Cost-Plus is a popular retail pricing strategy. It maintains a margin and is easy to use, even for companies with thousands of SKUs.

Cost-Plus works as the name suggests. A retailer calculates the total cost of selling a product – sourcing, warehousing, marketing – and then adds a markup.

Cost + markup = price

The model is simple: know your product cost, choose a margin, and apply it to each item or category.

The strategy works well with stable prices, few competitors and unforeseen transaction costs. But otherwise it has weaknesses.

3 shortcomings of cost-plus pricing

product cost. The first complexity is fluctuating product costs. Storage prices rarely remain stable.

Consider recent events – Covid, the war in Ukraine, inflation and even unpredictable weather like the Northern California floods. Everyone changed the price to make or buy inventory.

An item might cost $4.00 in Q1 and $4.25 in Q3. If there was no remaining inventory before the price increase, the seller could only increase the price to match the new cost, a simple use of Cost-Plus.

But what if the seller held $4.00 in inventory when prices went up to $4.25?

Imagine a retailer sells an average of 75 widgets per month but needs to reorder in gross batches of 144. The lead time for these orders is around 30 days, forcing the merchant to place orders while maintaining an inventory. Thus, the seller could have 100 units in stock (at $4.00 each) when the price rise to $4.25 occurs. Ordering 144 more units results in an average cost of $4.15.

[(100 units x $4.00) + (144 units x $4.25)] / 244 = $4.15

But the 144 units ordered won’t arrive for a month. By that time, the price of ordering another gross will likely have moved again.

The problem is not insurmountable, but it illustrates the complexity of the cost-plus strategy.

Contest. Setting the target margin in cost-plus pricing isn’t as simple as doubling the price or picking an arbitrary profit for each unit sold. Rather, the margin should reflect the competition.

Michael E. Porter, a former professor at Harvard Business School, identifies five competitive forces of consumer brands: direct competitors, bargaining power of buyers, bargaining power of suppliers, the threat of new entrants, and the threat of substitution.

Direct competitors are the easiest to evaluate. How will a close competitor react when we set a target margin? Will the competitor match our price? Will it sell for less (or more)? Should we apply our margin equally to all items or vary by category or brand?

transaction costs. The final complication in an otherwise simple-sounding strategy is managing transaction costs like discounts, closeouts, and other marketing incentives.

At a strategic level, Cost-Plus is attractive. But then Porter’s market forces kick in, requiring sellers to offer free shipping, coupons, bundles, member discounts, and more. All reduce the average margin.

nuance required

Cost plus pricing on the surface it seems easy to use and maintain. But supply chain changes, competitive forces, and even marketing tactics can complicate this. Cost-Plus, while helpful, requires nuance and is probably not the only strategy to use.