Unless you provide very
high priced, custom-to-each-client services, the worst way to price your
products or service is cost-plus pricing. How cost-plus pricing works: You
calculate your full costs, including overhead, and set a price where all of
those costs are covered and so is an acceptable (to you) amount of
You plan to sell t-shirts, so you add in your direct costs (materials & ink
for the logos) of let's say $15, add in a piece of your overhead (salaries,
rent, etc.) let's say $12, plus your desired profit of $4 per shirt to
arrive at a price of $31.
Cost-plus pricing is not
only your worst choice, but it is also the most widely used
pricing strategy. That means that when
you start pricing more intelligently, you will have
a real advantage over most of your competitors!
So, you may ask, if
cost-plus pricing covers all my costs and gives me a fixed amount of profit
per sale – what's not to like? There are three key problems with it:
The price you establish may be so high that you will lose money through lost
sales. Consumers buy at a price that seems "right" to them. Can you picture
them thinking the following? "Well... this price is much higher than I
expected to pay, but the seller must need to make this much to cover costs –
so I'd better pay it or the seller may lose sales." I can't picture it
All cost-plus calculations require an estimate of sales to be accurate. To
figure in overhead, you have to apply it to each product sold. For example,
if your rent/phone/electricity/assistant costs add up to $100,000/year and
you estimate your company will sell 100,000 t-shirts, you apply $1 of your
overhead to the price of each t-shirt to cover that cost. But... what
happens if you actually sell just 20,000 t-shirts? That means you have
$80,000 of costs Which you did NOT cover. That means the fixed amount of
profit you built into each price has just disappeared. In fact, you have
lost money – with a pricing strategy that was supposed to "guarantee" you a
Nobody can do an accurate
enough prediction of sales volume to make cost-plus pricing work (except for
companies which create a separate bid for each large-priced, custom job they
bid on). After all, the number of products you can sell will vary widely
depending on the price you set.
Cost-plus pricing can cause you to underprice your products or services –
thus cheating your company of sales it could have earned. How? Let's suppose
by some miracle you actually guessed right on the units you would sell.
Let's say you calculated you could sell 100,000 t-shirts, and by using
cost-plus pricing you came up to a price of $26 – to cover all your costs
and add $4 profit per shirt. Then you sold 100,000.
Congratulations? Maybe not.
Maybe those consumers who bought at $26 would have been perfectly willing to
buy the same shirt at $29. What happened? You just cost the company
$300,000! That extra money could have allowed your company to test a new
product line... or covered losses from another product... or allowed the
owner (you?) to put your kids through college.