The cost-plus pricing model is a tried-and-true strategy for many industries—primarily due to how easy it is to implement. But when you’re running a SaaS or subscription business, the model breaks down quickly.
That’s because the subscription model is based on monetizing yourrelationship with the customer,a strategy built on the value your service provides. Because the cost-plus model bases yourpricing strategyon your operational costs alone, it doesn’t take into account how much value you provide to customers.
Most subscriptions also don’t have the hard costs associated with manufacturing a product. Instead, SaaS and subscription companies focus on the recurring revenue their customers generate. Most of your customers aren’t going to care about the costs involved in providing your service; as a result, there’s no motivation for them to value your product.
In today’s article, we’ll take a look at how the cost-plus pricing model works so you can understand how it is used for specific types of businesses. Further to that, we will also talk about why we don't think this is the right pricing method fo SaaS.
Cost-plus pricing is a pricing strategy that adds a markup to a product's original unit cost to determine the final selling price. It's one of the oldest pricing strategies in the book and is calculated based on just two things:
Your cost of production
Your desired profit margin
All you do is take the costs that go into building your product or providing a service to your customers and add a percentage on top for your profit margin. Every unit sold then provides the same revenue to cover your costs and yourprofitmargin.
How to use the cost-plus pricing formula
The name says it all. To use the cost-plus pricing method, take your total costs (direct labor costs, manufacturing, shipping, etc.), and add the profit percentage to create a single unit price.
Let’s say you run anecommerce storethat sells candles. It costs you $10 to make every candle, including materials and labor. To sustain your business, you need to make at least a 50% profit margin on every candle sold, based on the time required to produce all the ingredients, create the candle, list it on your website, and ship it out. This makes your cost-plus calculation look like this:
Simple, right? By selling each candle for $15, you can cover the cost to make it as well as your desired profit. That’s what makes this pricing model so appealing—it’s one of the easiest ways to determine a per-unit price for your product or service
Two examples of successful cost-plus pricing strategy
There are a number of different industries that utilize cost-plus pricing effectively. Typically, this model works best when there are defined costs involved in production or when the product itself is utilitarian in nature. Here are two industries that traditionally rely on the cost-plus pricing model.
Manufacturing companies thrive on cost-plus pricing. Because the products they create have relatively predictable fixed costs (such as labor, machine maintenance, raw materials), it’s easy to assign a profit margin percentage using markup pricing on top that sustains the business.
In most of these business arrangements, companies sell manufacturing products in bulk to existing customers with a contract. That makes it even easier to build a predictable revenue stream over time without requiring a price increase or decrease.
Think about the last time you went to the supermarket. Whether you were buying apples, cereal, or milk, you probably had a good idea of how much each would cost. That’s because grocery stores rely on the cost-plus pricing model as well. A Honey Crisp apple will be more expensive than a Red Delicious because the Honey Crisp was more expensive to buy.
Grocery stores also buy products in bulk, so it’s likely that they rely on a procurement company that follows the same pricing decision model as our manufacturing example.
Pros and cons of cost-plus pricing
While it might be attractive to start out with a simple and easy-to-use model, doing so can hurt your company over time if it isn’t a good fit for your unique needs. It’s important to understand the benefits of this model, as well as the potential pitfalls before moving forward.
Pros of cost-plus pricing
There are a number of benefits to the cost-plus pricing model if you’re working in the right market:
Fast implementation for just about any product
Easy to calculate
Predictable profit that always covers production costs
Customers understand the justification for your selling price
Cons of cost-plus pricing
The simplicity of cost-plus pricing leads to a number of issues for SaaS and subscription businesses:
Makes it too easy to disengage from your price after it’s been set
Lacks connection with the value your product provides to customers
Why cost-plus pricing does NOT maximize SaaS profits
For subscription companies, the simple answer is no. The subscription SaaS business model is not compatible with the cost-plus pricing strategy.
When you rely on a predictable profit margin, there’s no incentive to adjust your pricing to match customer expectations or changes in market conditions, which is one of the disadvantages of cost-plus pricing. That can lead to a stagnant price that isn’t aligned to your product’s value or better offers from competitors.
The cost-plus model works better when you’re selling physical products or working in an industry where value isn’t derived from ongoing relationships with your customers.
At ProfitWell, we recommend value-based pricing based off ofvalue metrics. You can still factor in any hard costs associated with running your business, like cloud storage or other infrastructure costs, as well. Choosing this model ensures that your prices will remain aligned with the value you provide to potential customers in a competitive market.
How to find the right price strategy for your business model
When you’re looking for the right model for your business, cost-plus pricing can help you understand how much you need to make to gain a profit. From there, it’s important to understand the value of your product or service in order to maximize the potential revenue and connect with customers’ willingness to pay.
OurPrice Intelligentlytool is tailor-made to help you build a better subscription pricing model. Chat with one of our pricing experts today to find out how we can help you grow your business.
Cost-plus Pricing FAQs
How to determine if cost plus pricing is a good pricing strategy for my business?
Cost plus pricing is a relevant product pricing strategy for physical products as it involves adding a markup to the original cost of the product. When thinking about pricing in a subscription model, the value of the product is not pegged to cost. Rather, the price of a product depends on the value-add from the ongoing service provided through the subscription.
What are the advantages of cost plus pricing?
The advantages of cost-plus pricing is a simple strategy to understand, the cost can be proven (eg, cost of labor, material cost, cost of production etc.), and the rate of return is consistent as it depends on the markup percentage from cost.
What are the disadvantages of cost plus pricing?
The disadvantages of cost-plus pricing is the risk that consumers do not value your product at the set price, cost-plus pricing is inflexible and cannot respond to consumer demand trends, and cost-plus pricing limits revenue growth through expansion.
Is cost plus pricing a good pricing strategy?
It depends on your business model. If your product’s value is derived from it’s cost of production, this is a legitimate way to increase profit margins using a markup. If your product is value-based, you might want to consider a different pricing strategy that can evolve with your market.
What is a cost-based pricing example?
For instance, if the cost of manufacturing a certain product is $1,000 and a business wants to achieve a 20% markup, the selling price of a product should be $1,000 + 20%, which equals $1,200.
What is usually the first step in cost-based pricing?
In the majority of cases, the first step involves calculating the costs of production. Alternatively, businesses can choose to first evaluate customer needs, expectations, and their perceived value.
By Patrick Campbell
Founder & CEO of ProfitWell, the software for helping subscription companies with their monetization and retention strategies, as well as providing free turnkey subscription financial metrics for over 20,000 companies. Prior to ProfitWell Patrick led Strategic Initiatives for Boston-based Gemvara and was an Economist at Google and the US Intelligence community.