Cost-Based Pricing

Cost-based pricing can be defined as a pricing method in which a certain percentage of the total cost is added to the cost of the product to determine its selling price. In other words, it refers to a pricing method in which the selling price is determined by adding a profit percentage to the cost of making the product.

This method of the price of products ensures that the company can recover a specific part of the cost incurred in producing them, even though it might result in some customers backing out from purchasing the goods due to the high price. Therefore, the cost of goods sold is primarily used for pricing.

1. Cost-based pricing is a type of pricing where the selling price of the product is determined by adding a specific proportion of the overall cost to the cost of the product. 
2. In other words, it alludes to a technique of pricing in which the selling price is established by multiplying the cost of production by a profit margin.
3. It is a pricing strategy that accounts for the costs of manufacturing, shipping, and selling the product while also including a reasonable rate of return to cover the company's costs and risks.
4. Every company wants to make money from the ventures it takes on. Profit is calculated by the selling price of its product or service. Greater earnings aren't necessarily the goal. For a product to generate revenue and make a profit, demand must exist at every price point.

Cost-based pricing strategy can be referred to as the pricing method that calculates the product’s price by firstly calculating the cost of the product in which the desired profit is added, and the result is the final selling price.

The cost-based pricing in marketing involves the costs for producing, distributing, and selling the product by adding a fair rate of return to compensate for the efforts and risks taken by the company. It is a simple way to calculate the product's price by calculating the total cost in which the desired profit is added to determine the final selling price.

Every organization aims to realize a profit in the business that it undertakes. Profit is determined by the selling price of its product or service. It is not always greater profits. The demand for a product at every price point is also important to determine the revenue generated and the profit.

There are various types of cost-based pricing strategy as given below.

#1 - Cost-Plus Pricing

It is one of the simplest cost-based pricing methods of the product. In cost-plus pricing method, an affixed percentage, also called markup percentage, of the total cost (as a profit), is added to the total cost to set the price. For example, an ABC organization bears the total cost of $100 per unit for producing a product. Therefore, it adds $50 per unit to the product as’ profit. In such a case, the final price of the organization's product would be $150. This pricing method is also called average cost pricing and is commonly used in manufacturing organizations.

#2 - Markup Pricing

It refers to a pricing method in which the fixed amount or percentage of the cost of the product is added to the product’s price to get the selling price of the product. Markup pricing is more common in retailing, in which a retailer sells the product to earn a profit. For example, if a retailer has taken a product from the wholesaler for $100, he might add up a markup of $50 to profit.

Where,

#3 - Break-Even Cost Pricing

In the case of Break-even Pricing, the company aims to maximize contribution towards the fixed cost. This is relevant, particularly in the industries that involve high fixed costs like the transport industry. The sales level required to cover relevant variables and fixed costs will be determined here.

#4 - Target Profit Pricing

In target profit pricing, prices target the specific level of profits or return it wants to earn on an investment.

Thus, the above are the cost-based pricing methods used in any organization.

Let us look at the formula used for the various cost-based pricing in marketing.

#1 – Cost-Plus Pricing

The formula to calculate the cost-based pricing in different types is as follows:

Price = Unit Cost + Expected Percentage of Return on Cost

#2 – Markup Pricing

Price = Unit Cost + Markup Price

Where,

Markup Price = Unit Cost / (1-Desired Return on Sales)

#3 – Break-Even Cost Pricing

Price = Variable cost + Fixed Costs / Unit Sales + Desired Profit

#4 – Target Profit Pricing

Price = (Total Cost + Desired Percentage of Return of Investment) / Total Units Sold

Let us look at an example to understand the concept.

A company sells goods in the market. It sets the price based on cost-based pricing. The variable cost per unit is $200, and the fixed cost per unit is $50. Profit markup is 50% on cost. Calculate the Selling price per unit.

Here, the selling price will be calculated based on cost-plus pricing.

This $ 375 will be the price floor.

Given below are the cost based pricing benefits.

1. A straight- forward and simple strategy;
2. Ensuring a steady and consistent rate of profit generation;
3. It finds the price of the customized product which has been produced as per the specification of the single buyer;
4. Finding the maximum possible product manufacturing cost is allowable if the final selling price is fixed.

Along with the cost based pricing benefits, an organization may also face some problems when this method of pricing is used, as given below:

1. It may lead to underpriced products.
2. It ignores replacement costs.
3. Contract cost overruns.
4. Product cost overruns.
5. This approach may ignore the opportunity cost of investment.
6. This approach may sometimes ignore the consumer’s role in the overall market.

The differences between the Cost-Based Pricing and the Value-Based Pricing are as follows:

This has been a guide to what is Cost Based Pricing. We explain it with examples, formula, differences with value-based pricing, advantages & disadvantages. You can learn more about it from the following articles –

• Average Cost vs Marginal Cost
• Absorption Costing
• Differential Cost
• Standard Costing Examples