What is a Cost-Plus Pricing Method? Pros, Cons & When to Use It
Working out pricing for a SaaS can be difficult, so consider using a cost-plus pricing method. It’s an easy method that can be quick to implement to improve product growth, but it does come with certain disadvantages.
- Cost-plus pricing, or markup pricing, is where you add a set to a product’s unit cost, often overlooking competitive market prices.
- The cost plus pricing adds a fixed percentage on top of production costs for one product unit.
- Cost plus pricing isn’t a good fit for SaaS due to the difference in the value it can provide and the low costs it takes to produce.
- You can use cost-plus pricing in your value proposition to build trust with potential customers by informing them that you’ll never charge more than a certain percentage.
- The formula for cost-plus pricing adds together the customer acquisition cost, total cost of goods sold, and desired profit margin.
- You can work out cost plus pricing simply with a formula, and it doesn’t involve extension market research.
- Justifying price increases is easier when adopting a cost plus strategy.
- The cost-plus strategy provides a consistent rate of return if you correctly add up business costs.
- You can lose a competitive advantage when using cost-plus pricing due to not conducting market research.
- There is a complete disregard for customer and their willingness to pay with a cost-plus strategy.
- Some other pricing strategies for SaaS are value-based, penetration pricing, competitive-based, captive, skimming, and prestige pricing.
What is a cost-plus pricing?
Cost-plus pricing, or markup pricing, is a strategy where you add a fixed percentage to the unit cost of producing a product to determine its selling price.
While this method focuses strictly on the unit cost, it overlooks competitive prices, potentially making it less suitable for businesses in competitive markets.
The cost-plus pricing strategy explained
The cost plus method is inherently inward-looking, focusing more on internal factors, like production and direct labor costs, than external elements, like market demand or what competitors might be charging.
This approach might not be the most suitable for industries like SaaS. In such sectors, your products’ inherent value to users can greatly overshadow the fixed costs of producing the software. Therefore, simply marking up costs might undervalue your product’s worth.
However, there’s a silver lining to cost-plus pricing. Integrating it into your value proposition can foster trust and transparency.
A declaration like, “We’ll never charge more than X% above our costs,” can reassure potential customers they’re getting a fair deal, enhancing their loyalty and trust in your brand.
How to use the cost-plus pricing formula in SaaS to calculate your product’s selling price
Cost-plus pricing is where a markup percentage is added to a product’s unit cost to make the final selling price.
At first glance, it might seem like a straightforward strategy for retail companies, but in the SaaS, specific nuances exist.
The formula for cost-plus in SaaS is:
Selling Price = CAC (Customer Acquisition Cost) + COGS (Cost of Goods Sold) + Desired Margin
- CAC (Customer Acquisition Cost): This is a distinctive factor for SaaS businesses. Unlike traditional businesses, where production costs are major, SaaS businesses often invest heavily in acquiring customers.
- COGS (Cost of Goods Sold): For SaaS companies, this generally refers to the direct costs of delivering the service to a customer. This might include server costs, support services, and other related expenses.
- Desired Margin: This is the amount of profit you want to make. It’s added to your total costs to ensure you’re not just breaking even but earning a profit.
Imagine you run a SaaS business. The cost to acquire a new customer (CAC) is $100. Your COGS amounts to $50 for each customer. You decide you want a profit margin (desired margin) of $75 per customer.
A cost plus pricing example using the formula is:
Selling Price = $100 (CAC) + $50 (COGS) + $75 (Desired Margin)
Selling Price = $225
Advantages of cost-plus pricing strategy
Diving into the world of pricing strategies can seem daunting, but the cost-plus method stands out for its simplicity and predictability. Below, we explore these benefits in detail.
Simple to implement
At its core, the cost-plus method revolves around a basic formula, focusing on your production’s total cost and customer acquisition cost (CAC), then adding a markup percentage.
Unlike other pricing methods that require intensive market research or deep dives into competitor pricing, cost-plus pricing means you won’t be engaged in price wars or constantly trying to undercut competitors.
It’s easier to communicate changes in your cost-plus pricing
One of the standout advantages of cost-plus pricing is the ease with which businesses can explain and justify their price levels and fluctuations.
If there’s a need to adjust prices — say, due to an uptick in production costs — the rationale behind such price changes is straightforward for consumers to grasp.
Cost-plus pricing provides a consistent rate of return
One of the primary appeals of the cost-plus pricing method is its consistent rate of return. Once you sum up the production and operational overhead costs accurately, you add a markup that guarantees a positive rate of return.
However, unexpected direct labor costs can fluctuate, and you might not easily predict them, which can eat into the set margins.
You can increase the arbitrary margin to counteract potential underestimations in variable costs to create a buffer against unforeseen expenses.
Disadvantages of cost-plus pricing strategy
While the cost-plus pricing strategy has drawbacks, understanding these limitations is crucial for businesses considering this pricing model. Let’s delve into some of the key disadvantages.
You can’t gain a competitive advantage
Cost-plus pricing can sideline the crucial aspect of market research. This pricing method overlooks external market dynamics by focusing primarily on internal costs. Market research is pivotal in crafting a holistic pricing strategy.
Without substantial market research, you’re navigating the market blindfolded when it comes to understanding consumer demand and the perceived value of your product.
Cost-plus pricing doesn’t take customers into account
The foundational idea of cost-plus pricing is to calculate costs and then add a margin. However, this strategy can often overlook the asking price the customer is genuinely willing to pay.
Cost-plus might not be the most effective strategy in the SaaS industry, where customers’ perceived value can vary widely.
Instead, SaaS companies might benefit from pricing models that factor in their unique value propositions and their target audiences’ specific needs and pain points.
Other pricing strategies for SaaS
While the cost-plus pricing method has merits, it’s not the only strategy SaaS companies can leverage. Let’s delve into some alternative pricing strategies:
- Value-Based Pricing Strategy: The value-based pricing approach involves understanding what customers are willing to pay for the product’s benefits and solutions.
- Penetration Pricing Strategy: With this strategy, companies initially set a low price to gain a significant market share quickly.
- Competitive-Based Pricing Strategy: This strategy revolves around competitor prices. SaaS companies using this approach will price their product in line with, slightly above, or below their competitors, depending on their product’s perceived value and market positioning.
- Captive Pricing Strategy: This strategy involves pricing a basic product in the lower range while keeping the essential complementary products or services priced higher.
- Skimming Pricing Strategy: Skimming involves setting high prices for a new product to “skim” maximum revenues layer by layer from those willing to pay more.
- Prestige Pricing Strategy: This strategy banks on the “premium” factor. Products are priced higher to give an impression of exclusivity or superior quality.
Whether you’re leaning towards cost-plus pricing or considering alternatives like value-based or skimming, it’s essential to remain adaptable. Want to build product experiences code-free? Book a demo call with our team and get started!