What Is Cost-Based Pricing?
Cost-based pricing can be defined as a pricing method in which a certain percentage of the total cost is added to the cost of the product to determine its selling price. In other words, it refers to a pricing method in which the selling price is determined by adding a profit percentage to the cost of making the product.
This method of the price of products ensures that the company can recover a specific part of the cost incurred in producing them, even though it might result in some customers backing out from purchasing the goods due to the high price. Therefore, the cost of goods sold is primarily used for pricing.
Table of contents
- Cost-based pricing is a type of pricing where the selling price of the product is determined by adding a specific proportion of the overall cost to the cost of the product.
- In other words, it alludes to a technique of pricing in which the selling price is established by multiplying the cost of production by a profit margin.
- It is a pricing strategy that accounts for the costs of manufacturing, shipping, and selling the product while also including a reasonable rate of return to cover the company’s costs and risks.
- Every company wants to make money from the ventures it takes on. Profit is calculated by the selling price of its product or service. Greater earnings aren’t necessarily the goal. For a product to generate revenue and make a profit, demand must exist at every price point.
Cost-Based Pricing Explained
Cost-based pricing strategy can be referred to as the pricing method that calculates the product’s price by firstly calculating the cost of the product in which the desired profit is added, and the result is the final selling price.
The cost-based pricing in marketing involves the costs for producing, distributing, and selling the product by adding a fair rate of return to compensate for the efforts and risks taken by the company. It is a simple way to calculate the product’s price by calculating the total cost in which the desired profit is added to determine the final selling price.
Every organization aims to realize a profit in the business that it undertakes. Profit is determined by the selling price of its product or service. It is not always greater profits. The demand for a product at every price point is also important to determine the revenue generated and the profit.
There are various types of cost-based pricing strategy as given below.
#1 – Cost-Plus Pricing
It is one of the simplest cost-based pricing methods of the product. In cost-plus pricing methodCost-plus Pricing MethodCost Plus pricing is the strategy of determining the selling price of a product in the market by adding a markup or profit premium to the actual cost of the product. This additional margin represents the entrepreneur's profit., an affixed percentage, also called markup percentage, of the total cost (as a profit), is added to the total cost to set the price. For example, an ABC organization bears the total cost of $100 per unit for producing a product. Therefore, it adds $50 per unit to the product as’ profit. In such a case, the final price of the organization’s product would be $150. This pricing method is also called average costAverage CostAverage cost refers to the per-unit cost of production, calculated by dividing the total production cost by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output. pricing and is commonly used in manufacturing organizations.
#2 – Markup Pricing
It refers to a pricing method in which the fixed amount or percentage of the cost of the product is added to the product’s price to get the selling price of the product. MarkupMarkupThe percentage of profits derived over the cost price of the product sold is known as markup. It is determined by dividing the company's total profit by the cost price of the product and multiplying the result by 100. pricing is more common in retailing, in which a retailer sells the product to earn a profit. For example, if a retailer has taken a product from the wholesaler for $100, he might add up a markup of $50 to profit.
#3 – Break-Even Cost Pricing
In the case of Break-even PricingBreak-even PricingThe formula for break-even price is Fixed cost divided by production volume plus variable cost. The break-even price is the price that the seller should quote which enables him to recover the costs of the business operations. , the company aims to maximize contribution towards the fixed cost. This is relevant, particularly in the industries that involve high fixed costs like the transport industry. The sales level required to cover relevant variables and fixed costs will be determined here.
#4 – Target Profit Pricing
In target profitTarget ProfitThe estimated amount of profit that management intends to achieve during an accounting period is called target profit, and it is forecasted and revised on a regular basis as the business progresses. pricing, prices target the specific level of profits or return it wants to earn on an investment.
Thus, the above are the cost-based pricing methods used in any organization.
Let us look at the formula used for the various cost-based pricing in marketing.
#1 – Cost-Plus Pricing
The formula to calculate the cost-based pricing in different types is as follows:
Price = Unit Cost + Expected Percentage of Return on Cost
#2 – Markup Pricing
Price = Unit Cost + Markup Price
Markup Price = Unit Cost / (1-Desired Return on Sales)
#3 – Break-Even Cost Pricing
Price = Variable cost + Fixed Costs / Unit Sales + Desired Profit
#4 – Target Profit Pricing
Price = (Total Cost + Desired Percentage of Return of Investment) / Total Units Sold
Let us look at an example to understand the concept.
A company sells goods in the market. It sets the price based on cost-based pricing. The variable cost per unit is $200, and the fixed cost per unit is $50. Profit markup is 50% on cost. Calculate the Selling price per unit.
Here, the selling price will be calculated based on cost-plus pricing.
This $ 375 will be the price floor.
Given below are the cost based pricing benefits.
- A straight- forward and simple strategy;
- Ensuring a steady and consistent rate of profit generation;
- It finds the price of the customized product which has been produced as per the specification of the single buyer;
- Finding the maximum possible product manufacturing cost is allowable if the final selling price is fixed.
Along with the cost based pricing benefits, an organization may also face some problems when this method of pricing is used, as given below:
- It may lead to underpriced products.
- It ignores replacement costsReplacement CostsReplacement Cost is the capital amount required to replace the current asset with a similar one at the present market rate. Usually, assets replacement occurs when their repair & maintenance charges surge beyond a reasonable level. .
- Contract cost overruns.
- Product cost overrunsCost OverrunsCost overrun, also known as budget overrun, is a scenario in which the cost of a project or business tends to rise above what was budgeted for. This can be due to improper budgeting or underestimating of the actual cost owing to unforeseen scenarios that were not factored into the budgeting process..
- This approach may ignore the opportunity cost of investment.
- This approach may sometimes ignore the consumer’s role in the overall market.
Cost-Based Pricing Vs Value-Based Pricing
The differences between the Cost-Based Pricing and the Value-Based Pricing are as follows:
|Basis||Cost-Based Pricing||Value-Based Pricing|
|Focus||It focuses on the company’s situation when determining the price.||It focuses on the customers when determining the price.|
|Prices||It prices between price floor and price ceiling; The market condition dictates where, between the floor and the ceiling, the company sets the price.||If it is used, the company sets its pricing in a range determined by what customers are willing to pay. Generally, the price is higher.|
|Benefits||It results in competitive prices. Companies using this strategy will likely attract consumers that look for products and services that are inexpensive.||It often earns high profits on each item sold, but some consumers may not be willing to pay the high price and purchase from a competitor.|
Frequently Asked Questions (FAQs)
A pricing approach used by businesses to determine the selling prices of goods and services is cost-based pricing. Companies can set pricing using this strategy in accordance with the costs associated with producing goods or rendering services. Cost-based pricing uses a variety of techniques to determine fair selling prices.
Cost-based pricing has a number of benefits, one of which is that it is comparatively simple to compute. Simply add the desired profit margin to your total costs. Cost-based pricing is, therefore, excellent for companies with slim profit margins or substantial fixed costs.
Cost-based strategies refer to the corporate choice to base the pricing of a product on the costs of production rather than on external considerations like competition or the economic environment. This is a classic method of pricing, which may be suitable in established markets with low levels of competition.
This has been a guide to what is Cost Based Pricing. We explain it with examples, formula, differences with value-based pricing, advantages & disadvantages. You can learn more about it from the following articles –