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What is Cost-Based Pricing?
Cost-based pricing is a pricing strategy where businesses set a selling price based on a product’s production, manufacturing, and distribution costs. Typically, they arrive at this figure by adding a markup percentage to the total cost of making and delivering the product.
Several expenses go into the costs of production and distribution, including raw materials, piece-rate labor costs, packaging, production supplies, overhead expenses (like rent and utilities), and shipping. Depending on which expenses a company factors into their calculation, their cost-based pricing strategy is either full-cost or direct-cost pricing.
- Full-cost pricing considers fixed and variable costs, plus a percentage markup. It’s more accurate because it accounts for everything, but calculating it is more complicated.
- Direct-cost pricing only considers the direct (variable) costs of producing and distributing a product, such as materials and labor. This approach is more straightforward but may leave businesses with a lower profit margin.
The concept behind the cost-based pricing model is relatively simple: calculate all the costs of bringing a product to market. Then, add a margin to determine the selling price. Plenty of businesses, big or small, use cost-based strategies (at least partially) because they’re relatively easy to implement and lead to predictable (and guaranteed) profit margins.
- Cost-plus pricing
- Markup pricing
- Break-even pricing
Why Companies Use Cost-Based Pricing
Although it doesn’t account for external factors like demand and competition, cost-based pricing is useful in many situations.
- Ensuring profitability when selling high-cost items. By considering all costs involved, companies can guarantee a profit margin with each sale. Products that are expensive to manufacture (such as engineer-to-order items) are often sold using this method.
- Covering production costs. In industries where fixed costs (like rent and equipment) make up a significant part of production expenses, cost-based pricing methods allow companies to recover those costs quickly and efficiently.
- Simplifying pricing decisions. Unlike value-based pricing, which requires extensive market research and analysis, the cost-based approach uses internal data, making it easier for businesses to set prices without external input.
- Setting a baseline price for a new product. Since cost-based models don’t require any external data/input, there are fewer variables involved. This makes it a useful starting point for companies launching new products and trying to determine the right price for them.
That said, it doesn’t account for demand. Setting prices based solely on costs might mean your product doesn’t reflect its true value in the market, leading to missed opportunities and lost profits.
Cost-based pricing also ignores what your competitors are charging for similar products. If they offer lower prices, you may have a harder time selling your product at your target profit margin.
And, it doesn’t incentivize efficiency and innovation. If a company relies solely on cost-based pricing, they have little incentive to focus on improving efficiency and reducing production costs.
So, cost-based pricing is best used in conjunction with other pricing strategies, such as value-based or competitor-based pricing. Companies that use a combination of these methods can ensure they are factoring in both internal and external factors when setting prices for their products.
Types of Cost-Based Pricing Strategies
Cost-plus pricing is the most common cost-based method. It involves adding a predetermined percentage markup to a product’s total per-unit cost. This method is useful when other costs, such as marketing or research and development, are difficult to calculate.
Cost Plus Pricing = Break-Even Price x Desired Profit Margin (%)
For example, if a company’s break-even price is $50 per unit and they want to make a 20% profit margin, the calculation would look like this:
Cost Plus Pricing = $50 x 1.20 = $60
So, according to the cost-plus pricing strategy, the selling price for this product would be $60 per unit.
The break-even pricing strategy is a cost-based method that aims to determine the price at which a company will break even — they neither make nor lose money. It’s used most often when launching new products or for one-time item production, like events or services.
Break-Even Price = (Total Fixed Costs / Number of Units Produced) + Variable Costs
For example, if a company has $10,000 in fixed costs and plans to produce 500 units, with variable production costs of $20 per unit, the calculation would look like this:
Break-Even Price = ($10,000 / 500) + $20 = $40
To determine the sub of fixed and variable costs, businesses conduct a break-even analysis beforehand to determine the point where revenue equals expenses and, after that point, how much profit they can make. This information helps them set prices to cover their costs and make a profit.
Ecommerce and retail businesses commonly use markup pricing. It’s a simple cost-based method where the selling price of a product is calculated by adding a predetermined markup to the cost of goods sold.
Mark-up Price = Cost of Goods Sold x Markup Percentage
For example, if a product costs $50 and has a 50% markup, the calculation would look like this:
Mark-up Price = $50 x 1.5 = $75
The markup pricing method is useful for businesses that sell commodities with no differentiation, like grocery items or raw materials.
Target Profit Pricing
Businesses use target profit pricing when they want to set reasonable, competitive prices while still accounting for profitability. It’s slightly different from cost-plus pricing in that businesses consider both the desired profit margin and the target price.
Target Profit Price = (Total Costs + Total Desired Profit) / Number of Units Produced
For example, if a company has $10,000 in total costs and wants to make a 30% profit, and they plan to produce 1,000 units, the calculation would look like this:
Target Profit Price = ($10,000 + ($10,000 x 0.30)) / 1000 = ($10,000 + $3,000) / 1000 = $13
In the above case, the target profit price for each unit is $13.
Advantages and Disadvantages of Cost-Based Pricing
Advantages of a Cost-Based Pricing Strategy
- Easy to calculate and understand. Companies with limited resources, very little data, and small teams can use cost-based methods without extensive market research. You’d need large amounts of data to implement competitive pricing or a value-based model, which generally requires time and/or significant resources.
- Simplifies product launches. Since cost-based pricing doesn’t rely on external data or inputs, it’s perfect for when your organization launches a new product. They can use the cost-plus pricing method to set a baseline price and adjust as needed once they gather more data or learn more about their target market.
