Cost-Based pricing (or the mark-up pricing) as the name suggests, is a method to set the price of the goods or services based on the cost. Under this, we add a percentage of the total cost to the cost itself to get the selling price of the product. We can add an absolute amount to the cost as well. This method generally uses manufacturing or production costs and distributing and selling costs for setting the price.
For example, the total cost of the mobile is $2,000 for a manufacturer. The manufacturer adds 20% of the cost to get the selling price. So, in this case, selling price would be $2,400 ($2,000 + 20%* $2,000).
Types of Cost-Based Pricing
Generally, there are four types of cost-based pricing. These are:
Under this, a company adds a fixed percentage of the total cost as mark-up to come up with the selling price. We can also call it the average cost pricing. The above example of the mobile explains cost-plus pricing. Usually, manufacturing organizations use cost-plus pricing.
Under this, the reseller adds a certain amount or percentage of the cost to arrive at the selling price. Most retailers use such pricing. For example, a retailer buys a mobile from the distributor for $500. On $500, the retailer would add a mark-up of $100 to earn a profit.
Break-Even Cost Pricing
Under this, a company aims to cover its fixed cost. Such pricing is mostly used by the industries having high fixed costs, such as the aviation industry. In this, a firm finds the price using a level of sales at which it would break even. Or, we can say it determines the amount that will cover the variable and fixed cost. Then, it sets the selling price above the break-even price using mark-up or cost-plus pricing.
Target Profit Pricing
Under this, a company first sets the target profit that it wants to achieve. Based on the target profit, the company calculates the selling price.
Cost-Based Pricing – How to Use?
A company usually determines a price range – floor and the ceiling prices. These represent the minimum and the maximum price that a seller would want for the product or service. Then based on the market situation, the seller determines the final selling price. The cost-based pricing helps a company to determine the floor price.
Let’s understand this with the help of an example. For Company ABC total cost of a product is $500. The profit margin or mark-up is 20%. On the basis mark-up pricing, the minimum selling price would be Total cost of the product plus a profit margin. This means $500 + 100 (20% * $500) or $600.
This $600 will be the price floor. Company ABC can determine the price ceiling based on factors such as its competitive status, price floor, the value that the product or service offers and more. After that, it could charge customers the price it sees fit based on market conditions.
Such use of the cost-based pricing may also help a company to overcome some of its drawbacks.
Following are the benefits or advantages of this pricing method:
- This method ensures that a company always generates profit. But, for this to happen, the mark-up should be sufficient to meet all the expenses. Also, sales should be as per the expectations.
- It is simple to understand and easy to apply.
- This method of costing covers all the production and overhead costs.
- Ensures that a company generates a consistent profit margin even when the cost rises.
- This method is also useful in finding the cost of any customized product.
- If customers are aware of the cost, then they can also understand the reasons behind the product price.
- This method helps companies to bid for large projects.
Following are the drawbacks of cost-based pricing:
- Such a method may result in price to be different from the market rate. Either the price could be much high to discourage buyers, or too low to result in a loss.
- This method does not encourage business to make efforts to control the cost. It is because the company simply passes the cost to the buyers under this method.
- It may sometime ignore the importance of customers.
- This costing method does not take into account the opportunity cost of the investment.
- It does not take into account the demand and competition.
- A company must be aware of all the costs it incurs to set the price. Overlooking any cost may result in underpricing.
To overcome the above drawbacks, a company may go for the market-based pricing. Under this, the company sets the price based on the price of similar products and services.
Another pricing method that a company may use is value-based pricing. Under this, the company takes into account the value of the product it offers to set the price. To determine the cost, the company tries to find out how much value the product or service holds for the customer. Or how much a customer would be willing to pay for it.
Even though there are several drawbacks of the cost-based pricing, if a company uses it rightly, it could prove beneficial. One way to use it is discussed above, under the sub-heading ‘How to Use.’ Another way such pricing could do wonders if a company implements it strategically.
A San Francisco-based clothing company, Everlane uses cost-based pricing very strategically to help gain the trust of the customers. The company is famous for being transparent with its pricing. What they do is disclose the actual cost of their product, including materials, labour and transportation, and then reveal their mark-up on that cost.1–4