What is cost-based pricing? Cost-based pricing is a
that is based on the cost of production, manufacturing, and distribution of a product. Essentially, the price of a product is determined by adding a percentage of the manufacturing costs to the selling price to make a profit.
For businesses looking to achieve their various goals and objectives, whether it be to boost their profit margins or calculate the return on investment for newly developed products, a strong pricing strategy is essential. However, how do businesses choose which pricing research techniques to use for their particular product or service? In this article, we explore two major categories of pricing strategies and highlight the key distinctions as well as their benefits and drawbacks.
Pricing Strategies: Cost-Based Pricing
What are the cost-based pricing formulas?
You can use a specific formula to determine your selling price for each technique under the cost-based pricing strategy, where P stands for the cost:
Cost-plus pricing formula
P = (cost per unit) + (expected % of return)
The selling price is calculated using the cost-plus formula by adding a fixed percentage of expected return to the cost per unit a company incurs. For instance, if a business spends $135 to produce one item and anticipates a 25% return rate, it will set a selling price of $160.
Markup pricing formula
P = cost per unit + markup rate
The markup rate for markup pricing is calculated using the following formula: (cost per unit) (1 – desired sales return). Before figuring out the sales price using the markup pricing method, businesses need to know the desired return rate. For instance, if a company wants a 24% sales return on each sale, it can figure out the markup rate and use that information to determine the markup pricing.
Target profit pricing formula
P is equal to (total cost + anticipated ROI%)/(units sold).
Total costs represent all operational costs incurred in creating and selling an item in the target profit pricing formula. Companies multiply the sum by the number of products they sell over a given time period after adding a percentage of the projected return on investment.
Break-even pricing formula
P equals total unit sales minus profit plus variable cost plus fixed cost.
A business can use the break-even pricing formula to determine how much revenue is necessary to cover the costs of producing, storing, and selling its products. The business can then increase this value to the total costs to obtain a fair selling price. Companies first add up all operational costs, both variable and fixed, and divide this number by the total of expected profit and product sales.
What is cost-based pricing?
Companies use cost-based pricing as a strategy when determining the selling prices for products and services. With this system of pricing, businesses can set prices based on the costs of producing their products or rendering their services. Cost-based pricing uses a variety of techniques to determine fair selling prices. Each approach focuses on the production costs of an offering as the foundation for figuring out the best price that produces high customer satisfaction and boosts a company’s bottom line:
Cost-plus pricing
Cost-plus pricing, a popular form of cost-based pricing, bases the price of goods and services primarily on their total cost of goods sold (COGS). A fixed percentage that represents the anticipated return on producing and selling goods is calculated and used by businesses. To determine an appropriate selling price, this percentage is combined with all costs related to the production, storage, and distribution of goods.
For instance, a business that produces and sells mobile phones might expect a 20% return rate, which it would add to its COGS to determine the selling price. The selling price provides the business with the income it needs to reach its 20% return objective.
Markup pricing
Most retailers use markup pricing, which involves adding a certain percentage to the cost of items they buy to get the final selling price. For instance, to determine the selling price, a store that sells children’s clothing will add a certain percentage to the cost of the clothing it provides. Businesses that use markup set selling prices that allow them to make a profit and attract customers.
Target profit pricing
To determine a selling price for goods or services, target profit pricing takes into account the company’s profit objective. For instance, to determine the price for its customers, an electrician services provider would add the target profit goal of $200 for each compressor replacement service it sells to the costs related to providing the parts and repair service.
Break-even pricing
Companies can determine the base price of goods that will cover the fixed costs of manufacturing and distributing products using break-even cost-based pricing. By first covering production costs and then determining the final selling price using a cost-plus or markup method, this approach provides businesses with a starting point for selling prices.
Advantages of cost-based pricing
Companies that use cost-based pricing as a means of determining sales prices can benefit from a number of factors. Several key benefits of cost-based pricing include:
Cost-based pricing versus value-based pricing
Cost-based pricing only considers production costs when determining selling prices. Businesses evaluate all expenses related to creating, marketing, and selling products and offering services. Cost-based pricing doesn’t take into account the quality of goods or services and enables businesses to set price ceilings and floors, providing a range of values that can be used as selling prices.
