A Margin Floor is Not Cost-plus
Great news! Most pricers have internalized the mantra “Don’t use cost plus pricing.” Unfortunately many don’t really understand the concept.
Here’s one common error: A part costs $1.00 to make, and the lowest price the company is willing to sell it is $1.25 because the CEO has a minimum margin of 20%. Is this cost plus pricing? Many people think it is.
However, most of the time, this is not cost plus pricing. This is only setting a floor price. Hopefully you set your actual prices using value based pricing. You determine that your customers are willing to pay prices that are significantly higher than the $1.25 floor price. If your customers are willing to pay $2.50 and that is what you charge, then you are using value based pricing, even though there was a price floor set.
However, if you always price as aggressively as possible, at the margin floor, then yes you are using cost plus pricing. Certainly you should be able find some customers who will buy some products are margins higher than your minimum.
Companies set margin floors for many reasons, but the key reason is to ensure employees aren’t pricing too aggressively. This doesn’t mean a company shouldn’t break a price floor. For example, it may be good business to sell one product at a loss if it helps sell many more of another product. (Think razors and blades, or milk at a grocery). However, breaking the margin floor should create exception reports for executives to verify that the reason is truly strategic.
The lesson today is: Don’t be afraid of using margin to set a price floor, but don’t set your prices there, or go below it, unless you have a strategic reason. Set your actual prices for value.
Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author
Photo by Tauassi