  (photo courtesy of Simon Howden) Do you remember when your mom or dad or looked-up-to-important-person-in-your-life (we hyphenate a lot – don’t judge) told you that if something looks/sounds/smells/tastes/feels too good to be true it probably is? You probably thought at the time that we were referring to some way you could get an extra $50 in your pocket simply by carrying those plastic bags of “sugar” to the guy standing on the corner of 8th and Harrison downtown. Or maybe the fact that you could drop those extra 20 pounds you’re carrying around for a rainy day by eating nothing but sweets for a week and watching a special pattern on your computer screen (results may not be typical). Or the fact that some rich foreigner wants to transfer $21M to you if you’ll just provide the bank routing numbers and a small fee to help the transaction along. Guess what? They were actually talking about a cost-plus pricing methodology. [OK, to be fair they may have been talking about those other things above or any number of other warnings that adults are just so damn good about giving when your elation at the future seems to have peaked. But mostly I'm sure they were trying to warn you about taking the cost-plus pricing methodology to heart and setting your prices by it. Go ahead - ask them!] But before we lend credence to said warnings, a little definition and conversation around what cost-plus pricing entails.
Cost-plus pricing is probably the easiest pricing methodology you’ll ever run across (next to free which, although it’s a legitimate price, is really hard to make a profit on). It takes your cost profile as a basis and adds a profit margin. Here’s how it works. You figure out your expenses on a per unit basis (as in total up your expenses for a set number of units, divide by the number of units) – we’ll call this your “unit cost basis”. You mark up your unit cost basis by 10%. Or 20%. Or 30%. Or whatever arbitrary or scientifically-arrived at number is appropriate. Yes, it’s that easy. The hardest part of this equation is really figuring out what your expenses and forecasted units are. This is really ironic considering that if you have any sort of forward looking budgeting going on you pretty much already have this. And if you don’t have any forward-looking budgeting (or whatever you want to call the “here’s what my business looks like in 6 months” stuff you do) you need to get some. Pronto. But not before you finish reading this. And, as dear old Uncle Harold would say “It’s 5 o’clock somewhere”. Which is really irrelevant to this conversation (although it is 5 o’clock in Seattle right now), but he’d follow that up with “if it sounds too good to be true it probably is”. Which is very germane to this topic, because the simplicity of cost-plus pricing is also its downfall. But we’re glass-half-full kind of people, so let’s focus on the benefits of cost-plus pricing before we torch it. First, it’s easy to calculate. Very easy. Cost-plus pricing is an absolutely piece of cake to do…which is probably why it’s as prevalent as it is. No market research to do, no competitive intelligence to gain. Cost + profit margin = price. Beyond that, it’s simple. No need to manage a ton of complex pricing structures – cost plus is very easy to administer because of its simplicity. You take your per unit costs, add your profit and call it good. Same formula for every unit. Pricing only changes if costs change. Does it get simpler than that? And finally it ensures you hit your target return…at least on a unit basis for each one you sell. Because it’s based on your cost plus profit you’re automatically covering your costs so you’re not in the hole…at least on every unit you sell. It can’t guarantee profit (since your sales will drive that), nor can it guarantee you cover your fixed costs (since that’s dependent on hitting your forecasted units). But it does guarantee you’re getting your desired profit margin on each unit. There’s your upside: easy to calculate, simple and guaranteed unit profit for every one you sell. Pretty compelling, right? Sounds even better than getting a $6M return on a $5,000 investment, right? Not so much. Cost-plus pricing provides absolutely no incentive for efficiency. Think about it – if your cost basis increases 25% from $100/unit to $125/unit guess what happens to your price? It increases 25% as well. A 50% increase in cost? A 50% increase in price. So what if you go out and work out a super-duper fancy-schmancy deal with your vendor to drop your per-unit cost by 80%? You get to watch your price drop by 80%. So tell us what your incentive is to invest your time, energy and money into negotiating a more attractive per-unit cost structure? Bingo – there isn’t one. Cost-plus pricing doesn’t yield optimal returns. If it did, really smart people would be doing it consciously (and not just because it’s the easiest way to price). All pricing with this methodology does is gives you the per-unit returns you’re requiring. That’s it. It doesn’t ensure you’re optimizing your returns unless – and this is a really big unless – by some stroke of absolute, positive luck you manage to set your profit % at a rate that happens to be optimal for your market. But if you’re managing your business by strokes of absolute, positive luck…we’ll say no more. Your market doesn’t care what your costs are, or (for the most part) whether you make a profit. Cost-plus pricing ignores the market. And you ignore your market at your own peril. Can’t stress that enough. A regulated business, such as telecom in the 1990s or the natural gas company these days, can get away with this (and they do), but unless you managed to start up a heavily-regulated online business (which carries its own set of problems) you need to care about your market. Profoundly care. Obsessively care. But that’s another topic for another blog (like Naomi Dunford’s IttyBiz) – suffice it to say for this conversation that it’s a really bad idea to ignore what your market cares about. And your market doesn’t care if your cost just went up 25%; they’re not going to be keen on paying 25% more because of that if they can get it less that 25% increase elsewhere. Before we close, and because we are the kings and queens of beating dead horses, let’s boil down why cost-plus pricing (generally) doesn’t work with a simple example. Think of your house (or if you don’t own a house think of someone else’s house). Let’s assume you bought it 10 years ago for $50,000. You’re ready to sell it now and move into that mansion in Palm Springs. Your next-door neighbor paid $72,000 for their house the very same day you bought yours for $50,000 and it’s identical to yours. If you use cost-plus pricing it would say they’d be able to sell their’s today for more than yours. Really? Yes – that’s cost-plus pricing. Oh – and don’t forget that if you used an annual 4% increase as your “plus” in cost-plus you’d sell your house for $74K, even though other comparable houses around you are selling for $120K. Seriously? Yes – that’s cost-plus pricing. But despite the downside to this “too good to be true” pricing strategy stay tuned – we’ll talk in a later post about when cost-plus pricing does work, and why it’s not a bad thing to have in your arsenal of pricing strategies. Keep with us – you’ll see.
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