Cost plus pricing is simple in its overall concept. A business calculates the cost to create products. From there, it determines what profits it wants after the costs of the product has been paid, and then it tacks on the profit on top of costs. It's a popular method of pricing because of its simplicity. Even government contracts ask for cost plus pricing.
Missed Profit Opportunities
Cost plus pricing throws money out the door. In the book, "Capon's Marketing Framework," Noel Capon writes that companies are prone to pricing too high or too low with cost-plus pricing. In markets where price isn't the most important thing to the consumer in their decision-making, his research shows that products are often underpriced. In markets where customers are counting every penny before making a buying decision, he shows that prices are often too high. Competitors are able to compete on pricing more easily with this method because they can predict your pricing ahead of time.
The concept of fixed costs means that these costs never change. Rent and salaries are fixed costs. If the company produces and sells a thousand more products one month and sells fewer the next month, the fixed costs don't change. That means if costs is the main factor in pricing, then the pricing should fluctuate from month to month. Raw materials and sales commission are variable costs or costs that change from period to period. Consumers can be sceptical of pricing fluctuations and it erodes brand trust.
If costs of production decrease, cost plus pricing suggests that pricing should decrease. Then, you lose out on profits. It works the opposite if production costs increase. Cost plus pricing doesn't inspire efficiency. As long as customers are paying production costs you don't have any incentive to lower costs or find faster, cheaper and more effective ways of producing products. It's easy for a company to become complacent. Meanwhile, competitors are taking steps to produce a better product faster, which allows them to steal market share.
Pricing all boils down to what consumers will pay for a product. Even if a name brand shoe only costs £2 to make, the consumer will pay £78 for it if a famous celebrity athlete's name is attached to the show. Cost plus pricing misses this important factor in pricing and profits. In the book, "Pricing with Confidence," Reed Holden and Mark Burton write that cost plus pricing "Ignores demand, image and market positioning and ignores the role of customers and the value they derive." Value based pricing is an alternative method for taking customer's perception into account for pricing.