Introduction
Whether you’re picking up a basic smartphone case or eyeing a trendy pair of sneakers, you’ve probably noticed that the price tag often seems higher than what it takes to manufacture these items. This pricing phenomenon often stems from a common strategy known as cost-based pricing. But what does this technique mean, and how do businesses use it to determine selling prices?
What Is Cost-Based Pricing?
Cost-based pricing is a mechanism that organizations use to determine the selling prices of their products and services. The cost-based pricing strategy’s primary goal is to maximize profits. This method entails calculating the manufacturing cost and then adding a profit portion to determine the final selling price. This pricing methodology comprises multiple techniques of computing selling prices and four different cost-based pricing strategies that are listed below:
Cost-plus Pricing
Cost-plus pricing is a way of valuing goods and services that bases the price on the overall price of goods sold (COGS). Businesses utilize a predetermined percentage, which represents the anticipated return when calculating prices. To determine a fair selling price, they add this proportion to the entire costs of manufacturing, distribution, and storage.
Markup Pricing
Most retailers employ a markup pricing approach. Retailers purchase products for resale and add a portion of the cost to determine the selling price. Companies that employ markup pricing create selling prices that enable them to profit while also appealing to their target market.
Target Profit Pricing
Target profit pricing calculates the selling cost for goods or services based on the business’s profit target. For example, if an electrical contractor has a profit objective of $500 for each compressor installation service sold, they can add this set amount to the overall costs connected with supplying both parts and repair service to determine a final price for consumers.
Break-even Pricing
The break-even pricing methodology enables businesses to determine the lowest price of items and covers all related manufacturing and distribution costs. This approach provides organizations with a simple foundation for selling pricing by first estimating overall production costs and then determining the final selling price employing a cost-plus or markup technique.
Various Formulae for Determining Selling Prices Considering Cost
You can use the following formulae to compute the selling amount for each of the four cost-based methods:
Cost-plus Pricing Method
SP = Cost per unit + Desired return%
The selling price is determined by adding a fixed percentage of anticipated earnings to the cost-plus formula, which also takes into account the cost per item a business pays. For example, if a corporation spends $200 to create one item and assumes a fixed 20% return rate, its selling price would be $220.
Markup Pricing Method
SP = Cost per unit + Markup rate
Using the formula (Cost per unit) / (1 − Desired sales return), markup pricing is calculated. Before determining the final selling price, firms must determine the intended return rate in order to compute the markup %.
Target Profit Pricing Method
SP = (Total cost + Target profit%) / (Units sold)
All operational costs associated with creating and marketing a product are included in the overall cost when using the target profit pricing formula. Businesses calculate a percentage of the expected profit on total cost and divide it by the number of items sold.
Break-even Pricing Method
SP = (Variable cost + Fixed cost + Expected total profit) / (Total number of items for sale)
Use it to calculate the profit required to pay for the expenses associated with creating and selling a product. The company can then calculate an appropriate selling price by adding this value to the entire cost. After adding up all of the fixed and variable operating costs, they divide the sum by the total number of goods sold and the anticipated profit.
Examining the Advantages of Price-Based Acquisition
Even though they are sometimes viewed with suspicion, cost-based pricing schemes have strong advantages that can have a significant influence on firms. This method is practical because of its ease of use and quick financial return.
Simplified Calculation
Cost-based pricing requires less market research, which makes it perfect for businesses with small teams and few resources. It removes the requirement for voluminous data, making it available to companies starting pricing strategies even in the absence of comprehensive data.
Simplifies the Launch of Products
Cost-based pricing is ideal for the introduction of new products since it is an internally focused approach. It offers a starting price that can be adjusted in response to information gathered and changing market perceptions.
Profit Guaranteed
The fundamental component of cost-based pricing is setting prices based on product costs, which guarantees a profit on every transaction. This dependability results from meeting both the targeted profit margin and the production cost.
Risk Reduction and Price Stability
Cost-based pricing aids in price stabilization and lowers the possibility of unfavorable circumstances like rivals engaging in price wars. It may restrict the capacity to draw customers with high costs, balancing prospects and income while averting price wars.
Defense Against Erratic Behavior
Cost-based pricing is especially helpful in areas that are prone to volatility, like technology and commodities, as it provides protection against abrupt shifts. Because it offers consistency in the face of industry fluctuations, it sustains profitability.
Useful Starting Point for Testing
It serves as a workable foundation for pricing optimization, enabling businesses to measure consumer responses. More complex pricing strategies are developed using data from cost-based pricing as the basis.
Simple to Use
Because cost-based pricing is easier to calculate than value-based pricing, many businesses prefer it. Cost-based pricing concentrates on a simple percentage calculation, allowing for well-informed price decisions, whereas value-based pricing depends on perceived product worth and necessitates in-depth market research.
Beyond its simplicity, cost-based pricing has many benefits. In dynamic business environments, it provides companies with a strategic basis for market penetration, flexibility, and profitability.
Cost-based Pricing’s Shortcomings
Take into consideration a few possible drawbacks of cost-based pricing methods.
1. Price differences with competitors: The cost-based pricing strategy ignores the prices that rival companies in the industry are asking for comparable goods and services. A corporation may miss out on income if it offers its product for significantly less than the going rate. On the other hand, it might lose clients if it raises the price, perhaps as a result of one pricey component.
2. Neglects customers’ perceived worth: When a business solely takes price into account, it misses out on customers’ desire to pay. The corporation might have been able to raise prices without losing clients if the product’s value to customers exceeds the price it sets.
The Bottom Line
Cost-based pricing is a prominent pricing strategy that helps businesses determine what to charge for their products or services by taking manufacturing costs into account. Although it is a very straightforward pricing strategy to understand and implement, it may not always be the best option for businesses looking to boost customer satisfaction or profit margins.
Businesses that employ cost-based pricing should ensure that the price they set creates a significant profit margin and covers all costs, including the projected return on investment (ROI). However, because this can have an impact on the company’s long-term performance, it is vital to consider consumer happiness and ensure that the pricing is fair and appropriate. Using Rubick.ai‘s price intelligence solutions will help to streamline this process, offering essential information for optimizing pricing strategies and increasing overall revenue. Discover how Rubick may transform your pricing strategy today.
