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Cost Based Pricing

Cost Based Pricing

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? What are the benefits of cost-based pricing, and what are some of its main strategies?

You'll find out the answers to these questions and much more by reading along!

Cost-Based Pricing Definition

Pricing a product using a system that considers the money spent on manufacturing and distribution is referred to as cost-based pricing. According to cost-based pricing, the price of a product is set by taking into account the cost it takes to manufacture the product and adding an extra percentage markup.

Cost-based pricing refers to setting prices based on the cost of production and distribution.

A business might have a price ceiling determined by how much customers are willing to pay. On the other hand, it determines the price floor based on the cost of production.

The expenses businesses incur play a significant role in their pricing approach.

Companies with fewer operating expenses are better positioned to reduce their pricing, decrease margins, and increase sales and profits.

Some businesses aim to lower their operating expenses to provide products at low prices.

On the other hand, businesses like Apple, BMW, and Rolls Royce, incur more expenses to provide value, which enables them to charge higher prices and maintain larger profit margins.

For example, the price of a Rolls Royce is way higher than that of a simple Volkswagen car.

The price is irrelevant for those who purchase a Rolls Royce, but the pleasure of owning a Rolls Royce is everything.

The objective is to control the gap between costs and pricing, which refers to the amount of profit a firm generates relative to customer value.

Types of Cost

There are two different types of costs that affect the pricing strategy of a company: fixed costs and variable costs.

Fixed costs refer to costs that do not change as the level of sales or production changes.

Examples of fixed costs include rent, salary, and interest payments. Regardless of the production level, a business will have to pay for rent, give workers their wages, and pay interest.

Variable costs change directly with the level of production.

Variable and fixed costs make up a company's total cost.

Companies are strongly affected by their cost levels. If competitors become more cost-efficient in production, they can gain leverage over the market. That would involve product price reductions, lowering the market share of less cost-efficient businesses.

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

One of the most common types of cost-based pricing strategy is the cost-plus or markup pricing strategy.

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

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:

pens to become profitable.

To learn more, check out our explanation of Break-even analysis!

Cost-Based Pricing Example

Let's now take a look at some cost-based pricing examples.

As an example of cost-based pricing, let's imagine that a law firm is interested in adopting the break-even, cost-based pricing model. If an attorney determines that their company's fixed costs are $200,000 and they charge $200 per hour, they know that to achieve financial stability, they will need to put in at least 1,000 hours of labour.

.

Another example of cost-based pricing is as follows.

Imagine a company that offers cleaning services. The company wants to ensure that it makes a 20% monthly profit. Maintaining a clean large office building for a month is $10,000. As a result, the cleaning company will charge the office building $12,000 (10,000 x 1.2) monthly in exchange for their services.

Advantages of Cost-Based Pricing

There are many advantages of cost-based pricing. One of the main advantages of using a cost-based pricing model is that it helps businesses consistently make a profit. However, for this to occur, a markup must be adequate to cover all of the costs. Additionally, sales have to be in line with expectations.

Another advantage of the cost-based pricing model is that it is easy to implement as a pricing strategy. A company must consider all costs and price its products or services accordingly.

Cost-based pricing also ensures that a firm will continue to produce a stable profit margin despite increasing expenditures. Regardless of how much the spending might change due to various reasons, a company will consistently profit from the markup it sets.

Customers can better comprehend the rationale behind the pricing of a product when they are aware of the cost of the product!

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.

This value could derive from higher productivity, increased enjoyment, or stability.

Businesses that create goods such as pharmaceuticals, chemicals, computer programs, software, artwork, etc, often use this pricing method.

Pricing determined by manufacturing or production costs is the foundation for cost-based pricing. The firm that employs cost-based pricing determines both a price floor and a price limit based on their expenses.

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.

Frequently Asked Questions about Cost Based Pricing

Cost-based pricing refers to setting prices based on the cost of production and distribution. A business might have a price ceiling determined by how much customers are willing to pay. On the other hand, it determines the price floor based on the cost of production.

Calculating the cost and adding a mark-up.

Prices may be different from the market rate.

Calculate the cost and add a percentage markup. For example, it might cost the business $20,000 to source and manufacture a batch of products. It decides that it needs to make at least $24,000 to cover fixed costs. As a result, it will add a 25% markup.

As an example of cost-based pricing, let's imagine that a law firm is interested in adopting the break-even, cost-based pricing model. If an attorney determines that their company's operating costs are $200,000 and they charge $200 per hour, they know that to achieve financial stability, they will need to put in 1,000 hours of labour.

Final Cost Based Pricing Quiz

Question

What is cost-based pricing?

