3 Flaws of Cost-plus Pricing

Cost-plus is a popular retail pricing strategy. It preserves a margin and is easy to use, even for businesses with thousands of SKUs.

Cost-plus works as its name implies. A merchant determines the all-in cost of selling a product — sourcing, warehousing, marketing — and then adds a markup.

Cost + Markup = Price

The model is simple: know your product costs, pick a margin, and apply it to every item or category.

The strategy works well with low inflation, few competitors, and unforeseen transactional expenses. But it has a few flaws otherwise.

3 Flaws of Cost-plus Pricing

Product costs. The first complexity is fluctuating product costs. Rarely do inventory prices remain stable.

Consider recent events — Covid, the war in Ukraine, inflation, and even unpredictable weather, such as the flooding in Northern California. Each altered the price to make or buy inventory.

An item could cost $4.00 in Q1 and $4.25 in Q3. If it had no remaining inventory before the price increase, the seller could merely increase the price to match the new cost, a straightforward use of cost-plus.

But what if the seller held $4.00 inventory when prices increased to $4.25?

Imagine a merchant sells 75 widgets a month on average but must reorder in gross batches of 144. The lead time for those orders is about 30 days, forcing the merchant to place orders while carrying inventory. Thus the seller could have 100 units in stock (at $4.00 each) when the price increase to $4.25 occurs. Ordering 144 more units results in an average cost of $4.15.

[(100 units x $4.00) + (144 units x $4.25)] / 244 = $4.15

But the 144 units on order will not arrive for a month. By that time, the price for ordering yet another gross will likely have moved again.

The problem is not insurmountable, but it illustrates the complexity of the cost-plus strategy.

Competition. Setting the target margin in cost-plus pricing is not as simple as doubling the price or picking an arbitrary profit on each unit sold. Rather, the margin should reflect competitors.

Michael E. Porter, a one-time Harvard Business School professor, identifies five competitive forces of consumer brands: direct rivals, buyers’ bargaining power, suppliers’ bargaining power, the threat of new entrants, and the threat of substitutions.

Direct rivals are the easiest force to evaluate. What will be the response of a close competitor when we set a target margin? Will the competitor match our price? Will it sell for less (or more)? Should we apply our margin equally to all items or vary by category or brand?

Transactional expense. The final complication in an otherwise simple-sounding strategy is managing transactional expenses, such as discounts, closeouts, and other marketing incentives.

At a strategic level, cost-plus is attractive. But then Porter’s market forces intervene, requiring sellers to offer free shipping, coupons, bundles, membership discounts, and more. All reduce the average margin.

Nuance Required

Cost-plus pricing on the surface appears easy to use and maintain. But changes in the supply chain, competitive forces, and even marketing tactics can complicate it. Thus, while helpful, cost-plus requires nuance and is not likely the only strategy to apply.