Cost Based Pricing: Definition, Advantages, Disadvantages, and Strategies
- Cost-based pricing offers simplicity of implementation, guarantees profit by covering production costs, and fosters transparency with customers.
- However, it disregards consumer demand and competitors, may hinder cost efficiency and innovation, and fails to account for indirect costs.
- Careful consideration of competitor prices, market demand, production costs, and profit margins is essential for successful implementation.
“We tell you the cost of the material, the labor, transportation, duties, every bit of it, then we tell you our profit. What it does is build trust, because we are accountable to the customer.”
These were the words of Micheal Preysman, CEO and founder of Everlane, a clothing retail brand. His philosophy on pricing is a growing trend among businesses.
By breaking down the amount it costs to create a product and adding a profit percentage, companies like Everlane practice cost-based pricing. It’s a popular agency pricing model that guarantees profit and encourages transparency.
This article discusses cost-based pricing, its advantages, disadvantages, strategies, and factors to consider before adopting it for your business.
What is cost-based pricing?
In cost-based pricing, businesses set prices for their products or services based on the costs incurred during production. You determine the selling price by adding a fixed profit percentage to your production costs.
For example, let’s assume it costs your company $200 to make a piece of furniture. Adding a 20% margin means you’ll sell it for $240.
But unlike with competitor based pricing, this method ignores other essential factors like customer perceived value, average market price, or competition.
Its goal is to ensure you cover production costs and generate a profit on each sale. That makes it one of the most popular pricing models among manufacturing, retail, and construction companies.
Now let’s discuss some advantages and disadvantages of cost-based pricing.
Advantages of cost-based pricing
1. Simple to implement
With cost-based pricing, you don’t need any extensive competitor research, resources, or software to determine the selling price of your product or service. Simply add your desired profit margin to the manufacturing costs, and you’re good to go.
2. Guarantees profit
By strictly adhering to this pricing method, your company is guaranteed to earn profit. Adding a fixed markup to your manufacturing and overhead costs ensures you’ll generate profit despite rising production costs.
3. Enables transparency
60% of consumers said they believed trustworthiness and transparency were the most important traits of a brand—and the reason isn’t far-fetched.
Being transparent about your production costs helps customers understand why your product is priced the way it is. They can see how you arrived at the price and compare it with your competitors.
Take the aforementioned clothing retailer, Everlane for example. They publish the cost of their products on their website. As such, customers can easily justify the price when making buying decisions.
4. Easy for customers to understand
Whenever there’s an inevitable increase in the price of your products, customers may feel aggrieved and seek cheaper alternatives. But they are more likely to understand your decision if you cite a rise in production costs as a valid reason for the price increment.
Disadvantages of cost-based pricing
1. Ignores consumer demand and competitors
In a cut-throat market where pricing and consumer demand are essential to the success of any business, relying only on cost-based pricing isn’t a great strategy.
It ignores competitors’ prices and customers’ perceived value, resulting in a different market price. This means that using cost-based pricing results in losing customers to lower-priced competitors or charging peanuts compared to rival companies.
A more effective strategy will be to combine this pricing model with other methods to determine a reasonable price point for your products or services. This way, your business will remain competitive while generating profit.
2. No incentive to become cost-efficient
Relying on production costs to set prices for your products may result in a lack of incentive to reduce costs.
A fixed profit margin means you focus more on returns than streamlining operations—a headache that can lead to inefficient operations and higher manufacturing costs in the long run. And if you keep increasing prices due to production costs, it’s only a matter of time before customers switch to your competitors.
3. Unable to account for indirect costs
Manufacturing costs aren’t the only thing that makes up the total price of a product. There are other indirect costs to consider such as marketing, distribution, and labor expenses.
As such, setting a price point that reflects the true cost of your products may be difficult to achieve and could lead to reduced profit.
4. Hinders innovation
With a cost-based strategy, you’re less likely to experiment with new products or services.
There’s no motivation to innovate or improve on existing products, unlike value-based pricing where improving the perceived value of your product is the primary motivator. This makes it difficult to stand out and remain competitive in the industry.
Cost-based pricing strategies
Various industries use cost-based pricing to set or review the prices of their products and services. And they can choose from any of these two strategies: cost-plus pricing and break-even pricing. Let’s discuss both in detail.
1. Cost-plus pricing
In cost-plus pricing, you determine the selling price by adding a markup to the total production costs for one product unit.
Keep in mind that the costs take into account material, labor, and overhead costs. And the markup is a fixed percentage added to the total costs to get the selling price.
Cost-based pricing, also known as markup pricing, is a popular strategy among manufacturing, retail, e-commerce, and construction companies. It’s simple to implement and ensures businesses cover costs and generate a profit on each unit of product they sell.
