# What is Cost-Based Pricing? A Definitive Guide to Strategy

By Priceva
on March 15, 2023
There is a diverse range of pricing strategies used by companies: basically, they differ by the set of variables used to calculate the optimal prices of products. Cost-based pricing is one of the most widely used approaches because it takes into account limited and clear variables. This article covers this pricing strategy, and explains its types and the formulas used for price calculation, its advantages and disadvantages, and the principal differences from other strategies.

## Cost-Based Pricing Strategy

A cost-based pricing strategy 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. The price of the product can be easily calculated by totaling the expenses, to which the target profit is then added to figure out the ultimate selling price.

## Types of Cost-Based Pricing Strategy

The above-mentioned description of a cost-based pricing strategy is general – in fact, this approach can be divided into several subtypes, which we will describe below.

### Cost-Plus Pricing

This is the simplest approach to figuring out a product's pricing. In the cost-plus pricing approach, the price is determined by adding a fixed percentage (also known as a markup) of the entire product’s cost (as a profit). For example, say company N pays \$80 per unit to produce a product. It decides to add \$40 per unit to make a profit. The final cost of the company's product in such a scenario would be \$120. Average cost pricing is another name for this pricing strategy, which is popular in manufacturing companies.

Here’s how to determine cost-based pricing for various products:

Price = Unit Cost + Expected Return on Cost as a Percentage

Cost-plus pricing is widely used in the retail industry, where growing shipping and manufacturing expenses put profit margins at risk, leading to inevitable increases in product prices.

### Markup Pricing

With this pricing approach, the product's selling price is calculated by adding a set sum or percentage of the product's cost to the product's price. In the retail industry, when a company resells a product to make a profit, a markup pricing strategy is more typical. For instance, if a retailer purchases a product from a wholesaler for \$100, they may mark it up by \$50 to increase their profit.

Here, product cost is formulated in a simple way:

Price = Unit Cost + Markup Price

Note that your markup should be high enough to provide a margin that recoups operational costs as well as profit. You should monitor your company's gross margin to make sure this is the case. The gross margin is the price minus the cost of products divided by the price.

### Break-Even Cost Pricing

In this case, a company seeks to maximize contribution toward the fixed cost, which is especially important for industries where such expenses are high. Here, a retailer calculates the amount of sales needed to cover all essential variables and fixed expenses. Using a break-even pricing strategy, a business sells goods or services without making a profit or a loss.

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

### Target Profit Pricing

This strategy implies reaching a specific level of profit or return on investment.

Price = (Total Cost + Desired Profit %) / Total Units Sold

With target pricing, you can learn how to estimate the price of a potential item and determine how probable it is to sell and generate a profit.

## Benefits of Cost-Based Pricing

Cost-based pricing strategies have a number of significant benefits – they are relatively easy to leverage and are pretty comprehensive for customers.

### Ensured profit

Since all of a firm's operating expenses are covered by the final selling price of a product, cost-based pricing is one of the few pricing strategies that guarantees a company will earn a profit or at least break even. Additionally, businesses may set pricing floors and ceilings in case they need to raise prices to keep up with the competition or to recoup increased manufacturing costs.

### It’s easy to understand

The majority of customers are aware that growing production costs and varying market circumstances result in price hikes. Companies must be open and sincere with their consumers if they want to succeed with this strategy. With this pricing approach, price increases are easily justified because you can explain that the price depends on your costs.

### Flawless implementation

Because cost-based pricing is simpler to calculate than with a value-based pricing strategy, many businesses utilize it. Value-based pricing, which bases prices on how consumers perceive the worth of a product, may be expensive and time-consuming. Cost-based pricing, on the other hand, is only based on figuring out a percentage that would guarantee a profit after manufacturing expenses, which makes it much simpler to determine the ideal price.

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## Drawbacks of Cost-Based Pricing

Now, let us discuss a few possible drawbacks of cost-based pricing techniques.

