What is pricing based on costs?
Companies use cost-based pricing to decide how much to charge for their goods by looking at how much it costs to make, sell, and ship them. They often get this number by adding a markup percentage to the total cost of making and shipping the item.
Many costs go into making and distributing something, such as shipping, packaging, production supplies, overhead costs (like rent and utilities), and goods and labor. A company’s cost-based pricing approach is either whole- or direct-cost, depending on which costs they use.
Full-cost pricing considers both set and variable costs plus a specific percentage markup. It’s more correct because it takes everything into account, but it takes more work to figure out.
When setting prices, direct-cost pricing only looks at the fixed (direct) costs of making and selling a product, like labor and supplies. This method is easier to understand, but businesses might make less money.
The idea behind cost-based pricing is pretty easy to understand: figure out how much it costs to bring a product to market. After that, add a margin to get the sale price. Many big and small businesses use cost-based tactics because they’re easy to implement and lead to predictable (and guaranteed) profit margins.
Synonyms
- Cost-plus pricing
- Markup pricing
- Break-even pricing
Why businesses set prices based on costs
Cost-based pricing is helpful in many scenarios, even though it doesn’t consider demand and competition.
Make sure you can make money when you sell expensive things. Companies can be sure of making a profit on every sale by taking into account all the costs. Engineered-to-order items and other things that are expensive to make are often offered this way.
They are paying for the costs of creation. In fields where fixed costs, like rent and tools, are significant parts of production costs, cost-based pricing helps companies get those costs back quickly and easily.
They are making pricing choices easier. Value-based pricing needs a lot of study and analysis of the market. On the other hand, the cost-based approach uses internal data, making it easier for businesses to set prices without input from outside sources.
They are putting a starting price on a new item. Cost-based models have fewer factors because they don’t need any outside data or input. Because of this, it’s a good place for companies putting out new items to start looking for the best price for them.
Still, it doesn’t take demand into account. If you only use costs to set prices, your product might not be worth what it’s worth on the market, which could mean missed chances and lost money.
With cost-based pricing, you don’t have to worry about what your competitors are asking for similar goods. You might be unable to sell as many of your products at the profit margin you want if they offer lower prices.
It also doesn’t encourage speed or new ideas. If a company only sets prices based on costs, they don’t have much reason to work on becoming more efficient and lowering production costs.
It is best to use cost-based pricing and other pricing methods, like value-based pricing or pricing based on competitors. When setting prices for their goods, companies that use more than one of these methods can be sure that they are taking both internal and external factors into account.
Different ways to set prices based on costs
Price Based on Cost
The cost-based method that is used most often is cost-plus Price. Adding a set percentage fee to the total cost per unit of a product is what it means. This method works well when figuring out other costs, like those for marketing or R&D, is hard.
Cost Plus Pricing = Price at Which You Break Even x Profit Margin You Want (%)
This is how the math would look if a company’s break-even price is $50 per unit and they want to make a 20% profit margin:
Price Plus Cost = $50 x 1.20 = $60
The cost-plus pricing approach says this item should be sold for $60 per unit.
Price Break-Even
The cost-based break-even pricing approach tries to find the price at which a business will not make or lose money but will be even. It’s mainly used to launch new goods or make things that are only used once, like for events or services.
Break-Even Price = (Total Fixed Costs / Number of Units Made) + Costs That Change
For instance, if a company has $10,000 in set costs and wants to make 500 units, with $20 per unit as variable costs, the math would look like this:
Price at which you break even: $10,000 divided by 500 units plus $20 equals $40.
Beforehand, businesses do a break-even analysis to find the point where income equals expenses and to see how much profit they can make after that. This helps them figure out the sub of fixed and variable costs. This helps them figure out how much to charge so they can cover their costs and still make a profit.
Increase the Price
Businesses that sell things online and in stores often use markup prices. Using this simple cost-based method, the selling price of a good is found by adding a set profit to the cost of goods sold.
Markup Price = Gross Sales Price x Markup Rate
This is how the math would look for a product that costs $50 and has a 50% markup:
Price with markup: $50 times 1.5, or $75
Businesses that sell goods that aren’t different from one another, like grocery things or raw materials, can use the markup pricing method.
Price to Make a Profit
Target profit pricing is used by businesses to set prices that are fair and competitive while still making money. It’s a little different from cost-plus pricing because companies think about the goal price and the profit margin they want to make.
Target Profit Price = (Total Costs + Total Profit Wanted) / Number of Units Made
For instance, if a company wants to make a 30% return on a $10,000 product and plans to sell 1,000 units, the math would look like this:
- Target Price for Making Money = $10,000 plus $10,000 times 0.30 / 1000 = ($10,000 + $3,000) / 1000 = $13
- In this case, the goal price for each unit to make a return, is $13.
- The pros and cons of pricing based on costs
- Pros of setting prices based on costs
It is simple to figure out and understand. Companies that don’t have much money, data, or staff can use cost-based methods instead of doing a lot of market research. Competitive pricing or a value-based plan would need a lot of data to be put into place, which usually takes time and a lot of resources.
