricing or underpricing products, potentially losing market share or leaving money on the table.
