Setting the price is one of the most important jobs of marketing, no matter what business you are in, in that the price of a product or service often plays a great role in that product’s or service’s success, not to mention in the profitability of a business.
A pricing policy refers to how a business sets the prices of its products and services based on costs, value, demand, and competition. Pricing strategy, on the other hand, refers to how a business uses pricing to reach its strategic goals. An example is offering lower prices to increase the number of sales or offering higher prices to reduce the backlog. Though there is a certain level of difference between the two terms, pricing policy and strategy tend to overlap. The different policies and strategies are not necessarily mutually exclusive.
Cost-plus pricing is a cost-based pricing strategy that is used for setting the prices of products and services. Cost-plus pricing is gotten by adding a markup to the unit cost. The unit cost comprises the sum of the fixed costs and the variable costs, divided by the number of units, or products. The markup is a percentage expected to be the profit margin for the manufacturer or seller.
Advantages Of Cost-Plus Pricing
- It is simple to calculate the prices of products or services. However, you need to define the overhead allocation method. To be regular in calculating prices of several products and services.
- It is a great pricing method for contract profits. As the contractor is certain of having their costs reimbursed by the customer and of making a profit.
- The pricing can be justified by the supplier or the manufacturer, simply by pointing out the increase in the costs of production.
Disadvantages Of Cost-Plus Pricing
- Cost-plus pricing excludes competitive prices. Businesses may set prices of their products without checking the market situation or what prices their competitors are selling similar products. They may then end up setting the prices for their products or services either too high or too low. Either way, this kind of pricing can greatly impact market shares and profits, as well as customer patronage.
- The engineering departments of companies will not feel the need to carefully design a product or service with the appropriate set features and characteristics for the target market. They can simply design what they want and launch them on the market.
- If a government body enters into a contractual agreement with a supplier under the cost-plus pricing method, the supplier or manufacturer can include as many costs as they want, and they will be fully reimbursed. This happens because there are no cost-reduction incentives included in the contract. The contractor and the supplier should have cost-reduction incentives in the contract for the suppliers.
- Cost plus pricing strategy does not give room for replacement costs. This is because this pricing strategy works based on historical costs, ignoring the fact that those costs may have changed. Ignoring these replacement costs means that the products and services may be priced way too low or way too high. Ultimately the prices will work to the detriment of the business.
This pricing strategy is better used in a contractual situation. The supplier and the customer can settle on the terms of their contract and the prices and everyone will walk away free and happy.
Cost-plus pricing is not acceptable for pricing products and services that are sold in a competitive market. This is because they are usually overpriced. Product and service prices should be set at what the customers are willing to pay. Not based on a sum total of your costs plus a markup percentage to guarantee you a profit.
More Potential Problems of Cost-Plus Pricing
Critics argue that the cost-plus pricing strategy fails to provide a business with an effective pricing strategy. A major problem with the cost-plus pricing strategy is that determining a unit’s cost before its price is difficult in many industries because unit costs may vary depending on volume. As such, many business analysts have criticised this method, arguing that it is no longer appropriate for modern market conditions (as mentioned in the disadvantages, it calculates based on historical costs).
Cost-plus pricing typically leads to high prices in weak markets and low prices in strong markets, thereby limiting profitability because these prices are the exact opposites of what strategic prices would be if market conditions were being considered.
While businesses must factor in costs when creating a pricing strategy, costs alone should not determine prices. Many businesses involved in producing or selling industrial products and services sell their products and services at incremental cost and make their substantial profits from their best customers and from short-notice deliveries.
When considering costs, managers should ask what costs they, the customers, can afford to pay. Taking into account the prices the market allows, and still allow for a profit on the sale. In addition, managers must consider production costs in order to determine what goods to produce and in what amounts.
Nevertheless, pricing generally involves determining what prices customers can afford before determining what amount of products to produce. By bearing in mind the prices they can charge and the costs they can afford to pay, managers can determine whether their costs enable them to compete in the low-cost market. Where customers are concerned primarily with price, or whether they must compete in the premium-priced market. In which customers are primarily concerned with quality and features.