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# 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.

## Final Cost Based Pricing Quiz

Question

What is cost-based pricing?

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 _________.

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.

Fixed cost

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Question

___________changes directly with the level of production.

Variable cost

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Question

What are some examples of fixed costs?

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.

True

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Question

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

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.

Cost-plus pricing strategy

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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 _______.

Cost-plus pricing strategy

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Question

What are some of the 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.

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

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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.

value-based pricing

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Question

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

cost-based pricing.

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Question

Where is value-based pricing used?

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?

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

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Question

What is the definition of a variable cost?

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

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Question

Fixed costs are always high at high levels of production.

False

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Question

Fixed costs are high at low levels of production.

True

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Question

Variable costs are high at high levels of production.

True

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Question

Variable costs are high at low levels of production.

True

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Question

Variable costs are high at mid-levels of production.

False

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Question

What is the term responsible for lowering variable costs?

Economies of Scale

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Question

A spreading effect occurs for which kind of cost?

Fixed

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Question

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

Fixed Costs

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Question

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

Variable Costs

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Question

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

Total Cost

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Question

Total costs are high at mid-levels of production.

False

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Question

Total costs are high at high-levels of production.

True

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Question

Total costs are high at low levels of production.

True

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Question

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

the level of output

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Question

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

break-even formula, break-even graph.

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Question

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

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?

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

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Question

The fixed cost line is always ______________.

vertical

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Question

Total cost is the sum of _____________

fixed costs and variable costs

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Question

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

remain the same

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Question

What are examples of variable costs?

Rental costs

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Question

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

True

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Question

What is the margin of safety?

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

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Question

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

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?

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 _________.

percentages

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Question

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

Target profit

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Question

What are the components of break-even chart analysis?

Fixed cost line

Variable cost line

Total cost line

Revenue line

Break-even point

Show question

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