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Frameworks, core principles and top case studies for SaaS pricing, learnt and refined over 28+ years of SaaS-monetization experience.
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Cost-plus pricing is one of the oldest and most straightforward pricing strategies used across various industries, including SaaS. In its simplest form, this approach involves calculating the total cost of developing and delivering a product or service, then adding a predetermined markup percentage to arrive at the final selling price.
While many SaaS companies have moved toward value-based or competitor-based pricing models, understanding cost-plus pricing remains essential for executives looking to build comprehensive pricing strategies that ensure profitability while maintaining competitive positioning.
Cost-Plus Pricing Definition: The Fundamentals
Cost-plus pricing (also known as markup pricing) follows a basic formula:
Selling Price = Total Costs + Markup
The total costs typically include:
- Direct costs: Development expenses, server costs, customer support wages
- Indirect costs: Office space, utilities, administrative salaries
- Overhead costs: Marketing, sales commissions, legal fees
The markup is usually expressed as a percentage of the total costs and represents your desired profit margin. For example, if your total cost to deliver a SaaS product is $100 per user and you want a 30% markup, your selling price would be $130 per user.
Types of Cost-Plus Pricing Models
1. Standard Cost-Plus Pricing
This approach uses predetermined or estimated costs rather than actual costs. It's useful for forecasting and planning but may not reflect real-world cost fluctuations.
2. Actual Cost-Plus Pricing
This method uses the actual costs incurred, providing a more accurate representation of expenses but potentially leading to pricing inconsistencies over time as costs fluctuate.
3. Variable Cost-Plus Pricing
In this model, only variable costs are considered in the base calculation, with fixed costs covered by the markup. This approach can be particularly relevant for SaaS companies with high fixed costs and low marginal costs.
Advantages of Cost-Plus Pricing for SaaS Companies
Simplicity and Clarity
One of the main advantages of cost-plus pricing is its simplicity. The calculation is straightforward, making it easy to explain internally and to stakeholders. According to a McKinsey study, 37% of companies choose cost-plus pricing because of its simplicity and ease of implementation.
Guaranteed Profit Margins
When implemented correctly, cost-plus pricing ensures that costs are covered and a predetermined profit margin is achieved. This can provide financial stability, especially for early-stage SaaS companies focused on achieving profitability.
Justifiable Price Increases
When costs rise due to inflation, supply chain issues, or expanded features, cost-plus pricing provides a clear rationale for price increases. This can make price adjustments more palatable to customers if communicated transparently.
Limitations of Cost-Plus Pricing in SaaS
Ignores Market Dynamics
Perhaps the most significant limitation is that cost-plus pricing ignores customer willingness to pay and competitor pricing. According to a study by Simon-Kucher & Partners, companies that use value-based pricing are 25% more profitable than those using cost-plus approaches.
Overlooks the SaaS Cost Structure
SaaS products typically have high fixed costs for development but very low marginal costs for serving additional customers. Cost-plus pricing may not adequately account for this unique cost structure, potentially leading to underpricing at scale.
Risk of Operational Inefficiency
Without external market pressure on pricing, companies may become less focused on cost efficiency. If increased costs can simply be passed on to customers, there's less incentive to optimize operations.
When Cost-Plus Pricing Makes Sense for SaaS Companies
Despite its limitations, there are scenarios where cost-plus pricing can be appropriate for SaaS businesses:
1. New Market Entry
When entering a market with limited competition or price references, cost-plus pricing can provide a baseline while you gather market data.
2. Custom Enterprise Solutions
For highly customized enterprise SaaS implementations requiring significant resources, cost-plus pricing ensures profitability on complex projects with unpredictable costs.
3. Regulated Industries
In heavily regulated sectors where profit margins are scrutinized, cost-plus pricing provides transparency and compliance with regulatory requirements.
4. As a Pricing Floor
Even companies using value-based pricing often use cost-plus calculations to establish a pricing floor below which they won't sell, regardless of market pressures.
Implementing Cost-Plus Pricing: Best Practices
If you're considering cost-plus pricing for your SaaS business, here are key steps to implement it effectively:
1. Comprehensive Cost Analysis
Ensure all costs are accurately captured, including:
- Product development costs
- Infrastructure and hosting
- Customer support and success
- Sales and marketing
- Administrative overhead
2. Segmented Cost Allocation
Different features or customer segments may have different costs. Modern cost-plus approaches often segment costs to reflect these differences rather than using a blanket markup.
3. Regular Cost Reviews
SaaS costs can change rapidly with technology shifts. Implement quarterly cost reviews to ensure your pricing remains aligned with actual expenses.
4. Competitive Benchmarking
Even when using cost-plus pricing, regularly benchmark against competitors to ensure your prices aren't dramatically out of line with market expectations.
Blending Cost-Plus with Value-Based Pricing
Many successful SaaS companies use a hybrid approach that incorporates elements of both cost-plus and value-based pricing:
- Use cost-plus calculations to establish a minimum viable price
- Conduct customer research to understand willingness to pay
- Analyze competitive pricing and positioning
- Set final prices that reflect value while ensuring costs are covered
According to Pricing Strategy: Setting Price Levels, Managing Price Discounts and Establishing Price Structures by Tim J. Smith, "The most successful companies use cost-plus pricing as a starting point rather than an ending point in their pricing strategy."
Conclusion
Cost-plus pricing offers a straightforward approach to ensuring profitability in SaaS businesses. While it has limitations in capturing market value and may not optimize revenue in competitive markets, it provides a solid foundation for financial stability and can serve as an important component of a more sophisticated pricing strategy.
For SaaS executives, the key is understanding when cost-plus pricing is appropriate and when other approaches might better serve your business objectives. By recognizing the strengths and limitations of markup pricing, you can develop a more nuanced approach that balances profitability requirements with market realities and customer expectations.
As you evaluate your pricing strategy, consider how cost-plus pricing might fit within your broader approach to monetization, and where it might need to be supplemented with value-based or competitive considerations to maximize your company's growth and profitability.