Imagine you are a lawyer and planning how to price your services. Running your small law firm costs you $100,000 a year. You want to make at least $80,000 a year. How much should you charge for your services? Should you take into account the costs you incur? Look no further because we've got you covered with the ultimate guide to cost-based pricing! From the definition and strategy to the formula and real-life examples, we'll explain everything you need to know about this pricing method. Plus, we'll explore the advantages of cost-based pricing and highlight the key differences between cost-based and value-based pricing.
Cost-Based Pricing Definition
Cost-based pricing is a pricing method where the cost of manufacturing and distributing a product is taken into account. With this method, a percentage markup is added to the cost of production and distribution to determine the selling price of the product. This means that the price of a product is determined by adding up all the expenses involved in making and delivering it, and then adding a profit markup.
Cost-based pricing is a pricing method based on the cost of production and distribution.
Let's say a company produces and sells a product for $50. The cost of production and distribution for each unit is $30. To determine the selling price, the company adds a 20% profit margin to the cost of production and distribution, which is $6. Therefore, the company would set the selling price at $36 to ensure they cover their costs and make a profit.
Cost-Based Pricing Strategy
A cost-based pricing strategy aims for businesses to achieve a specified profit margin over and above the entire cost of production and manufacturing. A cost-based pricing strategy enables companies to cover production expenses and make a profit.
There are two cost-based pricing strategies—namely, cost-plus pricing strategy and break-even pricing strategy.
Cost-Plus Pricing Strategy
The cost-plus or markup pricing strategy is one of the most common types of cost-based pricing strategies.
The cost-plus pricing strategy works by adding a set markup to the total cost of production.
Take, for example, construction companies. Before submitting bids for a project they might be undertaking, they estimate the total cost of production. After they estimate and come up with the costs, they add a markup for profit.
Lawyers, accountants, and other professionals typically price by adding a standard markup to their costs.
Applying a standard markup is common for various reasons. To begin with, retailers are often more concerned with the cost of their products than their demand level. When sellers simplify pricing by connecting it to the cost of production, they eliminate the need to make frequent modifications in response to shifts in demand.
Second, since prices are more likely comparable when all companies in an industry utilise the same pricing mechanism, price rivalry is reduced significantly.
Third, pricing based on costs plus a markup is usually more equitable for both consumers and sellers. When there is high customer demand, sellers profit from their investments but do not take advantage of customers.
Break-Even Pricing Strategy
Break-even pricing, also known as target-return pricing, is the second pricing approach based on costs.
Without adding a markup, the price of a product is determined by adding up the costs of its creation, production, and distribution.
Instead of marking up each unit to earn income, this method calculates how many units a firm needs to sell to cover the manufacturing expenses.
The formula companies use to determine the break-even volume is
\(\hbox{Break-even volume}=\frac{\hbox{Fixed costs}}{\hbox{Price - Variable cost}}\)
This formula helps companies learn about the number of units they need to sell at a particular price to become profitable.
Let's say a company has invested $3,000 in manufacturing pens and the variable cost per pen is $1. If the firm sells the pen for $2, it needs to sell:
\(\hbox{Break-even volume}=\frac{$3,000}{$2-$1}= 3,000\)
The company needs to produce 3,000 pens to break even.
Fixed costs refer to costs that do not change as the level of sales or production changes, while variable costs change directly with the level of production.
Cost-Based Pricing Formula
Cost-Plus Pricing Formula
\(\hbox{Selling Price}=\hbox{Cost of production and distribution per unit}+\hbox{Markup}\)
In this formula, the "Cost of Production and Distribution" is the total cost of producing and delivering the product or service, including all direct and indirect costs. The "Markup" is a fixed percentage or amount that's added to the cost of production and distribution to determine the selling price. The markup is usually determined by factors such as industry standards, competition, and desired profit margin.
Break-Even Pricing Formula
\(\hbox{Selling price}=\frac{\hbox{Total fixed costs}}{\hbox{Number of units sold}}+ \hbox{Variable cost per unit}\)
In this formula, the "Total Fixed Costs" are the expenses that remain constant regardless of the number of units sold, such as rent, salaries, and insurance. The "Variable Cost per Unit" is the cost of producing one unit of the product or service, including materials, labor, and other variable costs. By using this formula, a company can determine the minimum selling price that they need to charge to cover their total costs and break even.
Cost-Based Pricing Example
Let's now take a look at some cost-based pricing examples.
