What is Cost-Based Pricing & How to Use It Right?
As a buyer, people often highly appreciate transparency since with it, they will be aware of how many parts in the product price are for the production cost, labor cost, inventory cost, transporting cost, and revenue.
With this model, the relationship between sellers and buyers will become fairer. It also allows them to explore the organization’s working process, which is also the root that people tend to prefer to purchase goods from these stores.
In business, there is a strategy that can live up to these requirements. It is Cost-based Pricing.
So, what is cost-based pricing?
This pricing strategy is already applied in some companies and achieved success, named Everlane. In this article, we will help you clarify all your queries about this interesting strategy.
- What is cost-based pricing?
- What is a cost-based pricing strategy?
- What are the pros and cons of cost-based pricing?
- Advantages of cost-based pricing
- Disadvantages of cost-based pricing
- Examples of cost-based pricing strategy
What is cost-based pricing?
Cost-based pricing definition
Cost-based pricing is a method to help entrepreneurs calculate the price for their products or service. In this method, there are two main components: the cost of the items or services sold and the percentage of profit. This percentage will depend on the sellers’ desire, and it will be added to the product cost to generate profits.
Cost-based pricing consists of two types. They are cost-plus pricing and breakeven pricing.
This way, the business can be sure that they will never have to face the losses; there is always profit with each item sold successfully. It only comes true if the expected percentage is high enough and the number of sales is equal to or higher than what is set in the strategy. It is also an easy way to set the selling price, especially for the merchants who have just started their business.
However, there still exist some drawbacks of cost-based pricing. The fact that the selling price only depends on product cost and desired profit results in the differences between the product price and the market rate. In general, there are two confusing cases for this situation in which the product price is too high or too low. If it is too high, of course, fewer people will be willing to purchase your products or services. Otherwise, the stores will lose profit. Another dark point of this way is that businesses don’t have to control its cost; instead, it is given to customers.
Cost-based pricing formula
As mentioned above, when applying the cost-based pricing, product prices are the sum of product cost and expected percentage of profit according to the product price.
**Price = Product Cost + Expected Percentage Of Profit On Cost**
To make it more clear, let’s have a look at this example!
Every year, An office of a lawyer earns $400,000. In 2021, he plans that his office spends 2000 hours working, which means that $200 is the amount of money his office will be paid for each business hour. Still, this year, he also wants to gain an additional amount of $100,000. To get that revenue, they have to add $50 to each working hour, and the cost for every billable hour in 2021 will be $250.
What is a cost-based pricing strategy?
A cost-based pricing strategy is considered one of the most favorite options for manufacturing organizations. It is created to ensure that the profit will be more than the cost of production and manufacturing. In this strategy, entrepreneurs are given two methods, which are cost-plus pricing and cost-plus pricing.
Cost-plus pricing or markup pricing is considered the most straightforward type, estimated by adding the markup percentage of the total cost to the total cost of products or services. This markup percentage is the profit set by merchants.
According to Meredith Hart, content marketer for Owl Labs, the simple method for defining the price is cost-plus pricing strategy which is also known as markup pricing. In it, a certain rate is added to the cost of producing goods in each individual item (unit cost). “This pricing strategy ignores consumer demand and competitor prices”, she says.
In order to estimate the amount of cost-plus pricing, people will have to calculate the sum of material cost, labor cost, overhead cost. Then, this sum will be multiplied by (1 + markup percentage). This percentage is the merchants’ desire.
**(Material Cost + Labor Cost + Overhead Cost) X (1 + Markup Percentage)**
The second one is breakeven pricing, which is also called target-return pricing. This method is applied when the manufacturers or sellers want to increase the contribution to the product cost at the highest level. It seems to be more prevalent in the industry having high fixed costs like transports.
Unlike Cost-plus pricing that defines the product price by “cost-plus,” the price in this way is decided by the cost of “break-even” or “target-return.”
There are three primary elements in this method which are fixed cost, price, and variable cost. To estimate the cost based on breaking-even pricing strategy, people are required to divide the fixed cost by (price - variable cost):
**Fixed Cost ÷ (Price - Variable Cost)**
When applying this strategy, merchants can decide the number of products that a company or store has to sell to break even rather than mark up every product unit.
However, if the store has already set the goal in advance, the formula to calculate the price will be different. Instead, the return cost is added to fixed cost, and the formula will be the quotient of the sum of fixed costs and target return with the subtraction of price and variable cost.
**(Fixed Cost + Target Return) ÷ (Price - Variable Cost)**
This way is used to figure out the number of products that a company needs to sell to generate the return on investment assets.
From all the information above, it can be seen that cost-based pricing is an attractive option for businesses since not only entrepreneurs, even the fresh ones can apply with ease but it also allows them to guarantee that the cost for production and manufacturing will be covered in the price. The profit ratio is also assured stably, so entrepreneurs will no longer have to worry about losses even when the sales are high.
