Among the most critical decisions an entrepreneur makes, pricing products and services sit near the top of the list. Cost-plus pricing and tiered pricing models represent two of the most widely-used pricing methodologies—and are possibly the easiest to grasp. Before diving into these methods, let’s start with a story that shows how important pricing strategy is to a company’s bottom line.
An oft-cited study published in the Harvard Business Review in 1992 revealed that a one percent price improvement yields an 11 percent gain in operating profit. The statistic comes from a detailed dive into the pricing machinations of Tech-Craft, a U.S. manufacturer of home appliances.
Tech-Craft analyzed competitor pricing for microwave ovens—a product line for which little differentiation exists among manufacturers—and found that its rivals’ pricing structures were just as intricate as its own. From dealer list price to pocket price—or what the customer ultimately paid for the appliances—10 different discounts amounted to an aggregate 39.1 percent average price concession from the starting point. These 10 price reductions constitute what is called the pocket price waterfall, or the series of discounts from the manufacturer to the customer. The pocket price waterfall details the depth of each price break as the product makes its way to a buyer for the pocket price, which step by step reduces the revenue a company keeps from each sales transaction.
The company further uncovered that retailers, when comparing price among suppliers, focused mainly on cash or order-size discounts. Tech-Craft’s customers didn’t expend much effort in dissecting how off-invoice discounts affected individual orders. Consequently, the nuances of discounts such as co-op advertising dollars and annual volume bonuses rendered buyers much less reactive to changes in what they didn’t readily see with each transaction.
Armed with this analysis, Tech-Craft, through a 3.5 percent average pocket price raise, was able to realize an 11 percent unit volume increase along with a 60 percent operating profit improvement. To achieve those results, the company pursued a three-fold strategy. It raised prices for the least resistant customers and lowered prices for more sensitive ones. Finally, Tech-Craft gradually lessened discounts across the waterfall in areas that didn’t negatively impact retailer buying habits.
Couple price improvement with the notion that a business can build a brand and market its wares ‘til the cows come home, but if customers fail to see value, a pricing miscalculation could put the business out to pasture.
J.C. Penney, the troubled retailer, began to harpoon itself when it introduced “fair and square” pricing seven years ago. The chain eliminated all things sacred to the department store shopper—namely, discounts, sales, and promotions. Plans backfired when psychologically-conditioned customers weren’t sold on the notion that a $50 coat presented greater value than a $100 coat, marked down by 50 percent. As if the imposing shadow of ecommerce retailers wasn’t enough, J.C. Penney’s pricing foibles saw sales plummet by nearly 25 percent in 2012, and its downward spiral—greased by bankruptcy rumors—continues in 2019.
While Tech-Craft and J.C. Penney’s pricing adventures are a bit advanced, cost-plus pricing and tiered pricing, at their very basic levels, are easier for businesses to apply than models requiring extensive programming and development. Some businesses use more sophisticated pricing strategies such as demand-based pricing that leverages algorithms to adjust prices upward in peak buying times, and vice versa in troughs. Expect to spend more on Friday evening in Los Angeles on an Uber fare than you would on Tuesday morning in Los Alamos.
Cost-plus pricing is a pricing method that takes a supplier or manufacturer’s total cost of a good, and then adds a percentage of profit margin to that base figure. Tiered pricing shows how offering greater product quantities or service upgrades can positively impact a business’s top-line revenue. Let’s explore each of these further.
Cost-plus pricing defined
When a business chooses a pricing method, they usually choose one of the following two paths: a model in which a seller pockets a flat-dollar amount from selling a unit of merchandise, and a scenario in which a business slaps a fixed percentage of profit on top of the cost of the good. Cost-plus pricing aligns with the latter focus in that a business totals all fixed and variable costs of a good or service and then adds, for example, a profit margin of 30 percent.
Once a total cost to manufacture or acquire a product is determined, anyone with a basic calculator can add a percentage gain to the equation and know exactly how much profit to expect from a sale. When multiple items come off the production line, properly allocating manufacturing overhead is crucial to accurately figure differences in your starting costs between products.
Companies use cost-plus approaches for a variety of reasons, not the least of which is transparency. It’s pretty simple for a company to state uniformly that it marks up each of its products by 30 percent. With that in mind, it’s also easy for patrons to understand the exact reason for a price increase. A 10 percent hike in manufacturing costs must get passed on to the customer if the desired level of profit is to stay intact.
Naturally, cost-plus pricing has its detractors:
- Some observers say this method ignores the prices of competitors. The willingness to stick to a hard-and-fast margin may result in a product being overpriced in relation to the market.
- On the opposite end, customers may not have objected to paying a higher price for an item, and your business then misses out on the opportunity for additional profit. This strategy is the opposite of value-based pricing strategies, which monitor real-time peaks and valleys in consumer demand and ratchet prices up or down accordingly.
Further advantages of cost-plus pricing include the simplicity of its application. Neither you nor your customers need to ruminate over a flat 30 percent margin added to the cost of a good. In that way, your customer knows exactly what they’re getting in terms of price and quality. Cost-plus also negates any illusions of price gouging since consumer cost is directly correlated to acquisition cost and the addition of the desired margin.