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Answer

Cost-based pricing refers to setting prices based on the cost of production and distribution.

Show question

Question

While a business might have a price ceiling determined by ___________, the price floor is determined by _________. 

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Answer

how much customers are willing to pay, the cost of production

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Question

__________ refers to the cost that does not change as the level of sales or production changes.

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Answer

Fixed cost

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Question

___________changes directly with the level of production.

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Answer

Variable cost

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Question

What are some examples of fixed costs?

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Answer

Examples of fixed costs include rent, salary, and interest payments. Regardless of the production level, a business will have to pay for rent, give workers their wages, and pay interest.


Show question

Question

The sum of variable and fixed costs makes up a company's total cost.

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Answer

True

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Question

What are the two main types of cost based pricing strategy?

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Answer

There are two cost-based pricing strategies—namely, cost-plus pricing strategy and break-even pricing strategy.


Show question

Question

_______works by adding a set mark-up to the total cost of production.

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Answer

Cost-plus pricing strategy

Show question

Question

Before submitting bids for a project they might be undertaking, construction companies estimate the total cost of production. After they estimate and come up with the costs, they add a mark-up for profit. This is an example of _______.

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Answer

Cost-plus pricing strategy

Show question

Question

What are some of the advantages of cost-based pricing?

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Answer

One of the main advantages of using a cost-based pricing model is that it helps businesses consistently make a profit.

Another advantage of the cost-based pricing model is that it is easy to implement as a pricing strategy. 

Show question

Question

A firm that uses _________ takes into account the value of its product or service rather than the cost that the company expended in order to manufacture and produce it.


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Answer

value-based pricing

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Question

Pricing that is determined by manufacturing or production costs serves as the foundation for ________.


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Answer

cost-based pricing. 

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Question

Where is value-based pricing used?

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Answer

This pricing method is often used by businesses and people that create goods such as pharmaceuticals, chemicals, computer programs, software, and artwork.

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Question

What is the definition of a Fixed cost?

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Answer

A fixed cost is a production cost that isn't affected by the level of output.

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What is the definition of a variable cost?

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A variable cost is a cost that changes as output increases or decreases.

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Fixed costs are always high at high levels of production.

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False

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Fixed costs are high at low levels of production.

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True

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Variable costs are high at high levels of production.

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True

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Variable costs are high at low levels of production.

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True

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Variable costs are high at mid-levels of production.

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False

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Question

What is the term responsible for lowering variable costs?

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Answer

Economies of Scale

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Question

A spreading effect occurs for which kind of cost?

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Answer

Fixed

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Question

Identify whether the following are variable or fixed costs:
Rent, Land, Salaries, Insurance

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Answer

Fixed Costs

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Identify whether the following are variable or fixed costs:
Raw Materials, hourly workers, shipping costs

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Answer

Variable Costs

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What do you get when you add variable costs and fixed costs together?

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Answer

Total Cost

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Total costs are high at mid-levels of production.

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False

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Total costs are high at high-levels of production.

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True

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Total costs are high at low levels of production.

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True

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Question

Break-even analysis is the analysis that determines ______________ at which the company can at least cover production costs. 

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Answer

the level of output

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Question

Break-even analysis can be conducted with a  ___________ or a _____________.

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Answer

break-even formula, break-even graph.

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What is the formula for calculating the break-even point?

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Answer

Break-even point = total fixed cost/contribution per unit 

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Question

Where is the Break-even point (BEP) on the break-even chart analysis?

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Answer

The point where the total cost line and total revenue meet. 

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The fixed cost line is always ______________.

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Answer

vertical

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Total cost is the sum of _____________

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Answer

fixed costs and variable costs

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Fixed costs are costs that ________ as the level of output changes. 

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remain the same

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What are examples of variable costs?

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Rental costs

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Break-even analysis assumes that the price and variable costs will remain the same as the level of output increases. 

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Answer

True

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Question

What is the margin of safety?

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Answer

The margin of safety is the difference between the current output level and the level of break-even output. 

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The higher the margin of safety, the higher the risk. 

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True

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Question

Suppose company A produces 25 units against the break-even output level of 15 units. What is the margin of safety? 

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Answer

25 - 15 = 10 (units) or 10 / 25 * 100 = 40%

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Question

The margin of safety can be expressed in both units and _________.

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Answer

percentages

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Question

_________ is the amount of profit expected by the shareholders or managers by the end of the accounting period. 

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Answer

Target profit 

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Question

What are the components of break-even chart analysis?

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Answer

Fixed cost line

Variable cost line

Total cost line

Revenue line

Break-even point

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