It makes launching products easier. Cost-based Price is excellent when your company releases a new product because it doesn’t depend on outside data or inputs. The cost-plus method lets them set a starting price and make changes as needed as they get more information or learn more about their target market.
Makes a sure-fire profit gap possible. When you consider the cost of production, each sale brings you a return. If you rely too much on competitive and value-based models, you might end up selling at a loss because of things outside of your control, like changes in the market or the prices of your competitors.
It keeps you safe from instability. Cost-based pricing can help businesses stay profitable by protecting them from sudden changes in industries that change a lot, like technology or goods.
₷A good starting point for testing. It can be hard to get price management right. You can use how the market responds to your cost-based Price to gather information and ideas that you can then use to create more complex pricing strategies.
Problems with a Pricing Strategy Based on Costs
Ignores what the market wants. A plan based only on costs thinks that the Price of a product should be set by how much it costs to make, without considering how people act or how the market works.
There is no promise of sales. You don’t have to charge that much for every sale just because it makes you money. If you base your pricing on costs, you might set the Price of a product too high or too low, which can cost you sales and money.
Not thinking about how much something is worth. A cost-based model believes that customers only care about how much something costs to make, without taking into account how a customer might see the value of a product in relation to its Price. So, while it works well in some fields, like custom manufacturing, DTC ecommerce often needs a more complex way of setting prices. If you don’t, a huge company like Amazon will steal your business.
Some examples of pricing based on costs
Making things
When it comes to real-world cases of cost-based pricing, business-to-business manufacturing stands out. The cost-plus pricing model makes it easy for businesses to figure out their producing costs and set a profit margin because it’s mostly based on contracts. In this way, they can keep making money while still fulfilling orders.
When you hire a maker to make something for you, business-to-business buyers expect to get a cut of the cost. The buyer also expects to pay any extra costs for tailoring since the company is making changes to the order just for them.
Industries Based on Goods
Price sets are usually based on costs in fields like oil and gas. The Price of a barrel of liquid oil is based on how much it costs to get the oil out of the ground, refine it, and ship it to markets.
Companies use cost-based pricing to stay profitable because there is a direct link between how much it costs to make a good and how much it sells for on the market. They can change production and costs to account for changes in prices caused by market forces.
What’s Going
Companies use break-even prices to make sure they don’t lose money on ticket sales when they put on events. Businesses use this method to figure out how much it will cost to host an event, including the cost of renting the space, paying for food, and advertising. The Price of the ticket is then found by dividing that number by the number of people who are likely to show up.
Shop around
Cost-based prices can be used by stores if the customer knows how much things cost to make. This doesn’t always work for every kind of goods because of big online stores like Amazon and big department stores like Walmart.
There’s no need for a cost-based strategy for goods that have a clear market price for a certain amount of quality. For instance, you shouldn’t sell a basic design t-shirt for less than $25, even if you could make and ship them for $2 each.
But cost-plus pricing makes sense for one-of-a-kind items, like a T-shirt with patented moisture-wicking technology. Customers don’t think it’s unfair to charge more for a product because it has a unique quality that makes it valuable (especially if it’s well marketed).
Industries Based on Service
There needs to be a cut for professional services to pay their staff, contractors, and any set costs they have. It’s built on quotes and contracts, just like manufacturing. So, .
It also helps them figure out how many jobs they need each year, three months, or month to keep making money. One example is a company that charges $3,000 a month for a marketing fee. The retainer pays for one copywriter who charges $75 an hour, one graphic artist who charges $100 an hour, and some other costs. This gives you a starting point that you can change as needed.
Using technology to put cost-based pricing into action
Analytics for Business
Even though it’s an easy equation, you’ll still need to find the right profit level based on how much customers are willing to pay. As you get new subscribers, sell your inventory, or provide your services, you’ll need business analytics tools to help you figure out how well your current Price matches what buyers think it’s worth.
When prices are optimized, more sales happen. It might be worth it to accept a price that is lower than your goal margin if it helps you sell a lot more or run your business more efficiently. You can use this information to find that amount and work toward it.
Software for Enterprise Resource Planning (ERP) helps you figure out your prices right now. You can use it to figure out your costs both overall and per unit because it shows you your costs and expected overhead profit. ERP can also keep track of inventory, show changing production prices, and show past information on sales and expenses. You can also use it to make your cost-based plan better over time.
Set up, Price, and quote (CPQ)
As was already said, quote-based pricing works well for most businesses that use cost-based pricing.CPQ software speeds up pricing by using artificial intelligence and setting pricing rules. Sales teams use it to make itemized quotes, which, if you program them correctly, show prices that will make money for your business.
Getting paid
You’ll have to keep sending your customers bills for your goods or services. How you bill and the type of payment system you use can make paying more expensive, such as through transaction fees.
But you’ll need it to keep track of your money. It’s not enough to charge people for the goods and services you offer; you’ll also have to charge them for things like shipping and customizing.
