The most effective way to capture the highest profit margin and achieve your revenue goals in B2B markets is to price products and services to value – that is, recognize and communicate the economic value they deliver to your customers. We have discussed this approach through many of our past newsletters.
Still, using a cost plus pricing methodology – applying a desired margin to a product cost to arrive at a selling price – also has merit when the approach is applied strategically. If used alone, a cost plus pricing methodology leaves gaping holes for margin and revenue leakage. However, our pricing consultants find that incorporating it into your broader pricing strategy can be a smart move, provided you limit its application to the management of low-margin business.
How should you use cost plus pricing?
Use it to set price and margin floors. Say a distributor has 30 different product groups, each with a desired target margin. Those target margins are the goal, but they won’t be attained in every instance. Discounted prices will erode margins on some transactions, causing price realization to often fall well below the target. That’s why margin floors – the absolute minimum margin levels you are willing to accept – are an essential element of your pricing strategy.
Ask yourself: How far below the target are you willing to go?
One of the keys to controlling margin leakage is to establish a margin floor for each product group within each market to prevent low- and negative-margin transactions. These limits essentially say that you will not, under any circumstance, sell below this level. Business that falls below the margin floor is unacceptable.
Of course, your margin floor will vary depending on the product group and its cost structure, price sensitivity, competitive environment and a host of other factors. When you are managing thousands of SKUs whose costs may be changing on a regular basis, it can be difficult to monitor every transaction. But setting margin floors using a cost plus approach helps keep your business profitable by preventing transactions from slipping below your threshold for minimum profit margin.
Pricing consultants often see a half-margin-point improvement by setting margin floors with a cost plus approach. That’s $100,000 in margin improvement on $20 million in revenue. While we recognize that this approach is simple, it is an effective tactic for grabbing some margin improvement quickly (assuming that your costs are accurate). It’s also relatively easy to sell to the sales team and customers because no one really expects you to sell at a loss or a ridiculously low margin.