Here’s the formula to determine your selling price using the cost-plus pricing strategy:
Selling price = (unit cost) + (markup × unit cost)
For example, let’s assume it costs $200 to deliver a 1,000-word blog post (including the writing, software used, and overhead costs) and your target profit margin is 30% on each unit.
To calculate the selling price:
Production costs = $200
Target profit = 30%
Selling price = (200) + (0.3 × 200) = $260
Selling each blog post for $260 helps to cover your costs and generate a profit of $60 on each content piece sold.
2. Break-even pricing
In break-even pricing, businesses solely rely on the cost of production, manufacturing, and distribution of a product to determine the selling point. The goal is to attain a specific profit target return or break even without adding a markup.
Also called target-return pricing, it helps companies know how many units of a product or service they must sell to cover costs without generating profit or incurring losses.
Here’s the formula for calculating the break-even price:
Break-even price = (total fixed costs ÷ expected unit sales) + variable cost per unit
The fixed costs represent expenses that don’t change with the level of production or sales. They remain constant regardless of whether the business produces or sells fewer or more units of a product. Examples include rent, salaries, insurance, and taxes.
Grow your industry knowledge
While the variable cost per unit is the amount it costs to manufacture one unit of product, and it changes with the production level. Examples include raw materials, labor costs, sales commissions, and shipping.
Let’s look at an example of break-even pricing in action.
Assuming you run a design agency and the fixed cost for your monthly recurring design package is $800. The variable cost per unit is $850, and you expect to sell four subscriptions per month.
To determine the break-even selling point using the break-even pricing model:
Fixed costs = $700
Variable cost per unit = $800
Expected monthly sales = 4
Selling price = (700/4) + 800 = $975
This means the selling price you need to break even and cover total costs is $975 provided you can sell four subscriptions per month. You could price the subscription at $999 to ensure that you have a profit margin. But if you sell fewer subscriptions, you’d run at a loss.
Factors to consider before adopting cost-based pricing
When implementing cost-based pricing for your business, it’s important to keep the following factors in mind.
1. Competitor prices
If you operate a business in a highly competitive industry, it’s best to consider what your competitors are charging before you implement cost-based pricing. Though it may be a great way to penetrate the market and attract price-sensitive customers, this only works if you charge much lower than the average market price.
What’s more, customers who associate high prices with superior quality may consider your product a knockoff.
On the flip side, charging far higher than your competitors will attract high-value customers willing to pay for quality. But it can also scare away potential customers looking for cheaper alternatives.
So, your best bet is to research your competitors’ prices to determine a fair selling price.
2. Market demand
The law of supply and demand should be factored in when implementing cost-based pricing for your business.
If there’s high demand for a trending product, you can increase your profit percentage without losing customers.
Conversely, if there’s a low demand for your product or similar products in the market, you may need to lower your margins to attract customers and increase sales volume.
3. Production costs
Since this pricing method solely relies on production costs, this factor shouldn’t be overlooked.
Ensure you carefully calculate the unit cost of creating a product or service before setting a selling price. Any miscalculations can result in charging too little or too much, affecting your profit margins.
4. Profit margins
While it’s important to cover costs, ensure you’re making a reasonable profit on each sale. You may be tempted to set higher or lower margins, but it’s crucial to strike a balance between generating revenue and being competitive in the market.
Considering all the factors above will help you successfully implement a pricing strategy that works for your business.
Examples of industries using cost-based pricing
Manufacturing industry: cost-based pricing is widely used by manufacturing companies. They calculate the production costs including raw materials, labor, and overhead expenses, and add a profit margin to determine the selling price of their products.
Retail industry: most retail companies consider the cost of purchasing, transporting, and warehousing products before adding up a markup to set their prices.
Construction companies: with the numerous costs involved in a construction project, it’s easy to see why companies in this space employ cost-based pricing. They calculate the costs of labor, materials, equipment, and overhead expenses and add their markup to determine the project’s cost.
Catering businesses: companies that offer catering services often use cost-based pricing. After factoring in the costs of ingredients, staff, equipment, labor, and other related expenses, they add a markup to determine the pricing for their services.
Service providers: some service-based businesses like consultants and agencies often use cost-based pricing. They consider the costs associated with providing their services, such as salaries, rent, equipment, and other operational expenses, to set prices for their services.
Final thoughts: Is cost-based pricing right for your agency?
A cost-based pricing method allows businesses to leverage their cost structure to set prices that cover costs, maintain profitability, offer transparency, and foster loyalty with customers.
However, consider key factors like your competitors, consumer demand, and perceived value when setting prices for your products or services. This way, you’ll have a better chance of thriving in a competitive market.