Do a search for cost plus pricing and you’ll get 75 million hits. The vast majority of these will state that cost plus pricing is a terrible pricing model and to avoid it like the plague.
These writers assume the worst about companies’ ability and interest in doing the hard work required to price effectively.
They assume you choose cost plus because you’re lazy. Have no data. Think you sell in a vacuum (no competition). Have no sense of your market. Etc.
Here’s one particularly hostile point of view:
“The guarantee of a target rate of return creates little incentive for cutting cost or for increasing profitability through price differentiation. Stakeholders easily become passive towards pricing, facilitating laziness and an atrophy of profits as the market and customer continues to change.”
Cost plus pricing in a critically useful INTERNAL tool. It forces a company to recognize all its costs and to price products and services high enough to generate a specific profit.
Why is this important? Without profit, there is no business. I assume management will steer the company to use cost plus pricing effectively.
Each potential pitfall can be overcome with some thoughtful management.
I look at it like this: Expenses+PROFIT=Revenue. This equation requires profit with every sale rather than thinking (hoping?) that there will be a profit after expenses are accounted for.
When done right, cost plus pricing can help the firm generate very healthy profits.
Connection Between Cost Plus and Value Based Pricing
When knowledge based firms realize the extraordinary value of adopting Value Based Pricing (VBP) to replace time-based pricing, they inevitably ask two questions:
1) How do we determine the value upon which the price is based?
2) How do we ensure we make a profit, and increase profits over time?
I’ve described the process that answers the first question here. You’ll see the step-by-step methodology.
Let’s look at the second question: How do we make a profit and increase profits over time?
Cost plus pricing is a huge internal help in answering this question. With cost plus, you have to identify and add up all your costs. You multiply your costs by the desired/required profit percentage to determine the firm’s total required revenue for the year.
Total costs = $1 million.
Profit required = 25%
Revenue=$1 million x 1.25=$1,250,000.
From this total revenue figure you turn your attention to the EXTERNAL-your clients. You work to determine what value you must deliver to them that will be commensurate with the fees that add up to $1.25 million.
CPA Firm Example
Here’s how I would think this through with a CPA firm owner. Typical tax return work is low profit (maybe 8-9%) and consumes everyone for 4 months, making it very difficult to deliver other value to clients. Whatever other services are offered are also low profit. Annual revenue might equal $1 million but profit is only $80,000.
Advisory services to the firm’s best and better clients will generate between 20-25% profit. The firm designs a range of advisory services specific to meeting the needs, wants, and desires of existing clients. The firm goes through the VBP phase-in process which is enthusiastically received by clients. If revenue remains at $1 million the first year, profits are $200-250 thousand.
Value Based Pricing Builds on Cost Plus
Cost plus pricing is an internal tool that gives the firm perfect clarity about all costs and the revenue it needs to generate in order to achieve the profit goal. Value Based Pricing is the external tool that leads them to figure out how to deliver value that will produce the revenue and the 20-25% profit.
Without the in-depth accounting of costs, and the required profit, you’ll be guessing about Value Based Pricing.
If cost plus is adopted and implemented because the company is lazy, and ignorant of market conditions, the company will eventually fail.
But when an firm is diligent about maximizing its advantages, cost plus pricing is the best way to ensure your revenue generates the required profit through the adoption of Value Based Pricing.
How is your firm shortchanging its profit? If you think you could do better, let’s talk.