Cost-Plus Margin Pricing, an Overview

Most U.S. companies use the cost-plus margin approach to set their prices. Through this strategy, a firm determines how much money it wants to make from selling the product, i.e., the sales target. Then, it subtracts its manufacturing cost from that sales target and divides it by the number of units it plans to sell.

Example: To illustrate, say Nike decides to make a new edition of its best-selling Air Jordan sneakers. Nike plans to make 600 pairs of Air Jordans to generate $1 million in sales. Nike’s cost to manufacture the new Air Jordans is $10 per pair, which translates to $6,000 for 600 pairs. Therefore, under a cost-plus margin approach, Nike determines the price of the sneakers by subtracting $6,000 (manufacturing costs) from $1 million (sales target) and dividing by 600 (number of units). MSRP for a pair of Nike’s new Air Jordans? $1,656.66.

As you will notice, this strategy fails to consider whether the consumer will purchase the item at the cost needed to reach the sales goal. And, it blindly assumes that market demand for the item exists (probably a safe bet in the case of Air Jordans).

Why Does Anyone Use Such a Horrible Strategy?

Proponents of cost-plus margin typically advance three arguments in its favor: First, it is simple. The company does not need to look outside its own ledger to determine the price for a product. And, because a casual familiarity with arithmetic is all that is required, anyone can come up with a price. Second, it is fair. Unless the company is marking up prices thousands of times, the method provides a simple way to justify a retail price. Third, cost-plus margin is financially prudent because it ensures profitable sales.

But, upon a closer inspection, we quickly see that not one of these arguments is compelling. Until the creation of Drop Pilot, the simplicity argument carried some weight, especially in the case of small businesses. For example, until now, the only alternative to cost-plus margin was to hire pricing consultants and pay them to guess what you should charge and then bill you thousands of dollars for doing so. But, now, for a 3% commission, any business can use Drop Pilot to learn what the public is willing to pay for their products. Therefore, the simplicity argument has little merit.

Second, there’s nothing inherently fair about utilizing cost-plus margin because the strategy is focused on what the company wants to charge instead of what the customer wants to pay. A more fair way to price is to let customers have a say in the process based on their willingness to pay.

Third, the guesswork associated with cost-plus margin renders it anything but financially prudent. If a company prices their product at $10 but the market is willing to pay $20, that company is actually losing $10 on every sale. This sort of sales model is not prudent, but the opposite.

In summary, cost-plus margin is like any other bad habit, easy to get hooked on, and hard to quit. The best businesses learn this early on and look for ways to improve their methods before it’s too late.