Cost-Plus Pricing Example
Let's take a look at an example of a cost-plus pricing strategy.
Let's say a company manufactures a product that costs $50 to produce and distribute, including all materials, labour, and overhead expenses. The company wants to earn a profit margin of 20% on each unit sold.
To determine the selling price using cost-plus pricing, the company would add the desired profit margin to the cost of production:
Cost of production = $50
Desired profit margin = 20%
\(\hbox{Selling price} = $50 + (20\%\times50=$50+$10=$60\)
So the company would set the selling price of the product at $60 to ensure that it covers all costs and generates a profit margin of 20%. If the company's costs of production or desired profit margin change, it can adjust the selling price accordingly using the same cost-plus pricing formula.
Break-Even Pricing Example
A bakery is considering launching a new type of cake and needs to determine the minimum selling price required to break even. The bakery estimates that the fixed costs of producing the cake, including ingredients, equipment, and labor, are $1,500. The variable cost per cake is $5, which includes the cost of ingredients and packaging. The bakery expects to sell 500 cakes in the first month.
To calculate the break-even point using the break-even pricing method, the bakery would add up the fixed costs and variable costs and divide the total by the expected number of cakes sold:
\(\hbox{Total cost = Fixed cost + (Variable cost per cake x Expected number of cakes sold) Total cost = $1,500 + ($5 x 500)}\)
\(\hbox{Total cost = Fixed cost + (Variable cost }\times\hbox{Expected numbers of cakes sold}\)
\(\hbox{Total cost}= $1,500+($5\times 500)\)
\(\hbox{Total cost}= $4,000\)
\(\hbox{Break-even price per cake}= \frac{\hbox{Total cost}}{\hbox{Expected number of cakes sold}}\)
\(\hbox{Break-even price per cake}=\frac{$4,000}{500}= $8\)
So the bakery needs to set the selling price of the cake at $8 per cake to break even and cover all costs.
Advantages of Cost-Based Pricing
There are many advantages of implementing a cost-based pricing strategy:
Helps businesses consistently make a profit: By taking into account all the costs involved in producing and distributing a product or service, cost-based pricing ensures that the selling price is high enough to cover these costs and generate a profit.
Easy to implement pricing strategy: Cost-based pricing is a straightforward pricing strategy that can be easily implemented by businesses. It requires calculating the total cost of producing and delivering a product or service and adding a markup to determine the selling price.
Provides transparency to customers: Customers can better understand the pricing rationale when they are aware of the cost of production and distribution. This can increase customer trust and loyalty towards the business.
Ensures stable profit margin despite increasing expenditures: With cost-based pricing, a company can consistently maintain its profit margin even if the cost of production and distribution increases due to various factors such as inflation, rising wages, or material costs.
Helps in setting a competitive price: By calculating the total cost of production and distribution, a company can set a competitive price for its products or services based on industry standards, market demand, and competition.
Supports financial planning and decision-making: Cost-based pricing provides a clear understanding of the costs involved in producing and distributing a product or service, which can help businesses in making informed financial decisions and planning for future investments.
Difference between Cost-Based and Value-Based Pricing
A firm that uses value-based pricing considers the value of its product rather than the cost that the company spent to manufacture and produce it. As a result, the business first calculates how much money or value the consumer will earn from using their product or service. Businesses that create goods such as pharmaceuticals, chemicals, computer programs, software, artwork, etc, often use this pricing method.
The main difference between cost-based and value-based pricing is that in cost-based pricing, the price is largely determined by the company's internal costs, while in value-based pricing, the price is determined by what the customer is willing to pay based on the perceived value of the product or service, which may be higher than the cost of production.
A pricing range is defined by its floor, the lowest possible price, and its ceiling, which is the highest possible price for a given product or service. If the market circumstances are such that the going competitive price is lower than the price floor, the firm may choose to price its products at the price floor or strive to reduce its expenses to lower the price floor.
Cost-Based Pricing - Key Takeaways
- Cost-based pricing refers to setting prices based on the cost of production and distribution.
- There are two cost-based pricing strategies—namely, cost-plus pricing strategy and break-even pricing strategy.
- The cost-plus pricing strategy works by adding a set markup to the total cost of production.
- One of the main advantages of using a cost-based pricing model is that it helps businesses consistently make a profit.
- A firm that uses value-based pricing considers the value of its product or service rather than the cost that the company spent to manufacture and produce it.
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