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Cost plus pricing, also known as cost-based pricing, is commonly used as a starting point for many SaaS companies. This pricing approach involves adding a desired profit margin (e.g. 20%) to the costs incurred during product development, marketing, and selling.
While cost plus pricing doesn't take into account competitor pricing, perceived product value, customer price sensitivity, or other factors that should influence pricing decisions, it serves as a useful framework for initiating pricing discussions when there is limited information available.
Cost-plus pricing is a method in which you calculate your business's expenses and then add a desired markup percentage to determine the selling price of your product.
This approach is crucial in pricing strategies because your costs establish the foundation for a viable minimum price to ensure profitability.
When considering a cost-plus pricing strategy, people often focus on the cost of goods sold (CoGS).
For SaaS businesses, CoGS can include expenses such as cloud infrastructure, customer support, software engineering, and other product-related costs.
Based on our experience with over 25 SaaS startups, CoGS typically accounts for approximately 30% of revenue. However, for businesses dealing with physical products, hardware, or custom development, the CoGS may be higher.
It's important to note that relying solely on CoGS for cost-plus pricing is inadequate, as it overlooks sales and marketing costs.
In addition, a significant SaaS metric for many businesses lies within these operating expenses: the customer acquisition cost (CAC).
The Cost-Plus Pricing Strategy Explained
Cost-plus pricing is a straightforward approach to pricing your SaaS product. However, it has acquired a negative reputation within the startup community for two significant reasons.
Firstly, it falls short in maximizing profit potential, as the majority of the value ends up benefiting customers rather than the business itself.
Secondly, it neglects the importance of customer feedback by solely focusing on internal expenses. Just as it would be impractical to seek product-market fit without engaging with customers, the same principle applies to achieving "price-market" fit.
Cost-plus pricing has a poor reputation in the SaaS industry, yet it's crucial for founders to grasp this pricing strategy. As competition heightens, prices tend to align with cost-plus due to the inevitable commoditization. Although this process may take years, it's vital to acknowledge that your business can still thrive.
However, comprehending your business's cost-plus pricing is easier said than done. It's all too easy to overlook significant costs that should be factored into your approach, such as customer acquisition expenses.
In the SaaS realm, gross margins (revenue minus the cost of goods sold) are typically high enough to render the cost of producing and delivering additional units inconsequential. The key driver behind your customer acquisition cost lies in how you choose to sell your product.
Pros of Cost-Plus Pricing
👍 Easy to Use and Implement
Using a cost-plus pricing strategy is straightforward. You analyze your production costs, such as labor, materials, and overhead, and then determine a markup price. No extensive research is required.
👍 Cost Recovery
Using cost plus pricing allows businesses to recover their costs and make a profit. It involves calculating all expenses and using that information to set the price, ensuring that each sale contributes to covering expenses. This approach minimizes the risk of financial loss and helps keep the business operating smoothly.
👍 Cost Control and Efficiency
Cost plus pricing encourages businesses to closely monitor and control their costs. This involves tracking costs, regularly reviewing them, and identifying areas of inefficiency, reducing wastage, and improving operational effectiveness.
👍 Builds Trust With Customers
Cost plus pricing provides customers with a clear and transparent breakdown of costs, enabling them to understand how the selling price is determined based on the actual expenses incurred by the business. This level of transparency not only fosters trust and credibility with customers but also empowers them to make informed decisions.
Drawbacks of Cost-Plus Pricing
👎 Your Prices Can Be Too High
If you don't take into account competitor prices, there is a possibility that your selling price might be too high. This can lead to a decrease in sales if customers decide to buy from a cheaper competitor.
👎 Your Prices Are Not Flexible
The pricing model of "cost plus" assumes a fixed cost for each product or service, but this may not always be accurate.
Factors such as changes in demand, market trends, and competition can disrupt this assumption. When market prices decrease or costs fluctuate, businesses that rely on cost plus pricing may struggle to quickly adjust prices in order to remain competitive and profitable.
👎 You Can’t Guarantee That All Costs Will Be Covered
Sales volume is projected prior to pricing the product, but sometimes this estimation is incorrect. If the sales are overestimated and a low markup is applied to price the product, fewer items are sold, potentially leaving the production costs uncovered.
Consequently, this often leads to a financial setback for the company.
👎 Pricing Efficiency Is Not Guaranteed
When businesses utilize a cost plus pricing strategy, there is no guarantee of pricing efficiency. The motivation to optimize costs and operational efficiencies may be lacking as the selling price is primarily based on incurred costs. Consequently, there may be less emphasis on expense control and working smarter.
This approach can present challenges in expense reduction, productivity improvement, and process innovation for enhanced competitiveness.
Cost-plus pricing is not the optimal approach for maximizing SaaS profits
The cost-plus pricing approach is not recommended for maximizing profits in the SaaS industry. More specifically, this strategy is less effective for subscription companies because it does not allow for flexibility in adjusting prices based on customer expectations or market changes.
Consequently, prices can remain stagnant and fail to reflect the value of your product or competitive offers.
The cost-plus model is more suitable for industries where ongoing customer relationships are less important, such as physical product sales.
When You Should Use Cost Plus Pricing
Cost plus pricing is most effective in certain industries.
Here are four common situations where you can employ this pricing strategy:
✅ Cost-Driven Industries
In cost-driven industries like manufacturing, construction, or consulting, a significant portion of the overall pricing is allocated to costs.
By adopting a cost plus pricing approach, these industries ensure that all the resources, expertise, and efforts required to deliver complex offerings are properly considered. This approach results in fair compensation for the value provided.
✅ Long-Term Contracts
Long-term and government contracts frequently demand clear cost breakdowns and justifications of expenses. Cost plus pricing is a simple and transparent approach to determine the selling price by considering all relevant costs.
This transparency builds trust and facilitates efficient contract management.
When You Shouldn’t Use Cost Plus Pricing
While cost plus pricing can prove effective in certain situations, it may not always be the optimal approach. Let's explore some instances where cost plus pricing may fall short:
❌ The Market Is Ultra-Competitive
In today's competitive market, companies face the challenge of meeting customer expectations to stay ahead. While cost plus pricing is common, it may not always lead to desired outcomes.
Customers prioritize lower prices and may be deterred by excessively high prices. To strike a balance between profitability and affordability, companies must consider market willingness to pay and understand customer behavior.
This allows businesses to achieve financial goals while keeping customers happy and satisfied.
❌ You Have An Unique Selling Point
In a fast-paced world where technology is advancing every day, companies need to keep innovating in order to stay ahead. Apple has been leading this charge, with its focus on innovation, luxury, and exceptional quality.
In this case, setting prices based solely on cost may not accurately capture the premium customers are willing to pay for these features.
Therefore, psychological pricing may be preferred. Prestige pricing, for example, allows Apple to set prices higher than their competitors, which reinforces the perception of exclusivity and luxury.
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Demand-based pricing is a strategic approach that involves setting the price of a product or service based on consumer demand. The objective is to maximize sales and profits by charging customers an amount they are willing to pay.
Skimming is a pricing strategy where you initially set your SaaS prices higher than usual, then gradually lower them over time. The idea is to attract a smaller target market first and generate initial revenue.
Captive pricing, also known as captive product pricing, is a pricing strategy where a "core" product is offered at a lower price, but additional products required to fully use the core product are charged separately.