What is cost based pricing?

Cost based pricing is regarded as one of the easiest ways to calculate the price for a product or service. The pricing strategy can be expressed in two particular forms, namely full-cost pricing and direct-cost pricing. In such a case, full-cost pricing depends on several variables - fixed costs and percentage markup. In addition, direct-cost pricing contains variable costs and percentage markup. One of the key indications of cost plus pricing’s success is when marginal revenues equal marginal costs. As a pricing strategy, cost based pricing is easier to use than value based pricing. It is considered to be the simplest method of the pricing available.

Most often, cost based pricing is utilized for the sake of profit maximization. It is calculated through an evaluation of the cost of production of a product along with adding a profit percentage to the price to determine the final selling point. Such a pricing strategy ensures that a company receives a profit margin that meets the anticipated rate of return. Cost based pricing is widely used because of its simplicity and the degree of information required to anticipate the profit. At this point, cost plus pricing is better than value based pricing in cases when the data on costs and demand cannot be obtained easily—experts label cost based pricing as one of the most rational approaches toward profit maximization.

When it comes to understanding cost plus pricing, it is crucial to say a few words about value-based pricing in itself. The pricing strategy emphasizes price-setting based on how consumers perceive the value of a particular product or service. From the get-go, one can see that assessing perceptions is not the most rational and accurate way to determine the price. In such a case, cost based pricing is more precise than value based pricing.

Cost based pricing strategy

In a nutshell, cost based pricing is a pricing strategy in which a company adds a markup to the price of a product over the cost of production and manufacturing. The strategy often involves adding a fixed percentage added on top of production costs for one unit. In contrast to value-based pricing, the cost plus pricing strategy ignores competitor prices and consumer demand.

When calculating cost based prices, there are several key elements to consider. In the case of calculations, one needs to add aspects like labor, material, and overhead costs. The next step is to multiply the sum by one in addition to the markup percentage. Essentially, this is the basic strategy for calculating cost based pricing.

The different method for calculating cost plus pricing is called target-return or break-even pricing. Within the scope of the pricing strategy, the price for a particular product is determined by the cost of production, manufacturing, and delivery without markup percentage. In such a case, this type of cost-based pricing method is used to calculate how many units a firm requires to sell to compensate for the cost of production and delivery. This pricing strategy is different from the basic one because no marking up is added to generate profit.

The important thing is that companies often do not need to determine cost-based pricing manually. There is a range of available resources, platforms, and agencies offering services in calculating different aspects of cost plus pricing. What is more, there are even resources you can use for free.

Cost based pricing example

Speaking about various examples of cost based pricing, it is crucial to consider several instances. Many consumers value transparency and do not want cloudy prices for products and services. Transparency in pricing is what often grants a competitive advantage. There is a clothing retailer Everlane, which effectively uses cost plus pricing as its primary pricing method. What the company does is reveals all the aspects of its pricing strategy, both the cost of production, manufacturing, and delivery along with the markup percentage. In such a case, consumers can see the origin of a production price, which cannot be done in value based pricing, based on the true cost of every element from materials to transportation.

In terms of another cost-based pricing strategy, namely break-even pricing, one should consider a hypothetical example. Let’s imagine an attorney is willing to use the break-even cost based pricing strategy to determine the cost of a service one offers. At this point, the cost of running a firm is about $200,000. The attorney charges $200 per hour. A person should work about 1,000 hours to achieve a break-even price in such a case. If an attorney wants to reach 10 percent of return on costs, he should work additional 100 hours. Such an example of cost based pricing offers a simple perspective on how much one should work or produce to achieve the anticipated return.

Companies using cost based pricing

Some prominent examples of companies using cost based pricing include Walmart and Ryanair. These are considered the low-cost producers in their respective industries. Both companies set lower prices and get a massive competitive advantage by appealing to cost reduction. Price reduction results in a smaller margin. However, it also means greater sales and profits, compensating for the margin. Ryanair and Walmart use cost based pricing as a key pricing strategy allowing greater competitive advantage through lower prices.

However, even companies that generate higher costs use cost based pricing. They claim higher prices and higher margins. Essentially, it is about balancing between price margin and willingness to sell more. Such companies prefer cost plus pricing to value based pricing.

Conclusion

Cost based pricing is simple to use. With its two core strategies involved, companies might not even engage in manual cost-based pricing calculations. There are services to help you with that matter. In contrast to value based pricing, cost plus pricing relies on accurate and precise information. Even when such information is not available, firms can still use internal factors to set the best price for the product. The important aspect is not to be greedy and try to set realistic expectations on profits, which will benefit everyone involved.

FAQ

What is cost-based pricing?

Cost based pricing is one of the easiest ways to calculate the price for a product or service. It is based on product cost as the major factor and reference point while crafting a shelf price.

How is the cost-based price calculated?

The cost-based price is calculated through an evaluation of the cost of production of a product along with adding a profit percentage to the price to determine the final selling point.