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The Hidden Costs of Cost-Plus Pricing

Kalle Aerikkala< Kalle Aerikkala July 18, 2019

In his article “When Cost-Plus Pricing is a Good Idea” Utpal Dholakia, Professor of Marketing at Rice University’s Jesse H. Jones Graduate School of Business, makes a solid argument for why cost-plus pricing is a viable pricing strategy, and why it can be better than customer value-based pricing strategies. He advocates three main reasons:

  1. It is easy to calculate, implement and justify
  2. It does not exploit market imbalances
  3. It helps support a low-cost strategy

Let me therefore start by saying that I do agree that cost-plus pricing can be a viable strategy in some situations. However, modern pricing strategy, and the software used to support it, has to balance at least three different C-factors in determining the ”right price”: cost, customer value and competitive situation.

Relying on cost only has some obvious disadvantages, with the most important being the inherent lack of customer focus and non-consideration of competitive offers. But even the advantages outlined by Professor Dholakia are not as clear as they might seem. Let’s examine each one of them in more detail.

Is a cost-plus strategy easy to calculate, implement and justify?

If all products sold have the same characteristics, cost-plus as a percentage of purchase price might be an easy method. But in many cases the product portfolio is more complicated than that. Take for example the wines on a restaurant wine list. Many restaurants want to offer a selection, from low-cost/high-volume house wines to more premium first growth estate wines. However, adding a standard percentage rate to the purchase price of all wines would make the price of the premium wines prohibitively expensive, so many restaurants either use a combination of percentage and actual dollars (or euros, pounds, kronor etc.), or have different calculation models for different price ranges, to set the menu price.

The same situation applies for most retailers and manufacturers, where there is a need to balance the pricing strategy for a smaller range of high volume/high inventory turn-over items – and usually fierce competition from a multitude of other companies with similar offers – with a large selection of low-volume/long-tail products where competition might be more limited.

Another classic example can be found within marketing consultancies and communication agencies. Initially the standard remuneration method for an ad campaign was that the agency fee was calculated as a percentage of the media cost for the campaign. This worked reasonably well for a while, but increasingly there became to be a disconnect between two types of cost: the manpower and other resources used to plan, create and produce the communication activity, and the cost of the media channels used to deliver the communication to its audience. Increasingly, many agencies have therefore turned to the classic time-based/hourly-rate model, but even this simple cost-plus model is seriously flawed – as are most time-based models for expertise services.

The fundamental issue with time equals cost is that thinking time and experience are very difficult to allocate with precision. Manual labor, such as the time it takes to dig a hole, is reasonably straightforward to calculate on a cost basis, but how about the time it takes to come up with a good idea for a marketing message? If the team working on the project comes up with a great idea quickly, should this cost less than an equally talented team working longer on the same project before they find they right message? Or is a complicated idea, requiring more manhours to produce and execute, automatically better and worth more than a simple idea requiring fewer hours?

Another classic problem with cost-plus models, especially in manufacturing, is how to allocate the overhead costs. Should this be done on a pro-rata basis (i.e. where overhead cost are shared equally as a percentage factor), on a cost analysis basis (i.e. costs shared “fairly”, based on an analysis of resources used), a combination of these, or any other form? Hence, whilst “cost plus” is easy to say, it is actually often a lot harder to define and implement than what it might seem at first. And if it is hard to define the method used for calculating what would be called a cost-plus strategy, the consequence is that it will also be difficult to be totally transparent about how it is done, and how to communicate and justify the method.

Do other strategies exploit market imbalances?

Professor Dholakia uses the examples of, among others, Uber and Coca-Cola to argue against market-based pricing. However, the customer frustration – sometimes even rage – that ensued demonstrates that Uber and Coca-Cola did not practice customer-value based pricing at all, but rather a form of opportunistic pricing. Pricing based on perceived customer value recognizes the balance of needs between supplier and buyer, whereas opportunistic pricing means get as much as you can and do not worry about long-term relations or customer satisfaction levels.

Read: Roadmap for Fast Profit Growth

Most consumers understand the laws of supply and demand, and appreciate that prices can vary, but only within certain socially acceptable limits. If there is a shortage of a commodity, whether it be because of production issues, increased demand, change in competition or other reasons, consumers accept that prices will rise – but only to a level where they feel they are not being taken advantage of. This is the implied social contract of reciprocity and fairness that we – and most social animals – base much of our relations on. What this revised price level is, and how quickly it changes, is something that a sophisticated modern pricing system can accommodate and help pricing managers stay on top of. And incidentally, the response from the customers of Uber and Coca-Cola showed clearly that these companies were not using a customer value-based strategy, as the customers quickly let the companies know that their products were not worth the money they wanted to charge.

Does cost-plus pricing support a low-cost strategy?

Professor Dholakia argues that if you want to be a low-price player that uses a cost leadership advantage in the market, it helps to use cost-plus pricing to convey this position. However, he seems to get (at least) two different strategies mixed up in his argument. On the one hand, there is the strategic position of being the low-price leader in a market, and on the other there is the strategy of cost-plus pricing. They can be related, but he does not present evidence for neither the full relation nor the causality. In some situations, a low-price position comes with attributes such as lower service levels, reduced product range etc., as these are both means to achieve lower costs and ways of demonstrating that low cost comes at a price.

Incidentally, it should also be noted that low cost is not the same as superior customer value. In fact – and this is a common semantic mistake that sometimes even professors can make – EVERY successful brand delivers superior customer value, as value is defined by “what I get” vs “what I pay”. Successful brands would not be successful and achieve sales growth if they did not deliver superior value for their customers, irrespective of at which price points they compete.

Professor Dholakia uses Costco as an example to make his point, as they use – and communicate – a cost-plus strategy to support their role as a price leader. But a sample of one is not the same as evidence that cost-plus is a better pricing strategy, or even necessary, for a company that wants to be perceived as a price leader. This can easily be shown by using another example of a well-known company that pursues a price leadership strategy through low operational costs, but which does not talk about a cost-plus strategy.

IKEA is a global home furnishings success with its “democratic design” philosophy and its desire to make good design affordable and available to all. One of its ways to prove its operational cost leadership is its clear strategy of “if the customer does some of the work, they get to keep the savings”, demonstrated by elements such as its flatpack design and open warehouse store structure. Another detail is its focus on “the first item we design in a new product is the price tag”, i.e. how its designers always look for ways of keeping costs down without compromising on quality or performance. In other words, IKEA communicates very clearly how the company is a cost, and low price leader, but it does so without using a cost-plus pricing strategy.

Know your options

In summary, it is clear that cost plus has its role as a pricing strategy in a number of instances, for example for complementary products or where the real customer-perceived value might be difficult to assess, due to low volumes, special buying conditions, or otherwise. And more importantly, cost should of course always be considered in every pricing strategy, in order to find the right balance between cost, customer-perceived value and the competitive structure for each product and for the total portfolio. But even when a cost-plus pricing strategy is used, be careful about what the real advantages are, and what alternative strategies exist.

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