Contrarily, in value-based pricing, businesses take into account the value of goods and services by estimating the amount of value (financial or intrinsic) that they provide to consumers. Several elements, such as improved effectiveness, satisfaction, or the fulfillment of a particular need, assist businesses in determining the value of a product or service. Value-based pricing, as opposed to cost-based pricing, may be used by many service-based industries.
Disadvantages of cost-based pricing
Cost-based pricing has some disadvantages in addition to its benefits, such as the following:
Examples of cost-based pricing
To calculate cost-based pricing using each formula, use the examples below:
Example using cost-plus
Assume for the purposes of this example that a manufacturing company wants to determine the selling price for a new mobile device it develops using the cost-plus method. The company determines an appropriate selling price when its costs for producing one device are $125 and its expected percent of return is 20% using the cost-plus pricing formula P = (cost per unit) + (expected% of return):
P = ($125) + (20%) = $145 where P = (cost per unit) + (expected percent of return)
The business decides to set the selling price for the new device at $145 per unit based on the cost-plus pricing calculation.
Example using markup
Assume for the purposes of this illustration that a retail company buys and resells handmade sweaters and jackets for $15 per sweater and $20 per jacket. With the help of the markup pricing formula, the company can determine an appropriate sales price to make a profit and pay for its COGS. The company first calculates the markup rate for the sweaters and jackets using the formula (cost per unit) (1 – desired sales return):
Sweaters = (cost per unit) – (desired sales return) = ($15) – (25%) = ($15) – (1.0) 25) = $15 ÷ 0. 75 = $20.
Jackets = (cost per unit) – (desired sales return) = ($20) – (25%) = ($20) – (1.0) 25) = $20 ÷ 0. 75 = $27.
In other words, the company sets a markup price of $27 for the jackets and $20 for the sweaters. In order to determine the selling prices for the sweaters and jackets, the company uses the markup pricing formula P = cost per unit + markup price.
P = cost per unit plus markup price for sweaters is $15 + $20 = $35.
P = cost per unit plus markup price for jackets is $20 + $27 = $47.
The company establishes its selling prices at $35 for sweaters and $47 for jackets using the markup pricing formula.
Example using target profit
In this illustration, a service provider wants to set a price for its translation services, so it applies the target profit pricing formula to choose the best price. When the company’s total service costs are $250 per service and its projected percentage of returns is about 30% of the $2,500 returns, it uses the following formula if it knows it sells an average of 50 translation services per period:
P = (total cost + projected ROI% (units sold) = P = ($250 + 30% of $2,500) (50) = ($250 + $750) (50) = ($250 + $1,000) (50) = $20
The provider of the service decides that $20 per translation hour is a reasonable starting point for pricing this service for its customers.
Example using break-even
Let’s say a manufacturer wants to use the break-even pricing strategy to cover its production costs and turn a healthy profit on each sale. The business can determine the selling price for its newest product using the break-even pricing formula P = (variable cost + fixed cost) (total unit sales + profit). The business uses the following financial information to determine the product’s break-even price:
By entering this data into the formula, the business determines its selling price:
P = ($4,500 + $3,000) (350 + $150) = P = ($7,500) ($500) = $15. P = (variable cost + fixed cost) (total unit sales + profit) =
This means that in order for the business to break even or cover its entire cost of production, it must set a price floor of at least $15 per item.
FAQ
What are the three cost-based approaches to pricing?
- Price = Unit Cost + Expected Return on Cost as a Percentage
- Price = Unit Cost + Markup Price.
- Markup Price = Unit Cost / (1-Desired Return on Sales)
- Price = Unit Sales + Desired Profit / Variable Cost + Fixed Cost
What are the problems in cost-based pricing?
Three types of general pricing strategies exist: the cost-based pricing strategy (cost-plus pricing, break analysis, and target profit pricing). Buyer-Based Pricing Approach (perceived-value pricing). Competition-Based Pricing Approach (going-rate and sealed bid pricing).
How do you calculate cost base pricing?
Cost-based pricing strategies base their pricing on production costs, to which a profit margin must be added to determine the final product price. Companies that use cost-based pricing use their costs to determine a price floor and a price ceiling.