What are the pros and cons of cost-based pricing?
From the previous section, perhaps you are partially aware of the outstanding benefit of cost-based pricing. But that is not all, cost-based pricing includes both good points and bad points that you should consider carefully before determining to apply or not.
Advantages of cost-based pricing
Easy to apply
When using this formula, merchants are not required to make complicated calculations since all the essential components are just the cost and desired percentage. Therefore, they don’t need to be good at maths or possess modern computer systems. Instead, they can easily figure out the product price in a couple of seconds by themselves.
Ensure that the incurred costs are included
Since the percentage of profit based on product price is already included in the cost-based pricing formula, sellers will receive a small proportion for profits whenever there is a new product sold. Thus, they have to make sure that the targeted level of sales is reached.
Streamline the process of decisions to appraise and invest
From the based-cost pricing, investors will have a transparent figure of the product price and another cost. They can make use of this source to evaluate the situation of the product as well as anticipate its future to decide whether to invest or not.
Offer suitable price of new launched products rapidly
One of the enormous challenges for manufacturers is to set prices when a new product is produced. Entrepreneurs often have to deal with many issues like the cost for production or manufacturing, inventory, and more. More than that, they have to guarantee that they will gain profit from the items. By this formula, these problems will be solved easily.
Disadvantages of cost-based pricing
Neglect the consumer demand
Instead of considering customer demand to evaluate the product price, cost-based pricing decides the product price based on the production cost and the proportion of profit set by sellers. All the concern is about the selling sides which is not a good sign. Since this can lead to the case that the products don’t meet the customer requirements and cannot be sold.
Neglect the market’s competition
Business is like war. Each person in business is a soldier, so if they focus only on the manufacturers as in the cost-based pricing formula, they can be easily defeated by their competitors. With this strategy, merchants can face two cases: the price is too low or too expensive. If the items are higher than the same types of other sellers, the store will obviously lose customers. Otherwise, they will lose profit.
Besides, producers can neglect the production cost through the cost-based pricing strategy since it is passed to customers. In case the production system is ineffective, the price will be much higher than normal. And, there is hardly any unique merchandise in the market. This means that businesses always have to compete with others, and with the inefficient system, they will lose a considerable advantage. Of course, the likelihood of loss will increase significantly.
Reduce the popularity of new introduced products
What’s more, exploiting cost-based pricing is not an ideal solution for new products. When first launched, the item can be strange to the public and if they manufacturers offer the high price to get the investment back. They will be more likely to face losses. Consequently, considering the price carefully to make sure that it reaches targeted customers will be much better.
Hard to keep up with the change of market
As mentioned above, the cost-based pricing ignores the market’s competition and customer demand. However, they are two crucial factors for the change and development of the market. If the company frequently neglects them, they will find it challenging to sell the products, and an unavoidable result will be the collapse.
Lose the motive to improve
The cost-based pricing determines the product price on the basis of production cost, which means that they have no motive to improve themselves like modifying the manufacturing system, inventory, management, etc. and offer products with the same quality but lower price.
Examples of cost-based pricing strategy
Even though there are still several disadvantages in using cost-based pricing, this strategy is trusted and used by multiple businesses. This is because they will receive the trust from their customers and anticipate the profit with each successful transaction.
With it, companies can figure out the amount of money to breakeven in seconds. Let’s take the example of the lawyer’s office in the formula section. This company gets $400000 annually with their business by working 200 hours (each hour costs $200). Imagine that they need $20000 out of the amount $400000 to run their business, they will immediately find out that they can break even with only 100 hours working.
If they want more, they will have to work more, and the rate of profit will influence their working hours, like more than 200 business hours for 20 percent of return on investment, and more.
Another example is the true one in reality, it is Everlane, a clothing retail company.Unlike traditional companies, this company takes advantage of the cost-based pricing for their business.
This company has gained the status in the market as recently is based completely on the transparency in price thanks to cost-based pricing. They let buyers know the actual cost behind every item displayed on their platform: everything from materials, labour cost to transportation cost, etc. And, they also reveal their price markup. This transparency helps then get the attraction and good impression from customers and finally boost sales.
In fact, the strategy that Everlane uses is the cost-plus one. They mark up their goods by two or three times, compared to the true cost. Then, they exploit this as a marketing strategy since hardly any traditional stores reveal the true cost and their markup price is often five or six times higher than the true cost.
Overall, it can be denied that one of the most crucial factors to determine the profit of each company is its pricing strategy.
With cost-based pricing, the biggest benefit that entrepreneurs receive is transparency which increases the customers trust and drives more sales. Besides, it is also simple to use and people will not be worried about the complexity.However, the inflexibility and the ignorance of the market’s competition and demand is their greatest challenge. It requires the merchants to make smart decisions to balance the cost-based pricing’s strengths and weaknesses in their company case.