Question

Explain how Samsung could benefit by product pricing in terms of cost-plus concepts. This explanation should include

• Samsung’s future plans, such as, expansion, consolidation, and downsizing, and
• how costs concepts could be used in the decision making

Answer 1

Cost plus pricing involves adding a markup to the cost of goods and services to arrive at a selling price. Under this approach, you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to it a markup percentage in order to derive the price of the product. Cost plus pricing can also be used within a customer contract, where the customer reimburses the seller for all costs incurred and also pays a negotiated profit in addition to the costs incurred.

The Cost Plus Calculation

As an example,Samsung has designed a product that contains the following costs:

• Direct material costs = $40.00

• Direct labor costs = $11.00

• Allocated overhead = $16.50

The company applies a standard 30% markup to all of its products. To derive the price of this product, Samsung adds together the stated costs to arrive at a total cost of $67.50, and then multiplies this amount by (1 + 0.30) to arrive at the product price of $87.75.

Benefits of Cost Plus Pricing

The following are advantages to using the cost plus pricing method:

• Simple. It is quite easy to derive a product price using this method, though you should define the overhead allocation method in order to be consistent in calculating the prices of multiple products.

• Assured contract profits. Any contractor is willing to accept this method for a contractual agreement with a customer, since it is assured of having its costs reimbursed and of making a profit. There is no risk of loss on such a contract.

• Justifiable. In cases where the supplier must persuade its customers of the need for a price increase, the supplier can point to an increase in its costs as the reason for the increase.

The Strategic and Tactical Benefits of Cost-Plus Pricing

When implemented with forethought and prudence, cost-plus pricing can lead to powerful differentiation, greater customer trust, reduced risk of price wars, and steady, predictable profits for the company.

No pricing method is easier to communicate or to justify. Cost-plus pricing is inherently fair and nondiscriminatory to customers. What can be a more reasonable explanation for a price increase than to state, “Our input costs went up by 8% this year, so we are raising our prices by 8%”? Clothing retailer Everlane goes even further, using cost-plus pricing to make its value proposition of “radical transparency” come alive. For every garment it sells, Everlane provides a detailed breakdown of costs for materials, labor, duties, and transport, along with its markup. This way, customers can easily verify Everlane’s emphasis on paying fair wages to workers manufacturing its garments and actively endorse this company value by buying its products.

Cost-plus pricing is the very antithesis of value-based pricing, which seeks to discover differences between customers’ economic valuations and to exploit them by customizing prices. Just consider the consumer outrage generated by Uber’s surge pricing, Coca-Cola’s dynamic vending machine pricing based on outside temperature, or the variable rate pricing of electric utilities. In all these cases, many customers saw the seller’s value-based pricing moves as nothing more than gouging. Cost-plus pricers don’t face this risk. Sure, they may underprice their products for some customers, but they will sleep peacefully at night knowing customers consider their prices to be fair.

Another pragmatic benefit of cost-plus pricing is that it is simple to implement. Every frontline retail employee or bartender with a calculator can apply a markup percentage to wholesale costs and calculate the asking price, something that many mom-and-pop stores and bars appreciate.

If the major competitors in a market use cost-plus pricing, it stabilizes price levels. The amount of risk associated with pricing decisions is lowered for all players. Prices remain relatively stable, particularly when the higher-cost suppliers in the market offer higher-quality products and when lower-cost sellers offer lower-quality products. Companies are less likely to engage in price wars if they base their prices mainly on costs instead of competitors’ prices.

Cost-plus pricing can encourage shoppers to use factors other than price in buying decisions. When most of us walk into a discount mega-store, we expect to find low prices with lower service quality to match. By contrast, we expect higher service quality and more upscale and expensive products in high-end stores. When consumers believe prices reflect cost, they are more likely to factor quality into their decision, instead of just buying whatever’s cheapest.

A final and significant virtue of cost-plus pricing lies in executing a cost leadership strategy. When the company has unique competencies that allow for an advantageous cost structure relative to competitors, it can use cost-plus pricing to create and deliver the most enticing value proposition of all. It becomes a cost leader, and its low costs, the resultant low prices, and superior customer value become an integral part of its brand identity. Costco has maintained market leadership for decades by using this principle. The company mandates that nothing in its stores will be marked up by more than 14% (15% for its private-label products). It widely publicizes this pricing policy. When coupled with other cues such as a spartan store environment, limited assortments, and bulk buying, its cost-plus pricing creates a powerful image that the customer is going to get great deals at Costco.

Despite the ridicule heaped on it by managers, there is a gritty common sense and logic associated with cost-plus pricing that is difficult to dispute. For companies with a cost advantage or an interest in using price transparency as a differentiator, cost-plus pricing is a powerful strategic tool. For sellers interested in conveying that their prices are fair and building customer trust, cost-plus pricing is an effective tactic. In the herd-driven frenzy to adopt value-based pricing, managers shouldn’t throw out the cost-plus baby with the bathwater.