Cost-plus pricing is a well-known and oft-used pricing strategy.
You calculate the cost of your product or service … the cost of materials, labour, “time”, overheads, etc., … and you add a “mark-up” to ensure a profit.
As with most strategies, it has its pros and it has its cons.
The main pro is that you're guaranteeing you're covering your minimum costs.
Which is also, in my opinion, its main con. Because why only cover your minimum? Or why “fix” your profit-making potential to a specific level? Surely that means there's high chance you're leaving money on the table?
My first career saw me working as a chartered accountant in a large professional practice, which was a perfect example of exactly this….
Our charge-out rates were 3 x our hourly salary, to “recover costs, contribute to overheads and make a profit” … notionally, our rates were calculated as 1/3 = cost of salary, 1/3 = cost of overheads, 1/3 = profit.
So, it was cost-plus pricing. And it was being used by big “professional” service-based firms as their pricing strategy. Yet this “fixed” cost-plus pricing was costing them millions in missed fee opportunities….
Why? Because cost-plus doesn't take the VALUE of your service into account.
Nor does it take supply and demand into account, and the additional value that comes from that….
We charged that same cost-plus formula to all clients, regardless of the value it brought to their business, regardless of the benefits we were able to provide them, regardless of what they would have been prepared to pay for our expertise, and regardless of the high demand there was for our services. We were leaving money on the table.
Because people PAY FOR VALUE. Value is, in fact, people's primary concern when considering a purchase.
So if you're able to provide value, why wouldn't you want to charge what that is worth? Why would you focus on only covering your costs?
Most people become self-employed because they want the BENEFITS that it can bring … the benefits of flexibility, and FREEDOM, and of ultimately being FULFILLED by what they do.
And at the end of the day, financial security is never going to be achievable if you're only “covering your costs”. Which is why, when it comes to service-based businesses, cost-plus pricing is never going to be your optimal pricing strategy.
Why cost-plus pricing for service businesses usually equals undercharging
Cost-plus pricing is more appropriate to products than it is services.
With products, it works….
The cost of a product is far more specific and thus far more objective than a service. The materials used and the exact process of the design and manufacture are more easily judged and calculated … and usually also more easily recognisable in the quality of the end product (think of a designer-quality coat vs. one from a low-cost high-street shop), making its final price far more easily justifiable on the basis of its “cost to make”.
What's more … with a product, multiple items can usually be sold at any one time. Thus economies of scale also come into play, meaning a “mark-up” can represent potentially significant profit potentials if that product starts to fly off the shelves in its masses….
In services, however, the “costs” are far more subjective … not to mention that the volume potential is limited by the fact that a service can only be done one at a time, meaning it's intrinsically linked to time. So that “mark-up”, that “profit potential” can only ever be earned once per hour, or per day, or per “time period required for the job” … which is limited even further by the very fact there are never more than 24 hours in a day….
So calculating the cost of providing a service, in order to adopt a cost-plus pricing strategy, ultimately all comes down to calculating the cost of time. Which is what makes it a strategy unsuited to a service business, and here's why:
The cost of “time” is subjective in itself … depending on opinion, on lifestyle, on location, on personal needs….
There's the challenge of deciding what your time is actually worth, which can be a minefield in itself. This is also prime feeding ground for imposter syndrome and confidence issues that are likely to persuade you to settle on less than your true worth.
Plus, estimating the time a job will take is not always easy, meaning – even if the hourly or day rate you've settled on is “good” – people often work for longer than estimated which leads to two potential outcomes, neither of which are positive:
1. You bill according to the hours worked, which is higher than the price originally “estimated” to your client … meaning, despite the quality of the service they've received, they are unhappy as there is an unexpected “additional” cost.
2. You bill according to your original estimate, despite having had to work longer than expected … meaning you have earned less per hour than you'd calculated as needing or being deserving of … and meaning you are unhappy at the final rate earned.
And that's all before you've even looked at adding your “mark-up”, which should be the “cost of my time, plus a margin” but frequently ends up being “the cost of my time, plus 'just a little' … as I'm not sure I can get away with any more”.
Ultimately, trying to apply cost-plus pricing as a service business means trying to calculate the cost of your time and trying to define your worth in terms of hours, which all leads to your second guessing what you think your clients think your time is worth … which leads to a whole load of made up ideas.
It all leads to you focusing on trying to do a job in a certain amount of time, rather than just focusing on doing the best possible job.
Or it leads to you still doing the best possible job, and simply not charging enough for that valuable work … meaning you're not only undervaluing yourself, but you're making your life harder. NOT enjoying financial security, and not enjoying the freedom of being self-employed.
Costing your time rarely leads to satisfaction, particularly for yourself.
And the greatest irony of it all? Clients don't care how much time it takes you anyway … they only care about the service you can provide, and what that is WORTH, to THEM.
A service business' pricing strategy needs to be VALUE-based pricing, not cost-plus pricing
If you're using a cost-plus pricing strategy and pricing your services based on “how long it will take me”, you're putting yourself in a weak position immediately, purely because your whole pricing strategy is based around the need to justify your rate and prove your time is worth X … rather than being based around the VALUE you are able to provide.
If a potential client queries your quote, which you have calculated on the basis of how long you think it will take … your response; your justification, will be focused on your rate and your time … rather than the value your service will bring to them….
Whereas if you START by focusing on the value, you have a ready-made justification that is far more aligned with what they are interested in: what THEY ARE GETTING.
Think of it like this, which is a more compelling offer for your client? ... £500 for a service that will take “me” ten hours to complete, or £500 for a service that will provide YOU with the following tangible benefits: X, Y, Z….
It's always going to be the latter. Because people only go looking for a service in the first place, because they have a need.
And they're far less likely to dispute a price that you've justified by highlighting the ways in which that need will be met … in contrast to only telling them how long it will take you to do so.
So focus on fulfilling that need: focus on your service being capable of providing them with results and solutions that solve their problems, and that adds value to their business or lifestyle.
And set your prices according to THAT.
Price according to what they stand to GAIN from your service, focus on that as a justification, and how long it takes you becomes completely irrelevant.
And pricing this way – with value-based pricing – means your “mark-up” has the potential to be significant.
Because you may well be charging far more than you'd ever have dared if calculating it on the basis of how long it would take you … so the actual “cost” of your time may only be low….
Yet they're happy because you're providing them with something invaluable in terms of its benefits … you're solving their needs … you're offering them a service at a price that reflects what they're getting.
And you're happy, because you're achieving your first F: financial security … which leads to the freedom and fulfilment that inspired you to become self-employed in the first place.
Cost-plus pricing has its place in the world of products.
For services, it needs to be all about value-based pricing.