One of the most common pricing strategies, the so-called cost-plus pricing, is based on a specific rate of markup that is typical for the particular industry. In this strategy, the entrepreneur or the company determines the price of its products by a percentage markup on unit costs. Therefore, the markup formula is the following:
price = (1 + markup) * unit costs
The reason for the simplicity of this approach is that the markup percentage is set according to what is common in the industry, habits of the company, or rules of thumb. Besides, the price depends only on the markup and the cost of the unit. It disregards any other factors, such as a shift in demand. Therefore, any change in the cost of the unit leads directly to a proportional shift in price.
Merely relying on the typical markup rate and unit costs doesn't require extensive research or analysis which makes the approach very popular: around 75 percent of companies employ a cost-plus pricing method. However, the cost-based approach can have severe disadvantages if the consumers' behavior is neglected. To illustrate this, let's imagine that you make umbrellas. Each umbrella costs $5, and you sell each of them $10 each, according to the chosen markup and unit costs. The demand for umbrella can change very quickly depending on the weather: on sunny days probably only a few customers would buy your product for this price; costing you potential customers and income. However, on rainy days, the demand for umbrellas will rise dramatically. Therefore, customers would pay even more money to get your product so you could change your margin to be significantly larger.
Nevertheless, if you price you goods and services by applying a typical markup on unit costs, you can end up with an optimal price when competitors have similar costs and apply the same markup. Still, taking into consideration the behavior of consumers in a competitive market can help you to optimize the price of a product. In other words, linking markup to the price elasticity of the demand can make your price management more efficient. Besides, it is the marginal cost, the cost added by producing one additional unit of a product, which should be multiplied by the markup ration dependent on market behavior.
Managers in the retail sector are particularly well known for applying the cost-plus pricing scheme and rule of thumb methods. However, markups in retail don't follow a universal pattern. Instead, different markups are applied on distinct products depending on some experience-based principles:
- The lower the price, the higher the markup percentage should be.
- If you can shift the inventory quickly, you should probably have a lower markup factor.
- Lower markup ratios should be used for key-value products where consumers have a stronger price perception.
- Everyday products should have a lower markup than the special ones.
- The markup should be adjusted to the competition.
The advent of web-based business models (for instance, YouTube, Netflix) and the sharing economy (Uber, Airbnb) coupled with the opportunities provided by the Internet have had a revolutionary effect on pricing strategies. Since the marginal cost of the products or services of these businesses tends to be zero, the resulting price also tends to be low, which also can contribute to low inflation rates.
If you became curious what are some typical markups rates, read on to get some insight about the average markups in different industries.
