The cost plus method
The cost plus method is the simplest method for pricing products. It involves calculating the unit cost of producing the product and adding on a target profit margin.
Many financial services companies still use ‘cost plus’ methods. Part of the reason is technical – pricing financial products is complex and involves discounting cash flows rising many years into the future. This technical complexity is daunting and disguises the fact that at heart the methods used are no different from the small manufacturer who adds on 10% to costs to get the price.
In most industries companies have moved away from the cost plus approach. The disadvantage of the method is that it does not maximise the revenue from a product. In some situations the company should be charging considerably more than the cost plus approach would justify. For example a premium product which faces little competition. In other circumstances the company could cut prices and achieve volume that would reduce unit costs.
One reason why the cost plus approach is attractive is that it offers the illusion that profit can somehow be guaranteed. After all if you charge more than your costs how can you go wrong? This dangerous illusion can lead companies into the spiral of death.