Why cost-plus fails and how a Brand Ladder can help fix it

Cost-plus pricing is the grand bete noire of the pricing world. It lurks around every corner, in every spreadsheet, and behind every pricing decision, intent on leaving money on the table and sapping profits.

In case you've never heard of cost-plus pricing, it refers to the practice of slapping a flat rate (whether % or $) onto the cost of an item and making that the price.

Here's the thing: a lot of the time cost-plus works. When costs are increasing, cost-plus will ensure that a company remains whole from a margin % perspective. If your costs go from $100 to $110 and you've always kept a 50% margin, your implied price goes from $200 to $220. Couldn't be simpler, right? (As a side note, I suspect that the simplicity of cost-plus is a big part why so many pricing professionals dislike it, but that's a post for another day.)

So what's the problem with cost-plus when costs are increasing? There are many, but the one that has always stuck out to me is that it doesn't differentiate why a cost went up. If they rose because everyone is facing increased copper prices, well then it makes sense to pass that cost along. What if the cost has gone up because you're not keeping an eye on your scrap/waste numbers, or you're over-scheduling your labor and have idle hours, or you accepted a price increase from your supplier without challenging it? Regardless of the reason, everything you produce is more costly. You're adding price because you can't control your cost. Not exactly a great reason to raise your price.

What about when costs are decreasing? I can go on Ali Baba right now and find literally millions of manufactured goods at a fraction of the cost that I would have paid even a few years ago. (It's a good thing that I don't need 2,000 cast iron skillets.) Six Sigma/Lean/Agile/whatever flavor of the month can significantly cut costs by eliminating defects and/or prioritizing the highest impact work. Perhaps the greatest bogeyman of them all is the threat of a retailer or distributor to go private label. It hangs like the Sword of Damocles over manufacturers worldwide.

Funny, the Sword of Damocles looked bigger in the picture on Amazon.

How does this relate to cost-plus? I'm so glad you asked! The following story is true, only the names and specific details have been changed to protect the innocent.

I worked for a company that was spending a tremendous amount of time and effort to source products around the globe. There were all sorts of smart people working on it. In one specific case, they found the exact factory in China that was producing a nationally branded product. The manufacturer didn't really care if they were stamping Logo A or Logo B onto this product, so they agreed to go down the private label route. This should have been a big win for my company, right?

Well, it didn't work out that way. Although the following are fake-o numbers, I saw thousands of instances where this exact thing happened:

National Brand
Purchased for $5
GM% of 50%
Sold for $10
Gross Margin of $5/unit sold


Private Label
Purchased for $2
Gee, we really like that 50% margin, so let's hold that constant
Sold for $4 (Cost of $2 from above divided by 50% = price of $4)
Gross Margin of $2/unit sold

The issue is pretty straightforward: we're making $3 less per private label unit that we sell! It was a real shame because of how much hard work went into sourcing the product in the first place.

People grasped the problem right away, so we came up with a relatively quick solution that we ended up calling a Brand Ladder.

Standing on a haunted ladder, reaching for floating dollars? This guy gets it.

The Brand Ladder consisted of three steps:

1. Map each private label item to whatever national brand item it is replacing.
2. Hold the GM$ constant instead of the GM%. This would form one boundary of a "good" price.
3. Apply the desired % spread to competition. This would form the second boundary of a "good" price.

Let's take the Private Label example from above and put it through the Brand Ladder logic.

1. We had already mapped this item to the national brand, so that was an easy step. Make no mistake that it was tedious to go through thousands of items that had been private labeled.
2. The national brand was making $5/unit, so let's take that $5 and add it to our private label cost of $2. This gives us one boundary price of $7.
3. Somewhere along the line, it was decided that a 20% spread to the national brand would be enough to entice people to switch to our private label. Ok, so the national brand sold for $10, meaning a 20% spread put us at $8. This is the second boundary price.

Great! Pricing this item between $7 and $8 would be a fair price that would give us a tidy profit for our efforts, would give the consumer a cheaper alternative to the national brand, and would not undercut the national brand to such an extent that it would create ill will.

One additional benefit is that even if we held GM$ flat and charged $7 on a cost of $2, our GM% would go up to 71.4% ($5/$7 = 71.4%). I've never been enamored of GM% as a metric of success because I can't spend a percentage, but you better believe that everyone was thrilled when they saw that they could get a virtually free GM% increase of 2140 bps.

This was a simple solution to a big problem. Organizationally it was an easy sell up and down the line. The devil was in the details when it came time to operationalize the solution across 1,000s of SKUs, but that's half the fun of it.

I hope this example drives home the point that cost-plus can eat up your profits without you even realizing it, especially in a declining cost environment. With a little effort, you can get to a logical, more profitable solution that will make everyone happy. I'm going to get into this Brand Ladder concept in more detail at a later date, so stay tuned.