- Allows for a guaranteed profit margin. Accounting for production costs means you’re making a profit on every sale. Overreliance on competitive and value-based models may mean you’re selling at a loss due to external factors, like changes in the market or competitor pricing.
- Protects against volatility. In industries with high levels of volatility, such as commodities or technology, cost-based pricing can provide a buffer against sudden changes and help businesses maintain profitability.
- Good baseline for testing. Price optimization is a tricky equation to get right. You can use market reactions to your cost-based price to generate data and insights to eventually develop more intricate pricing strategies.
Disadvantages of a Cost-Based Pricing Strategy
- Ignores market demand. An entirely cost-based strategy assumes that the price a product sells for is based on its production costs, disregarding consumer behavior and market forces.
- No guarantee of sales. Just because each sale is profitable for you doesn’t mean your customers will pay that price. A cost-based strategy can lead to overpricing or underpricing a product, resulting in lost sales and revenue.
- Does not consider perceived value. A cost-based model assumes the only factors customers consider are production costs, ignoring how a customer may perceive value in relation to the price of a product. So, while it works well in industries like bespoke manufacturing, DTC ecommerce often requires a more nuanced approach to pricing. Otherwise, a massive company like Amazon will take your customers.
Examples of Cost-Based Pricing
B2B manufacturing is one of the best examples of cost-based pricing in practice. Since it’s mostly contract-based, the cost-plus pricing model makes it easy for businesses to understand their manufacturing expenses and set a profit margin. This way, they can fulfill orders while remaining profitable.
It works so well in contract manufacturing because B2B buyers expect that the manufacturer will receive a percentage of the cost. And, since the organization is customizing an order for the buyer, the buyer also expects to pay any additional costs for customization.
In industries like oil and gas, cost-based pricing is the norm. The price of a barrel of crude oil depends on its production costs, which includes extraction, refining, and transportation.
Since there’s a direct correlation between the cost of producing a commodity and its selling price on the market, companies use cost-based pricing to maintain profitability. Even when prices fluctuate due to market forces, they can adjust production and costs accordingly.
When organizing events, companies use break-even pricing to ensure they don’t lose money on ticket sales. With this method, businesses determine the total cost of hosting an event, including venue rental, catering, and marketing expenses. They then divide that number by the expected number of attendees to calculate the ticket price.
Retail companies can use cost-based pricing if the customer generally understands manufacturing costs. With massive ecommerce platforms like Amazon and retailers like Walmart, this doesn’t work for every type of product.
For products with a well-defined market price for a certain level of quality, there’s no reason for a cost-based strategy. For example, there would be no reason to sell a regular graphic t-shirt for less than $25, even if you found a way to produce and deliver it at a cost per unit of $2.
But, for unique products (say, a t-shirt with patented moisture-wicking technology), a method like cost-plus pricing is reasonable. The unique feature of the product gives it a distinct perceived value (especially if you market it well), so a higher price doesn’t seem unreasonable to consumers.
Professional services need to take a cut off the top to pay their employees, contractors, and fixed costs (if they have any). Like manufacturing, it’s quote- and contract-based. So, .
It also helps them understand how many projects they need annually, quarterly, or monthly to maintain profitability. For example, you may have a firm charging $3,000/month for a marketing retainer. The retainer pays for 1 X $75/hour copywriter, 1 X $100/hour graphic designer, and some overhead costs. This establishes a baseline cost you can tweak as needed.
Leveraging Technology to Execute Cost-Based Pricing
Although it’s a simple equation, you’ll still want to strike the right balance of profit vs. customers’ willingness to pay. As you acquire new subscribers, sell through your inventory, or render your services, you’ll need business analytics tools to help you gauge how effectively your current price reflects customers’ perceived value.
Optimized pricing results in more sales. Even if the ‘perfect’ price is below your target margin, it could be worth it if it helps you sell significantly more or find ways to operate more efficiently. Using this information will help you find that number and work toward it.
Enterprise Resource Planning (ERP)
ERP software helps you calculate your costs in real time. Since it shows you your expenses and projected overhead margin, you can use it to determine your costs both in total and per unit. ERP can also track inventory, reflect dynamic production costs, and display historical data on expenses and sales. So, you can also use it to refine your cost-based strategy over time.
Configure, Price, Quote (CPQ)
As mentioned above, most businesses that find success with cost-based pricing are quote-based. CPQ software uses preset pricing rules and artificial intelligence to streamline the pricing process. Sales teams use it to generate itemized quotes, which, assuming you’ve programmed the system correctly, reflect profitable sales prices for your company.
On an ongoing basis, you’ll have to bill for the services rendered or products sold to your customers. Depending on how you bill and what type of payment processing system you use, billing can lead to more costs (like transaction fees).
But, you’ll need it to manage your revenue. And, it’s not just about billing for the products and services you sell; you’ll also need to charge customers for additional costs like customization and shipping.
People Also Ask
What is the difference between value-based pricing and cost-based pricing?
Value-based pricing is a pricing strategy that considers a product’s perceived value (according to customers), rather than just the cost of production. This means companies can set prices that represent customers’ willingness to pay, instead of just covering costs. Cost-based pricing is the opposite — it focuses primarily on covering production costs and adding a markup for profit.
What is usually the first step in cost-based pricing?
The first step in cost-based pricing is always to figure out the baseline pricing. This requires a detailed analysis of the fixed and variable costs associated with producing and selling the product. Once the pricing team establishes a baseline, they can add a markup to determine the final price.