Disadvantages of cost plus pricing

1. It's horribly inefficient.

The guarantee of a target rate of return creates little incentive for cutting cost or for increasing

profitability through price differentiation. Stakeholders easily become passive towards pricing,

facilitating laziness and an atrophy of profits as the market and customer continues to change.

Just for some perspective, the government uses this strategy of guaranteed profit margins on

costs to make contracts with private businesses “easier.”  The result is an incentive to maximize

costs, which wastes billions of dollars and results in shoddy workmanship.

2. It creates a culture of profit losing isolationism.

This inward facing approach discourages market research. Although watching competitor

prices isn’t the end all, be all of pricing, it is pretty important. You should be aware of how much

a competing good costs because it can affect your own marketing and pricing strategies. Plus

with no research, you have little to no data on your customer's perceived value of the product

(more in the last point). 

3. It doesn’t take into account consumers.

Perhaps the biggest downfall of cost plus pricing is that it completely disregards the customer’s

willingness to pay. To make money, a customer must be involved. They’re the most important

part of selling anything, so any pricing strategy that doesn’t take customer value into account is

creating a vacuum that’s sucking all of the profit out of the business.

Furthermore, to be blunt, customers don't care about how much something cost you to make.

They understand there are costs associated with doing business, but consumers care more about

how much value you’re providing. For example, making a bottle of Rogaine may cost $3, $10, or

$50, but consumers only weigh price against the value of a husband with hair on his head, which

depending on the customer could be 2x, 10x, or 100x the cost depending on follicle
effectiveness. Simply barreling ahead with a desired rate of return can result in declining demand

that is disregarded until substantial losses occur. Even if consumers are buying your product,

there could still be a better price for revenue optimization and price differentiation.

Summary: Very few companies should use cost plus pricing 

To summarize, cost plus pricing isn’t ideal for most businesses, unless you truly cannot spend

some extra time on the most important aspect of your business, which sometimes happens when

you’re bogged down by fulfilling orders or the sheer number of items you’re offering customers.

Additionally, some businesses have very uniform costs surrounding their offerings that are the

same for all competitors. In this case, margins will probably be uniform, as well, which means

the pricing methodology should be more competitive (tomorrow’s post) or market based

(Thursday’s post). No software or SaaS company should use cost plus pricing, because the value

you’re providing is traditionally much more than your cost of doing business.