Key takeaways
- Cost-plus works well for setting a price floor, but it does not tell you how much customers are willing to pay. And if fixed costs are allocated by volume, prices rise on the very days when you are selling less.
- Customers at the same price can generate very different profits. In the example, customer X leaves a profit of THB 24 per unit, while customer Y makes a loss of THB 14 per unit.
- Value-based pricing needs evidence of the value customers receive compared with their alternatives. It is not setting a high price on gut feeling.
You price at cost plus 30%. Customers do not complain and sales go well, yet at year-end the profit is lower than expected. Some jobs feel as if you paid the customer to use your service. Customers not complaining can also be a signal of a different kind: that we are not yet capturing the full value we create for them.
The same cup of coffee sells at different prices at a roadside stall and in a hotel café, even though the cost of the coffee beans is similar. Customers do not pay according to the shop's costs; they pay according to what they receive and the alternatives available at that moment.
Markup is not the same as margin
Before going further, we need to tell these two terms apart.
Markup = profit ÷ cost Margin = profit ÷ selling price
A cost of THB 100 plus a 30% markup gives a price of THB 130, but the margin is 30 ÷ 130 = 23.1%. To target a 30% margin, you must sell at 100 ÷ (1 - 30%) = THB 142.9. When two parties use different terms in a meeting, the approved price often does not match the profit that was expected.
Where cost-plus goes wrong
The first problem is the allocation of fixed costs. When volume falls, the accounting cost per unit rises. If the same markup is added, the price goes up just as customers are already buying less.
Illustrative example Fixed costs are THB 6 million, variable costs are THB 40 per unit, and sales are 100,000 units. Total cost per unit is THB 100, markup is 30%, the price is THB 130 and EBIT is THB 3.0 million. In the table, volume is in units, cost and price are in THB, and EBIT is in THB million.
| Case | Volume | Cost per unit | Price | EBIT |
|---|---|---|---|---|
| Base | 100,000 | 100.0 | 130.0 | 3.00 |
| Volume falls, price held | 80,000 | 115.0 | 130.0 | 1.20 |
| Volume falls, markup applied by formula, and customers cut back further | 65,000 | 132.3 | 149.5 | 1.12 |
The price of THB 149.5 is calculated from a cost of THB 115 at 80,000 units. If volume falls further to 65,000 units, total cost per unit rises again. If the same formula is still used, the price would have to go up another round.
The second problem is cost-to-serve. The cost of looking after each customer is different, but formulas usually average it out so that everyone looks the same.
Illustrative example The list price is THB 130, variable cost is THB 40 and allocated fixed cost is THB 60.
| Per unit (THB) | Customer X | Customer Y |
|---|---|---|
| Price after discount (Y receives a 10% discount) | 130 | 117 |
| Variable cost | (40) | (40) |
| Cost-to-serve: small orders, rush delivery, rework, long credit terms | (6) | (31) |
| Profit before allocated fixed costs | 84 | 46 |
| Allocated fixed costs | (60) | (60) |
| Profit per unit | 24 | (14) |
Customer Y still contributes a profit of THB 46 before allocation. Stopping sales immediately could push the fixed costs onto other jobs. Remedies to consider first are raising the minimum order size, charging for rush delivery, or reducing the discount.
How to do value-based pricing
Start by asking: if the customer does not buy from us, what is the next-best alternative? Then ask how much better, in money terms, what the company offers is than that alternative.
Economic value = next-best alternative price + incremental value the customer receives
Illustrative example An annual machinery maintenance contract. Our cost is THB 250,000. A competitor offers THB 300,000. The customer loses THB 40,000 per hour when a machine stops. Our service reduces downtime by 20 hours a year more than the competitor's.
| Item | THB |
|---|---|
| Cost-plus price at 30% (margin 23.1%) | 325,000 |
| Next-best alternative price | 300,000 |
| Incremental value: 20 hours × THB 40,000 | 800,000 |
| Total economic value | 1,100,000 |
| Value-based price if 30% of the incremental value is captured (margin 53.7%) | 540,000 |
At a price of THB 540,000, the customer pays THB 240,000 more than the competitor's price but still keeps THB 560,000 of incremental value. The 30% split is an assumption that must be tested with real customers, and the downtime hours must be provable with data.
Cost-plus suits when
- The contract requires costs to be disclosed, or the work is cost-reimbursable
- The product is a commodity with a clear market price
- You need to set the lowest acceptable price
Value-based suits when
- Outcomes differ measurably from competitors'
- Different customer groups receive different amounts of value
- The sales team has evidence to explain the return to the customer
The two methods are not separate. Cost tells you the lowest acceptable price, while value and competitors tell you the ceiling you should try to reach. Between those two points lies the space for judgement.
Next steps
- Agree definitions of markup and margin so that every function uses them in the same way
- Separate variable costs from fixed costs, then set a price floor for each product
- Pick the first 20 customers and calculate net price and cost-to-serve
- Identify the next-best alternative for each customer group, and the incremental value in money terms
- Pilot the new prices with a small group first, and track win rate and margin
- Set discount approval authority, and record the reason every time a price is cut