Why Fixed Markups Can Lower Your Profit
Those using cost-plus pricing see the simple markup-based approach as the biggest benefit. However, this rigid formula-driven method comes with four risks.
Many small businesses calculate the selling prices of their products based on how much they pay for them.
They often take the cost of a product and double it to achieve a selling price that results in 50% gross profit.
This method is called cost-plus pricing or markup pricing.
Changing the fixed markup is straightforward. If you aim for a selling price with 67% gross profit, you triple your product cost and quadruple it for 75% gross profit. Because cost-plus pricing is so simple, it is a favorite among many retail companies and small businesses.
However, this method is not suitable for companies with subscription services because the cost of one additional license (marginal cost) is close to zero. The reason is simple: Once they finished programming the application, whether 500 users subscribe to the service or 5,000 does not increase the cost structure much.
What makes cost-plus pricing so dangerous, in my experience, is that it could unintentionally and unbeknownst to the business owners lower a company's overall profits.
Handle With Care
Its simple markup-based approach is often viewed as the biggest advantage by those who use cost-plus pricing. However, the assumption that profit-maximizing selling prices can be calculated using a rigid formula (cost x markup = price) is the center of this method's four most significant disadvantages.
Cost-plus pricing ignores customer preferences. Unless your company enjoys a monopoly, prices are usually set by market forces of supply and demand. The better you understand your customers and their preferences (demand), the more you could include these insights into your pricing decisions and marketing, potentially leading to increased sales at higher price points and improved gross profits. The pricing method that derives prices from the product attributes customers value most is known as value-based pricing.
Cost-plus derived prices could be significantly higher or lower than your competitors. The cost-plus pricing method ignores competitors' pricing decisions by focusing on product costs as the sole input to determine selling prices. As a result, you could either lose business to competitors or undercut them, leaving money on the table.
Cost-plus pricing ignores product quality differences. If you buy similar products for the same price and use the same markup, the cost-plus pricing method assumes they should also have the same quality. That's not a given. For example, if you find a new supplier offering you a similar product at the same cost but with higher quality, your selling price wouldn't increase because your cost hasn't changed, even though the product quality has improved. You would need to introduce an additional markup to correct this.
Cost reductions can lead to lower selling prices. Suppose you repeatedly buy products from one supplier and, therefore, qualify for an extra discount based on your purchasing volume. Wouldn't you want to keep that money and improve your profit? Unless you increase your markup to compensate for the extra discount, your selling price will decrease due to the lower product cost. Yikes! I have seen it time and again, even in large companies. While the buyers celebrate their success, the sales teams unwittingly pass this saving on to their customers by applying the old markup to the new, now lower, product costs.
Why Many Small Businesses Can't Afford Cost-Plus Pricing
With its rigid formula-driven approach that ignores customer preferences, market prices, and product quality differences, cost-plus pricing appears to be a quick but crude way to set selling prices.
To compensate for some of the method's drawbacks, you could devise a specific markup for each product category instead of a single markup applied to all products.
You could also compare the selling prices to those of your competitors. If your price is higher or lower than your competitors, you could adjust your price and bring it more in line with the market.
However, with each additional round of refinements and adjustments, the complexity increases, reducing the main benefit of cost-plus pricing, its simplicity. You may end up with a huge, difficult-to-maintain spreadsheet that comprises all of your products, their costs, and specific markups that calculate your selling prices. As a small business, can you afford this?
Fortunately, there is an alternative to cost-plus pricing; it is value-based pricing.
