Cost Based Pricing

Cost-Based Pricing Strategy

A cost-based pricing strategy aims for businesses to achieve a specified profit margin over and above the entire cost of production and manufacturing. A cost-based pricing strategy enables companies to cover production expenses and make a profit.

There are two cost-based pricing strategies—namely, cost-plus pricing strategy and break-even pricing strategy.

Cost-Plus Pricing Strategy

The cost-plus or markup pricing strategy is one of the most common types of cost-based pricing strategies.

Lawyers, accountants, and other professionals typically price by adding a standard markup to their costs.

Break-Even Pricing Strategy

Break-even pricing, also known as target-return pricing, is the second pricing approach based on costs.

Without adding a markup, the price of a product is determined by adding up the costs of its creation, production, and distribution.

Instead of marking up each unit to earn income, this method calculates how many units a firm needs to sell to cover the manufacturing expenses.

The formula companies use to determine the break-even volume is

\(\hbox{Break-even volume}=\frac{\hbox{Fixed costs}}{\hbox{Price - Variable cost}}\)

This formula helps companies learn about the number of units they need to sell at a particular price to become profitable.

Let's say a company has invested $3,000 in manufacturing pens and the variable cost per pen is $1. If the firm sells the pen for $2, it needs to sell:

\(\hbox{Break-even volume}=\frac{$3,000}{$2-$1}= 3,000\)

The company needs to produce 3,000 pens to break even.

Cost-Based Pricing Formula

Cost-Plus Pricing Formula

\(\hbox{Selling Price}=\hbox{Cost of production and distribution per unit}+\hbox{Markup}\)

In this formula, the "Cost of Production and Distribution" is the total cost of producing and delivering the product or service, including all direct and indirect costs. The "Markup" is a fixed percentage or amount that's added to the cost of production and distribution to determine the selling price. The markup is usually determined by factors such as industry standards, competition, and desired profit margin.

Break-Even Pricing Formula

\(\hbox{Selling price}=\frac{\hbox{Total fixed costs}}{\hbox{Number of units sold}}+ \hbox{Variable cost per unit}\)

In this formula, the "Total Fixed Costs" are the expenses that remain constant regardless of the number of units sold, such as rent, salaries, and insurance. The "Variable Cost per Unit" is the cost of producing one unit of the product or service, including materials, labor, and other variable costs. By using this formula, a company can determine the minimum selling price that they need to charge to cover their total costs and break even.

Cost-Based Pricing Example

Let's now take a look at some cost-based pricing examples.

Cost-Plus Pricing Example

Let's take a look at an example of a cost-plus pricing strategy.

Break-Even Pricing Example

Advantages of Cost-Based Pricing

There are many advantages of implementing a cost-based pricing strategy:

1. Helps businesses consistently make a profit: By taking into account all the costs involved in producing and distributing a product or service, cost-based pricing ensures that the selling price is high enough to cover these costs and generate a profit.

2. Easy to implement pricing strategy: Cost-based pricing is a straightforward pricing strategy that can be easily implemented by businesses. It requires calculating the total cost of producing and delivering a product or service and adding a markup to determine the selling price.

3. Provides transparency to customers: Customers can better understand the pricing rationale when they are aware of the cost of production and distribution. This can increase customer trust and loyalty towards the business.

4. Ensures stable profit margin despite increasing expenditures: With cost-based pricing, a company can consistently maintain its profit margin even if the cost of production and distribution increases due to various factors such as inflation, rising wages, or material costs.

5. Helps in setting a competitive price: By calculating the total cost of production and distribution, a company can set a competitive price for its products or services based on industry standards, market demand, and competition.

6. Supports financial planning and decision-making: Cost-based pricing provides a clear understanding of the costs involved in producing and distributing a product or service, which can help businesses in making informed financial decisions and planning for future investments.

Difference between Cost-Based and Value-Based Pricing

A firm that uses value-based pricing considers the value of its product rather than the cost that the company spent to manufacture and produce it. As a result, the business first calculates how much money or value the consumer will earn from using their product or service. Businesses that create goods such as pharmaceuticals, chemicals, computer programs, software, artwork, etc, often use this pricing method.

The main difference between cost-based and value-based pricing is that in cost-based pricing, the price is largely determined by the company's internal costs, while in value-based pricing, the price is determined by what the customer is willing to pay based on the perceived value of the product or service, which may be higher than the cost of production.

A pricing range is defined by its floor, the lowest possible price, and its ceiling, which is the highest possible price for a given product or service. If the market circumstances are such that the going competitive price is lower than the price floor, the firm may choose to price its products at the price floor or strive to reduce its expenses to lower the price floor.