Benefits of a Cost Plus Based Pricing Strategy for a Small Business

As a small business owner, we all know how important it is to set the right prices for your products or services. Pricing can make or break your profitability, your cash flow, and your customer satisfaction. However, pricing can also be one of the most difficult decisions to make, as there are many factors to consider, such as costs, competitors, customers, and market conditions.

One of the most common and simple pricing strategies that small businesses use is cost plus based pricing. Cost plus based pricing is a pricing method where a fixed percentage is added on top of the cost of production for one unit of product or service. This percentage is called the markup and it represents the profit margin that the business wants to earn.

In this article, we will explain what cost plus based pricing is, how it works, what are its benefits and challenges, and how to implement it in your small business.

What is Cost Plus Based Pricing?

Cost plus based pricing is also known as markup pricing. It’s a pricing method where a fixed percentage is added on top of the cost it takes to produce one unit of a product or service (unit cost). The resulting number is the selling price of the product or service. This pricing method looks solely at the unit cost and ignores the prices set by competitors or the value perceived by customers.

Cost plus based pricing is a simple and easy way to set prices, as it only requires two inputs: the unit cost and the markup percentage. The unit cost includes all the direct and indirect costs that go into producing one unit of product or service, such as materials, labor, overheads, etc. The markup percentage is determined by the business based on its desired profit margin and return on investment.

The formula for cost plus based pricing is:

Selling price = Unit cost x (1 + Markup percentage)

For example, let’s say you run a bakery that sells cakes. It costs you $5 to make one cake, including ingredients, labor, rent, utilities, etc. You want to earn a 40% profit margin on each cake sold. Using the cost plus based pricing formula, you can calculate your selling price as follows:

Selling price = $5 x (1 + 0.4) = $7

By selling each cake for $7, you can cover your costs and earn your desired profit margin.

The Benefits of Cost Plus Based Pricing

Cost plus based pricing has many benefits for small businesses, especially those that have low competition or high differentiation in their products or services. Some of these benefits are:

• It ensures profitability by covering all the costs and adding a fixed profit margin on each unit sold.

• It simplifies pricing by requiring only two inputs: unit cost and markup percentage.

• It reduces uncertainty and risk by providing a stable and predictable revenue stream.

• It allows flexibility and control by enabling the business to adjust the markup percentage according to changes in costs, demand, or market conditions.

• It supports growth and expansion by allowing the business to reinvest its profits into new products, services, or markets.

What are some Examples of Small Businesses that use Cost Plus Based Pricing?
Cost plus based pricing is often used by small businesses that sell products or services that are common in the market or that have low differentiation from competitors. In these cases, customers are accustomed to paying standard market prices and are not very sensitive to value or quality differences. Some examples of small businesses that use cost plus based pricing are:

• Retail stores: Retail stores such as clothing, grocery, hardware, and department stores often use cost plus based pricing to set prices for their productshttps://blog.hubspot.com/sales/cost-plus-pricing. They add a markup percentage to their wholesale or purchase costs to cover their overheads and earn a profit. The markup percentage may vary depending on the type of product, its demand, its seasonality, etc.

• Manufacturers: Manufacturers such as furniture makers, toy makers, candle makers, etc. often use cost plus based pricing to set prices for their productshttps://quickbooks.intuit.com/r/midsize-business/pricing-strategies-models-cost-plus/. They add a markup percentage to their production costs to cover their overheads and earn a profit. The markup percentage may depend on their industry average, their target return on investment, their break-even point, etc.

• Service providers: Service providers such as plumbers, electricians, cleaners, etc. often use cost plus based pricing to set prices for their services. They add a markup percentage to their labor costs to cover their overheads and earn a profit. The markup percentage may depend on their skill level, their experience, their reputation, etc.

What are the Challenges of Cost Plus Based Pricing?
Cost plus based pricing also has some challenges that need to be considered by small businesses. Some of these challenges are:

• It ignores customer value and competitor prices by focusing only on costs and profits. This may result in underpricing or overpricing the products or services and losing customers or market share.

• It discourages innovation and efficiency by providing no incentive to reduce costs or create more value for customers.

• It may face resistance from customers who are aware of the costs or who compare prices with competitors. Customers may perceive cost plus based pricing as unfair or exploitative.

How to Implement Cost Plus Based Pricing in Your Small Business?

To implement cost plus based pricing in your small business, you need to follow these steps:

1.
Calculate your unit cost. You need to add up all the direct and indirect costs that go into producing one unit of product or service. These may include materials, labor, overheads, depreciation, taxes, etc. You can use accounting software or spreadsheets to track your costs accurately.
2.
Determine your markup percentage. You need to decide how much profit margin you want to earn on each unit sold. This may depend on your industry average, your target return on investment, your break-even point, your cash flow needs, etc. You can use online calculators or formulas to find your optimal markup percentage.
3.
Set your selling price. You need to multiply your unit cost by (1 + markup percentage) to get your selling price. You can use this price as a starting point and adjust it according to customer feedback, competitor actions, or market conditions.

Cost plus based pricing is a pricing strategy that adds a fixed percentage to the cost of production for one unit of product or service. It is a simple and easy way to set prices for small businesses that have low competition or high differentiation in their products or services. Cost plus based pricing can help small businesses ensure profitability, simplify pricing, reduce uncertainty and risk, and support growth and expansion. However, cost plus based pricing also has some drawbacks, such as ignoring customer value and competitor prices, discouraging innovation and efficiency, and facing customer resistance.

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