Among the most critical decisions an entrepreneur makes, pricing products and services sits near the top of the list. There are a number of ways you can set your selling price for a new product, with no single method being the best choice for everyone.
Cost-plus pricing and tiered pricing models represent two of the most widely-used pricing methodologies — and may be the easiest to grasp. You’ve likely encountered a few other terms synonymous with cost-plus pricing: marginal-cost pricing, cost-based pricing or mark-up pricing.
Before diving into this method for making pricing decisions, let’s start with a story that shows how important pricing strategy is to a company’s bottom line. Then, we’ll look at what cost-plus pricing and tiered pricing are, and how you can use them in your business.
Pricing strategy case studies: Tech Craft & JCPenney
An oft-cited study published in the Harvard Business Review in 1992 revealed that a 1% price improvement yields an 11% 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.
Tech Craft compared the dealer list price to the pocket price — the price paid by a customer without any discounts or rebates. They found that from dealer list price to pocket price roughly 10 different discounts commonly cropped up during the process, amounting to a 39.1% average price concession from the starting point.
These 10 price reductions constitute what’s 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 from the manufacturer to the customer. Each price break during this waterfall 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. As a result, buyers were less reactive to changes in the things they didn’t readily see with each transaction. This meant reductions of less obvious discounts, like an off-invoice discount, weren’t noticed as often.
Armed with this analysis, Tech Craft, through a 3.5% average pocket price raise, was able to create an 11% boost in units sold along with a 60% 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.
A brand can focus on price improvement and market its wares until the cows come home, but if customers fail to see value, a pricing miscalculation could put the business out to pasture. This is a point made clear by JCPenney.
JCPenney, the troubled retailer, began to harpoon itself when it introduced “fair and square” pricing. 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%. As if the imposing shadow of eCommerce retailers wasn’t enough, JCPenney’s pricing foibles saw sales plummet by nearly 25% in 2012, and its downward spiral — greased by bankruptcy rumors — continued through 2019.
The importance of your pricing policy
While Tech Craft and JCPenney’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 that require 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 downward during times of low sales. Expect to spend more on an Uber fare on Friday evening in Los Angeles 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.
What is cost-plus pricing?
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 a set profit margin. Let’s say, for example, that you add a profit margin of 30%.
After determining the total cost to manufacture or acquire a product, 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 calculating 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%. With that in mind, it’s also easy for patrons to understand the exact reason for a price increase. A 10% 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. Sticking 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% 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.
Cost-plus pricing in action
Arriving at a cost-plus price for an item is pretty simple when you plug in the required variables for the equation. First, there are two important pricing terms to understand.
- Variable costs: a variable cost is any cost that fluctuates as your business or demand shifts. For example, the material used to create a product would be variable, as your monthly material spending would increase or decrease along with your demand.
- Fixed costs: a fixed cost is set in stone and doesn’t fluctuate from month-to-month, regardless of your production. Some common fixed costs are insurance, rent or utilities, as these will stay constant even if you make more or less of your product.
To understand cost-plus pricing in action, consider the following example:
You have 100,000 picture frames to sell and the total cost to manufacture them was $500,000 or $5 per unit, with variable costs consuming $4 and fixed costs set at $1. Your desired profit margin of 30% then gets added to the cost to make the frames. The formula looks like this:
(Fixed costs + variable costs) × (1 + profit margin) = price
In this case, the formula would look like this:
($4 + $1) × (1 + 0.30) = $6.50
So to maintain a 30% 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 number to add a margin to, it’s anybody’s guess as to what that margin actually is.
If your company wants 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 recommend completely replacing 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, serve companies well.
Cost-plus pricing is a potentially lucrative pricing model for many businesses, but it’s not the only pricing model around. You’ve likely come across 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 30-35% of companies adopt cost-based pricing because they’re not aware of the alternatives. Tiered pricing is the most accessible alternative for most businesses.
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 persuaded to buy 25 sheets because of the discount, total revenue rises from $80 to $87.50 while profit margin shrinks from 66% to 58%.
As another example, electrical distributors might offer bulk discounts on switchplates, with price breaks as more units are purchased. Theoretically, greater sales volume compensates for lower margins as overall quantity of sales increases.
Service providers also employ tiered pricing strategies to sell various packages — each option priced higher as the level or number of services increases. One example is a video streaming provider.
An upgraded package with a provider 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 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.
But with tiered pricing, 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 a confused and lost prospect.
Software development and sales organizations frequently offer tiered pricing subscription models as well. They use a manageable monthly fee for standard services to initially hook users. As time passes and a customer’s needs change, they 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 like 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 channel under the sun.
Cost-plus pricing, tiered pricing and you
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. Take your time, crunch numbers till it hurts, and think long and hard about the impact a price shift could have on current and potential customers.
A cost-plus pricing strategy can do wonders, but so can a tiered pricing model. And it’s possible neither of these avenues is right for you. The beauty of running a business is that you run the business. Don’t limit yourself to either of the big two models. Instead, research how to find the optimal pricing model for your business. Eventually, you’ll land on a number that allows your company to sell your product at a price that offers a great return.