Many observers look at Costco and marvel at its ability to continually turn profits despite wafer-thin margins. The warehouse retailer operated on a 13.2 percent gross margin in Q1 2018 while Target’s number more than doubled that figure at nearly 29 percent. Costco stays as lean as possible with respect to operations, and annual membership fees go a long way toward boosting the bottom line. In the age of the e-tailer, thriving and prospering in the brick-and-mortar space should be lauded and emulated.
Cost-plus pricing by name and number
Arriving at a cost-plus price for an item is pretty simple when you plug in the required variables for the equation. Consider the following example. You have 100,000 picture frames to sell and the total cost to manufacture was $500,000 or $5 per unit, with variable costs consuming $4 and fixed costs set at $1. Your desired profit margin of 30 percent then gets added to the cost basis on the frames. The formula looks like this:
Price = (Fixed costs + Variable costs) x (1 + profit margin) or
$6.50 = ($4 + $1)(1.30)
So to maintain a 30 percent margin, the picture frames should be priced at $6.50. However, some businesses, often startups or a business looking to penetrate a new market, don’t price for profits. They use break-even pricing to increase market share and construct a barrier to entry for competitors. Calculating break-even pricing is as easy as it gets. Simply remove the margin from the cost-plus equation, and your asking price represents your cost per unit.
Initially, it’s simple enough to formulate a basic cost-plus strategy but many pricing experts agree that such a model should factor in competition and customer value. By brushing aside competitor prices and a customer’s price ceiling, retailers might be leaving money on the table due to the static nature of a pure cost-based approach. Secondly, many companies lack the budget or expertise to accurately arrive at cost in the first place. Thus, without a solid floor to affix a margin to, it’s really anybody’s semi-educated guess as to what that margin actually is.
If your company desires to progress beyond a cost-based model, moving along the pricing maturity curve toward a more dynamic model might serve you well. Most big players these days rely on data analytics to price appropriately but on smaller scales, success depends on information—how to locate it, how to harness it, and how to apply it. As pricing evolves, even the more sophisticated models don’t condone wholesale replacement of intuition with science. Hybrid pricing strategies that rely on management’s knowledge of its customers, as well as data highlighting demographics, buying habits, and brand preferences, appear to serve companies well.
You might stumble upon a few other terms synonymous with cost-plus pricing: marginal-cost pricing, cost-based pricing, or mark-up pricing—but a strategy by any other name would still produce the same outcomes. Chances are strong that you’ve also encountered tiered pricing models, described below, which benefit businesses through volume discounts or a variety of service package options.
Tiered pricing defined
A paper from The Pricing Society reports that 30 to 35 percent of companies adopt cost-based pricing de facto because they’re not aware of the alternatives. Tiered pricing is the alternative in this context.
Let’s imagine you own a lumber yard that offers quantity discounts. You charge $10 for a sheet of plywood with an acquisition cost of $6. The price drops to $9.50 if the customer purchases more than 20 sheets. If that customer is then persuaded to buy 25 sheets because of the discount, total revenue rises from $80 to $87.50 while profit margin shrinks from 66 percent to 58 percent respectively.
As another example, electrical distributors might offer bulk discounts on switchplates, offering price breaks as more units are purchased. Theoretically, greater sales volume compensates for lower margins as overall quantities increase in number.
Service providers also employ tiered pricing strategies to sell various packages—each option priced higher as the level or number of services increases. An upgraded package may fetch $20 monthly for a streaming video package that allows multiple logins, rather than $10 for a single login. Revenue increases are dependent on overall usage, and margins may stay the same or even subsequently increase.
Present a range of price points to customers and let them choose a good or service based on what they can afford. In the case of a product purchase, first-time buyers—cognizant of the tiered arrangement—may convert to repeat customers based on incentives.
With the power and complexity of tiered pricing in mind, you don’t want to create a paradox of choice for customers when marketing services. This concept exhibits how customers who must work harder to make a buying decision often end up not purchasing anything at all. Attempting to sort through the benefits and features of 10 packages rather than three, for instance, may result in both a confused and lost prospect.
Software development and sales organizations structure tiered pricing subscription models to interest users drawn in by a manageable monthly fee for standard services. As time passes and needs change, subscribers may upgrade to a pricier package, boosting revenue for the seller.
Look no further than Comcast to witness how tiered pricing works in practice. The cable TV provider offers new customers a bottom-tier package that includes about 10 channels for a $30 monthly fee. Upgrade to a premium package for $60 per month and receive 140 channels with one premium channel such as HBO or Cinemax. Pull out all the stops for an ultra package and you might expect to pay greater than $1,000 annually for every available channel under the sun of the telecommunications giant’s universe.
Every pricing model has its pros and cons. The key to finding which one works best for your business involves forecasting sales figures and adjusting profit margins to yield results for various scenarios. Without such models, the trial-and-error method could prove time-consuming and costly when theory eventually gives way to practice. Business management software has all the tools you need to test the water in the market before you dive in.