The in’s and out’s of cost-plus pricing, and why it’s starting to get tough

A recent conversation on a Facebook chat about ‘how’ people work out their pricing for their products prompted a common theme of ‘I take my cost of goods and multiply it by 2 to get wholesale price, and then by 4 to get recommended retail price’. This approach is called ‘cost-plus’ and is one of the most common approaches to pricing when starting out as it is a simple formula and can be easily understood no matter what your product is or where you’re selling it.

If you’re using cost-plus model, then there are a few things that you should be doing to make sure your costs are real and you’ve got a fully costed COGS to do your profit planning. The best way to do this is to pull together a detailed spreadsheet that captures the elements below:

• Make sure you’re including ALL costs right down to printing the label on your courier bag

  • Include all the components in your items like ingredients, bottle, cap, label

  • PLUS your packaging – courier bag, courier cost, extra packing, postcards/ fliers/ promo material etc. They all have a cost and must be included to have true visibility.

• Use an estimated labour allocation for your time to produce each item

  • Remember living wage in NZ in 2022 is $23.65/ hour and this should be your minimum level. By including this allowance, you give yourself the opportunity to hire someone to do this part in the future and give yourself a ‘backstop’ if anything goes wrong or you want to bring on extra staff to grow sales.

  • If you decide not to include this in your costs and to take it out of profits, then at least know what the return for your time should be from the bottom line.

• Inwards freight and any additional shipping or other related product costs to get to you

  • These should be able to be allocated by item given they are volume related

• Shipping costs to send product to your customers

  • If you offer free shipping over a certain value, then keep an eye on that as well so you know how much the ‘free’ is actually costing you. This can mount up quickly and eat into your profit margin more than you expect it to.

• An estimate for credits or returns

  • This is best done by keeping track of how many you have to deal with as a proportion of the total). So you might have 2% of customers that you need to refund, which means allocating 2% of COGS to write offs.

Cost plus is ideal if you’re able to deliver:

• Flexible pricing that can change by order, customer or channel

  • This means you can flex for cost changes easily

  • Often this is used in larger construction or bespoke products such as louvres, custom furniture or designer pieces.

• Low overheads

  • So you can get maximum profits, especially if your volumes and turnover are relatively low or infrequent.

• Limited sales channels to enable control over retailer margins

  • Ideally focus on either direct to consumer via website or markets; and/or selected retailers with limited distribution eg art galleries, specialty stores, boutique grocers.

  • Avoid larger retail channels where there are significant additional cost expectations to consider, like discount margins, warehousing, distribution, rebates and more.

  • If you’re going into retail in a meaningful way, then a ‘top-down’ pricing model is the best approach as it means working back from RRP and having a clear market-based approach.

WHY COST PLUS GETS CHALLENGING WITH INFLATIONARY TIMES

The last ten years have been low inflation, low interest and increasing sense of disposable income (thanks to house price increases making us all feel better off!), has led to the cost-plus approach being used by many start-ups to successfully get going in business. But…. And it’s a big BUT. The wheels of this are all falling off a bit as we face into rapid inflation, huge cost spikes across all parts of the business from ingredients to packaging, freight and even the local courier & shipping as fuel prices bite hard.

So what are the assumptions behind this approach that are now coming unstuck:

• Cost fluctuations will be low and you can absorb them in your margin

• Sales are mainly through direct to consumer or a single end-retailer as there is no provision for Distributor or wholesaler in the margin.

• You can adjust pricing quickly and easily

• OR assumes you won’t change price and just hope that your costs go down as quick as they went up.

• Consumers won’t compare prices or switch easily based on price

• The 2x margin covers all your labour, overheads and provide enough funds to reinvest

• Low inflation and low interest rates

• Relatively consistent retailer margins

WHEN 2x ISN’T ‘ENOUGH’

Doubling your costs to get to a margin sounds like a big enough profit margin to run a business on, after all that’s a 100% mark up! But is it really?

The maths of a ‘2 x COGS = Sell price’ look like this:

COGS $5.00

Sell price 2 x $5.00 = $10.00

Plus GST $10 x 1.15 = $11.50 retail price

Margin $11.50 - $1.50 (GST) - $5.00 (COGS) = $5.00

Margin % $5.00 Profit / $10.00 (sell price excl GST) = 50% Gross Margin

This leaves $5.00/ unit to cover everything from labour (if you haven’t already included an allocation in COGS), to social media, photography, admin etc. If you’re starting out then your costs may not be too high, but nor are your volumes and this is where you can find yourself dipping into your personal bank account for the extra’s that don’t seem like a lot when it comes to absolute dollars… but are a LOT when you consider them as part of the costs of running your business. Yes, it’s nice to wrap your product in custom printed tissue that ‘only’ costs $0.50 a sheet, but if you’re only making $5.00/ unit before you pay yourself or deal with overheads, then that’s a 10% hit you’ve taken in your profit!!

Doing a breakeven analysis is one of the best simple tools you can do to understand the minimum volume you need to sell to cover the fixed and variable costs of your business each month.

There’s often a conversation focused on the multiplier or margin % when it comes to profit, but this misses the big lever of volume and scale that are what make big companies big; and keep small companies struggling to get ‘enough’ profit out of the business. A breakeven analysis helps to identify what your absolute minimum is to cover costs, and then what the incremental volume needs to be to reach a meaningful profit.

A 50% gross margin is good if you’re a large organisation with turnover >$1,000,000 where this gives you $500,000 to cover marketing, sales & overheads, and should give you a net profit of $50,000-$100,000 (average product EBIT estimate is 5-10% of turnover). If your turnover is closer to $100,000 then that’s $50,000 to cover all your costs and profit. This can be disheartening to see but is the reality for product based business. Remember, it’s about the mindset and expectations you have for your business that will determine whether the margin is enough. If it’s a hobby or passion project, then $50,000 may be plenty – if it’s the source of money to offset a regular salary, then it might not cut it.

IT’S NOT ALL BAD NEWS - YOU CAN IMPROVE PROFITABILITY

The first and most important thing is to get VERY intimate with your costs and all the numbers inside your business.

• Talk to your accountant about what your ‘enough’ profit goal is and be clear on what this looks like in terms of the effort, resource and investment you’re able to put into your business

• Do a detailed performance review looking at sales (units, rate of sales, channels etc) to understand where you are best to put your effort into driving harder.

  • Be prepared to STOP selling negative-margin products that may be favourite passions, but aren’t part of your bigger goals. If you really want to keep selling them as part of your brand story, then make sure you have enough other profitable lines to make up any shortfalls.

  • Volume is a powerful tool that not only gives you more turnover to cover fixed costs, but also can enable you to negotiate better for product costs & sourcing.

  • CAUTION: Getting volume at any price is a recipe for a very short-lived business. Just as you can’t live on 100% margin of $100, so you can’t live on 1% margin of $1,000 = either way its still $100 profit in the end….

• Understand your breakeven point for volume to cover your cost of goods and fixed costs so you know how much you need to sell to get to breakeven profit.

• If you’re selling direct, lift your prices by MORE than your costs have gone up.

  • If you wait til the costs have gone up BEFORE you increase prices, then you’ll be constantly chasing your tail and facing constant pressure. Give yourself a buffer to account for all the changes going on.

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Ultimately, what’s enough to you may not be the same for someone else. That means your plan and pricing strategy may be different, and that’s ok. What’s most important is that you can be clear on what you want, and how to plan your product, pricing and profitability to achieve your goals.

Check out our offers for DIY margin calculator and breakeven spreadsheets, as well as the potential to have an indepth 1:1 review of your pricing approach to dig into more and work out what to do next in your business.