### Ignorance of competitors’ prices

The cost-based pricing strategy disregards what competitors on the market are charging for comparable goods or services. A company may fail to reach its target profit margin if it sells its goods for significantly less than the relevant rates. On the other hand, if it sets a higher price because of one pricey component, it can lose buyers.

### Ignores the perceived value of the customer

By focusing simply on price, a business disregards the customer's desire to pay. If consumers place a higher value on the product than the current price, the business could have raised prices without losing customers.

### Inefficient manufacturing

Since businesses are sure that their cost of production will be reimbursed, they may lack the motivation to optimize operations and reduce manufacturing expenses.

Cost-based pricing may also lead to ineffective product production and manufacturing techniques. The manufacturing process won't need to be taken into account by any business that implements cost-based pricing because the consumer bears the expense. This means that organizations implementing a cost-based strategy risk unintentionally allowing their processes to grow more bloated rather than reducing manufacturing operations.

A key strategy for a corporation to save expenses and raise profit margins is to streamline supplier and production costs.

## Cost-Based Pricing Examples

Cost based pricing is used by a large number of retailers, for example, Everlane. This clothing seller bases their entire strategy on cost-plus pricing. They reveal the real expenses behind every product sold, from materials to labor and distribution. Of course, the price markup is also known, and it does not repel customers – the brand establishes a sense of transparency and fairness.

Alternatively, you can opt for a break-even pricing strategy. Here’s how it works. Say a company produces widgets, and the total cost of making one unit is \$10 (for labor and materials). The brand plans to produce 10,000 widgets and invests \$200,000 in fixed costs, including building a factory and purchasing machines. Its break-even price for every widget will be calculated as follows:

(Fixed costs) / (number of units) + price per unit or 200,000 / 10,000 + 10 = 30

A break-even pricing strategy allows you to calculate how much you need to produce or work in order to achieve a specific profit margin.

## Cost-Based Pricing vs. Value-Based Pricing

Cost-based pricing exclusively considers manufacturing costs to determine selling prices. Businesses examine all expenses incurred in the manufacture, distribution, and sale of products and services. Cost-based pricing allows businesses to define price floors and price ceilings, resulting in a range of values that may be used as selling prices. However, it ignores the qualitative aspects of goods and services.

When it comes to value-based pricing, businesses assess the worth of their goods and services by figuring out how much value (either monetary or intrinsic) they provide to customers. An improvement in efficiency or customer satisfaction, or meeting a particular demand are a few variables that assist businesses in determining the value of a product or service. Many businesses in service-based sectors may use value-based pricing.

## Cost-Based Pricing Could Be the Right Strategy for You

If you want to ensure a positive profit margin for your business, cost-based pricing might be the right choice for you. Not only does it allow you to calculate the optimal rates, but also makes your pricing approach transparent, which adds trust and can potentially boost your sales. If implemented correctly, cost-based pricing can lead to predictable profits and empower your company’s growth.

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## Conclusion

If you run a business that sells a large number of products that need to be priced fast, cost-based pricing could make the most sense. It can be easily leveraged through automated pricing software, because pricing is based on a few simple formulas. As a result, you can eliminate tons of manual labor and ensure foreseeable profit.

## FAQ

### How is a cost-based price calculated?

Depending on the approach implemented, cost-based pricing can be calculated based on fixed expenses and desired profits. Essentially, it boils down to calculating unit price and necessary markup to cover production costs and earn extra.

### What is usually the first step in cost-based pricing?

First and foremost, a company needs to define the cost of production of one product batch (or self-cost of a service) – this is usually a combination of fixed and variable expenses. Then the total cost is divided by the number of units to define the cost of a unit. After that, the unit cost is multiplied by the markup percentage – this makes it possible to calculate the selling cost and the profit margin of the product.

### What are the limitations of a cost-based pricing strategy?

First, this strategy does not take into consideration competitors’ prices, which means your calculated prices might be far from optimal. Second, if the cost of producing certain goods constantly varies, customers may be confused by the ever-changing prices. Third, when a company reaches a certain profit margin with this pricing method, it may ignore the opportunities to grow further and earn more.