Cost plus pricing: use it as the floor under your price

Cost plus pricing means you add up what one unit costs you, then add a fixed percentage on top: price equals unit cost times one plus the markup. It is the right method when the buyer is paying for your costs, as in many government research contracts. For software and most services it gives you a floor, and the price buyers would accept usually sits well above it.

The math takes a minute. The two places people get hurt are mixing up markup with margin, and treating the floor as the answer.

The formula is unit cost times one plus the markup

Here is a made-up example. Dana runs a small shop that makes powder-coated aluminum brackets for solar installers. She wants a list price for her standard bracket.

She picks a 30% markup. The price is $12.00 times 1.30, which is $15.60, and her profit on each bracket is $3.60.

Notice the overhead line. It only works out to $2.50 because Dana guessed she would sell 20,000 brackets this year. Hold on to that guess, because it causes trouble later.

Markup and margin are different numbers for the same sale

Markup is profit divided by cost. Margin is profit divided by price. Zoho's reference gives both formulas and the conversion between them: margin equals markup divided by (1 plus markup), and markup equals margin divided by (1 minus margin).

On Dana's bracket the markup is $3.60 divided by $12.00, which is 30%. The margin is $3.60 divided by $15.60, which is 23.1%. Same sale, two different percentages.

This is where plans go wrong. Say Dana's lender asked for a 30% gross margin and she applied a 30% markup. She would land at 23.1% and find out at year end. (Accountants call this kind of surprise "a conversation.")

To hit a target margin directly, divide cost by (1 minus the margin). For a 30% margin Dana needs $12.00 divided by 0.70, which is $17.14. Check it: $17.14 minus $12.00 is $5.14 of profit, and $5.14 divided by $17.14 is 30.0%. The markup that produces it is about 42.9%.

Each markup and margin pair matches the conversion table in Zoho's guide. The prices are our calculation.

Short version: decide which number you are targeting, write it down with its name, and convert before you multiply.

Cost-plus is the norm where costs are the uncertain part

Cost-plus makes sense when nobody can say in advance what the work will cost, so the buyer agrees to pay the costs and a fee. The US federal government is the best-documented case. Under FAR 16.301-2, a contracting officer uses a cost-reimbursement contract only when the agency cannot define its requirements well enough for a fixed price, or when the uncertainties in the work stop anyone estimating costs accurately enough.

The common version is cost-plus-fixed-fee. FAR 16.306 describes it as a contract that reimburses costs and pays a negotiated fee, fixed at the start, which does not change with actual cost (it can be adjusted if the work itself changes). It fits research or early exploration where the level of effort is unknown. The fee is capped: FAR 15.404-4 limits it to 15% of estimated cost for experimental, developmental or research work and 10% for most other cost-plus-fixed-fee contracts.

One version of cost-plus is banned outright. FAR 16.102(c) says the cost-plus-a-percentage-of-cost system "shall not be used." The reason goes back decades: a 1954 GAO decision explains that the ban exists because this system gives a contractor an incentive and an opportunity to increase profit by increasing costs.

Here is a made-up example of the difference. A research contract is estimated at $2,000,000 with a 10% fixed fee of $200,000. Actual costs come in at $2,400,000 with no change in scope. Under the fixed fee, the contractor still earns $200,000. Under the banned version, a 10% fee on actual cost would pay $240,000, so the overrun earned the contractor an extra $40,000.

Outside government, Wikipedia's summary notes cost-plus is also common for products made to a single buyer's specifications, and it lists the standard criticisms: it weakens the seller's incentive to control costs and ignores both demand and competitors' prices.

Short version: if a client insists on paying you cost-plus, propose a fixed fee in dollars. It is the version federal contracting rules allow.

Software and services leave money on the table under cost-plus

Cost-plus assumes the cost of one more unit is a meaningful number. For software it mostly is not. Hal Varian wrote in his 1995 paper "Pricing Information Goods" that digital goods are typically very costly to produce the first time and very cheap to copy after that.

That leaves you two bad options. A markup on the cost of one more customer gives a tiny price. A markup on average cost requires guessing your volume, and your volume depends on your price, so the formula quietly assumes its own answer.

Here is a made-up example. Priya sells a monthly compliance-report tool to dental groups. Hosting and support cost her $40 per customer per month, and a 50% markup gives $60. Now look at it from the buyer's side:

• The tool saves each office manager about six hours a month, and Priya's buyers value that time at roughly $35 an hour, or $210 a month.
• The usual alternative is a bookkeeping firm that prepares the same report for $150 a month.

So the cost floor is $60, the alternative is $150, and the value is about $210. Pricing at $120 instead of $60 would bring in an extra $144,000 a year across 200 customers ($60 times 200 times 12, by our calculation), and it would still be the cheaper option for the buyer.

Services have the same gap. A consultant who prices at salary plus a markup is charging for hours, while the client is buying a result. The consultant hourly rate post covers how to set a rate that covers costs; this post is about why that rate is the floor.

Cost-plus also moves in the wrong direction when demand falls. Go back to Dana. If she sells 10,000 brackets instead of 20,000, overhead per bracket doubles to $5.00, unit cost becomes $14.50, and a 30% markup pushes the price up to $18.85. The formula tells her to raise prices exactly when fewer people are buying.

How to use cost as the floor and find the ceiling from buyers

Cost-plus is still the right first step. Use it as the bottom of your range, then do the work that finds the top.

1. Compute the floor from the cost to serve one customer

Count what one more customer actually costs you each month: hosting, support time, payment fees, onboarding. Leave out what it cost to build the product, which you spent whether you sign this customer or not. Then convert your target margin into a markup with the formula above.

2. Price the buyer's next-best alternative

Find out what the buyer does today and what that costs them, including doing nothing. A competitor pricing analysis gives you the paid alternatives. The unpaid ones, like a spreadsheet and two hours of someone's Friday, only come out in conversation.

3. Estimate the value from the buyer's own numbers

Ask buyers what the problem costs them now: hours, errors, fines, lost deals. The value-based pricing post walks through building that estimate. Use their numbers, because yours will be optimistic.

4. Test prices between the floor and the ceiling

Talk to 10 to 15 buyers and show each one a concrete price in the range. Methods for asking about price without leading the witness are in how to research willingness to pay.

5. Keep cost-plus where the buyer is paying for your costs

Custom manufacturing runs, research work and open-ended projects with unknown scope are honest fits for cost-plus. Write the fee as a fixed dollar amount, and show the cost breakdown, since that transparency is what the buyer is paying for.

Your next step

Write down your cost floor today with its markup and its margin both labelled, then line up five buyers to tell you what the problem costs them. Instant Expert can find people matching a description, such as "practice managers at dental groups with three or more locations", and send them paid invitations for a short call or a written answer; you pay only if someone books or answers. For help with the pricing model itself, the directory lists pricing strategy consultants and pricing and packaging experts.