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.
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