If you are already selling products or services, you are more likely to know a few different pricing strategies. However, if you are just starting, you might not be familiar with the cost-based pricing model.
The pros and cons of cost-based pricing are always good to look at and reevaluate your current pricing methodology. Let’s take a closer look at why this pricing strategy is so popular, what types of cost-based pricing are out there, and how you can utilize them to formulate a good final price for your product or service.
What Is Cost-Based Pricing?
Cost-based pricing is a strategy that enables companies to factor in the costs that are incurred to create a product or service and adjust the final price accordingly.
Unlike other pricing strategies, the focus of cost-based pricing is primarily on the manufacturing costs used to determine selling prices.
One way to look at the cost-based pricing model is as a way to ensure profits. To ensure a profit, a price must be set for a product or service that covers all related costs and includes a profit margin.
This method provides a straightforward approach to pricing that can simplify financial planning and reduce the risk of loss.
Additionally, it helps maintain consistency in pricing across different products or services, ensuring that each contributes positively to the overall profitability of the company.
Lastly, cost-based pricing moves proportionally with the increases in supply prices, allowing businesses to adapt quickly to changes in production costs without sacrificing margins.
Key Takeaways
Cost-based pricing is a type of pricing strategy that aims to cover all of the expenses related to a product or service and turn a profit with a product’s final price;
Commonly used types of cost-based pricing strategies include the cost-plus pricing strategy, the target profit pricing strategy, and the break-even pricing strategy;
While cost-based pricing is excellent in ensuring that the final price guarantees profits, one drawback of this pricing model is the lack of attention it gives to market trends and prices of competitors.
How to Define Cost-Based Pricing?
Cost-based pricing is the process of determining prices for products or services based on their full cost. The price that a particular item will be sold at is determined by adding a profit margin or fixed profit amount to the cost of the item.
For example, if a manufacturer incurs $100 to produce a blender, and aims for a 20% profit margin, the selling price would be set at $120.
On the other hand, with value-based pricing, businesses take into account the worth of goods and services. It helps by figuring out how much value (financial or intrinsic) an item may provide to customers.
To determine the value of a service or product, companies will consider the improvement in efficiency, customer contentment, or the fulfillment of a particular demand.
For instance, a software company may price its product not just on the cost of development and support, but also on the potential efficiency gains for users, pricing it at $500 per license because it can save each user several hours of work each week.
Cost-based pricing is an adaptable pricing strategy that may be employed by various types of businesses. On the other hand, value-based pricing is sometimes used in place of cost-based pricing, mainly in service-based industries.
This strategic choice often reflects the differing priorities and competitive landscapes of product versus service-oriented businesses.
Why Is Cost-Based Pricing Important?
Since so many types of businesses can use cost-based pricing, it is a versatile and valuable pricing method.
The main benefit of utilizing cost-based pricing is its impact on the profit margins of a company or organization.
1. Ensures coverage of costs and profitability
Cost-based pricing directly ties the selling price to the production costs plus a predetermined profit margin.
This ensures that a business not only recovers all its expenses but also achieves the desired profit levels.
For example, by adding a margin to cover manufacturing and distribution expenses, a business can maintain steady profits even when production costs fluctuate.
2. Simplicity and ease of implementation
Unlike other pricing strategies that require extensive market and consumer research, cost-based pricing is straightforward to calculate and implement.
Businesses can quickly set prices based on the cost figures available from their accounting systems, making it an accessible strategy for businesses of all sizes.
3. Adaptability to changing costs
When production costs increase, businesses employing cost-based pricing can adjust prices accordingly without sacrificing their profit margins.
This adaptability helps companies remain competitive and financially stable by setting minimum price thresholds (floors) and maximum allowable prices (ceilings) to respond to market conditions and competition pressures.
What Are The Best Cost-Based Pricing Methods?
There are several types of cost-based pricing strategies, some of which may be more appropriate for your particular industry.
Take a look at the following methods to determine the best price for your goods or services, and consider which ones might benefit your profit margin the most.
1. Cost-plus pricing
Using the widespread practice of cost-plus pricing, businesses determine and apply a fixed percentage that symbolizes the anticipated return on manufacturing and selling items.
This pricing strategy does not pay attention to pricing trends or the prices of competitors, which could be considered a flaw.
2. Target profit pricing
Target profit pricing determines a selling price for items or services based on a company’s profit target. Instead of a markup percentage, target profit pricing uses a fixed predetermined sum, and prices goods accordingly.
3. Break-even pricing
Companies can determine the base price of items that cover the fixed expenses of manufacturing and delivering goods using break-even cost-based pricing.
This strategy provides firms with a solid basis of information. It determines the best final price by first covering manufacturing expenses and then establishing the final price via a cost-plus or markup method.
4. Marginal cost pricing
This method involves setting prices based on the marginal cost, which is the cost of producing one additional unit of a product.
Marginal cost pricing is particularly useful for companies looking to maximize revenue on perishable items or excess inventory that must be sold quickly.
By pricing items to cover the marginal cost, businesses can avoid losses and generate revenue from surplus stock.
5. Absorption cost pricing
Absorption cost pricing includes not only the direct costs of materials and labor but also allocates a portion of fixed costs (such as overhead) to the price of each product.
This method ensures that all costs are covered, which is especially important for businesses that have significant fixed expenses and need to ensure that each product sold contributes to these costs.
Additional Tips & Tricks
- Market research is always a valuable tool in determining the perceived value of a product or service, which can help to implement the correct pricing strategy and appropriate profit margin;
- In a turbulent market with large price fluctuations, a variable cost price setting method may be necessary to stay afloat;
- A unit cost price increment can require some difficult pricing decisions to be made. Yet, you can temporarily lower your profit margin to meet the company’s longevity goal.
The Bottom Line
Cost-based pricing is a method of determining the selling price for a product or service. This strategy is based on calculating the total price of manufacturing and distribution and adding a markup to the final price. Cost-based pricing is an effective pricing model if competitors and market movements do not already dictate pricing trends.
Determining the likely costs tied to your product or service is an important element of final price creation.
In this article, you’ve learned that determining the likely costs tied to your product or service is an important element of final price creation. With all this knowledge and information, it’s up to you now to decide if cost-based pricing is the right approach for your product or service.
Cost Based Pricing FAQs
There are several benefits to the cost-based pricing method. Primarily, it allows companies to account for their overhead cost and determine a selling price that covers the production cost, among other expenses.
Some industries may have a greater preference for value-based pricing. In essence, value-based pricing is applied when the perceived value of a product or service is already high. Markets where demand is high but supply is low often have products priced based on their perceived value instead of the production cost.
There are some drawbacks to consider when picking the best pricing strategy for your product or service. Cost-based pricing can create prices that deviate from market rates. Either the price is too high and turns away customers or it is too low to make a profit. Additionally, it ignores the presence of competition and the overall demand.
With market-based pricing, the business bases its pricing on what rival businesses are charging for comparable goods and services. With this method of pricing, a company can maximize prospective earnings while avoiding overcharging, which would turn away customers.
