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 or in other words, it refers to a pricing method in which the selling price is determined by adding a profit percentage in addition to the cost of making the product.
It is the approach to pricing, which 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 price of the product by calculating the total cost in which the desired profit is added to determine the final selling price.
Cost-Based Pricing Classification & Formulas
#1 – Cost-Plus Pricing
It is the simplest method of determining the price 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., affixed percentage, also called as markup percentage, of the total cost (as a profit) is added to the total cost to set the price. Say, for example, ABC organization bears the total cost of $100 per unit for producing a product. It adds $50 per unit to the product as’ profit. In such a case, the final price of the product of the organization would be $150. This pricing method is also referred to as the 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 used most commonly in the manufacturing organizations.
The formula to calculate the cost-based pricing in different types is as follows:
#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, then he might add up a markup of $50 to gain a 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 at maximizing contribution towards the fixed cost. This is relevant, particularly in the industries that involve high fixed costs like the transport industry. Here, the level of sales which will be required to cover relevant variable and fixed cost will be determined.
#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 are set to target the specific level of profits or returns it wants to earn on an investment.
Examples of Cost-Based Pricing
A company sells goods in the market. It sets the price on the basis of 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 on the basis of cost-plus pricing.
This $ 375 will be the price floor.
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.
Differences Between Cost-Based Pricing and 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.|
- 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 cost of product manufacturing allowable if the final selling price is fixed.
- 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.
Thus the Cost-based pricing 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.
This has been a guide to What is Cost-Based Pricing and its Definition. Here we discuss the formula to calculate the cost-based pricing along with examples, importance, classifications advantages, and disadvantages and its differences from value-based pricing; You can learn more about from the following articles –