Cost-Based Pricing

How Does Cost-Based Pricing Work?

Cost-based pricing is a pricing strategy oriented around ensuring production costs are met to achieve a consistent profit margin.

The pricing strategy starts with determining the total costs incurred in the production, manufacturing, and distribution process to quantify the breakeven point, where there is neither a profit generated nor loss incurred.

Once the break-even point (BEP) has been established, the selling price is set by adding a markup to reach the target profit margin.

By considering the total production costs in the pricing strategy, each product sale achieves a predetermined profit.

In particular, the distinct advantage of the cost-based pricing method is its simplicity and predictability, making it particularly useful for businesses with stable production costs and those aiming to maintain consistent profit margins.

The process requires an in-depth understanding of the unit economics that pertain to a specific product to estimate the total cost of producing and distributing a product, which is compiled via market research and historical sales data.

Costs can be placed into two categories:

• Fixed Costs ➝ FIxed costs remain constant regardless of production levels, such as utilities.
• Variable Costs ➝ On the other hand, variable costs fluctuate based on the production level (i.e. volume of output).

By accurately calculating the total costs, a business can ensure that the selling price will cover all costs and provide a net positive profit margin.

Once the total cost is calculated, a markup percentage is added to ensure a profit on each sale. The markup percentage is based on the desired profit margin, which can vary depending on the industry, market conditions, and competitive landscape.

However, the markup must also provide a buffer for unforeseen expenses or fluctuations in production costs.

The sum of the total cost and the markup percentage determines the selling price. Correct implementation ensures that each product sale generates a profit, covering all costs and achieving a profit margin.

Since production costs, market conditions, and competitive pressures are constantly changing, businesses must periodically adjust their cost-based pricing strategy to account for these changes.

Cost-based pricing can be ineffective in highly competitive markets where competition is based on price with minimal variation in product offerings, known as commoditized markets.

In such cases, businesses may need to reconsider their pricing strategy and pursue alternatives, such as value-based pricing or competitive pricing, to remain competitive and maximize profitability.

What are the Different Types of Cost-Based Pricing Strategies?

The main types of cost-based pricing strategies most commonly utilized by businesses to set the prices of their products or services include the following:

Cost-Based Pricing Formula

Businesses can employ various cost-based pricing strategies, including cost-plus pricing, markup pricing, break-even pricing, and target profit pricing.

Cost-based pricing strategies offer businesses flexibility in setting prices to cover costs, achieve profitability, and remain competitive in their respective markets.

Cost-Plus Pricing

The cost-plus pricing formula adds a fixed percentage markup to the unit cost of a product.

Where:

• Selling Price ➝ The price at which the product is sold to customers in the market.
• Unit Cost ➝ The cost incurred to produce or acquire one unit, including direct costs (materials, labor, manufacturing expenses) and a portion of indirect costs (overhead, administrative expenses).
• Markup Percentage ➝ The percentage added to the unit cost to achieve the desired profit margin, which is a function of the standard pricing set by competitors in the industry, the supply-demand dynamics, the competitive landscape, and the target profit margin.

For instance, if the unit cost is $100 and the business applies a 25% markup:

• Price = $100 + ($100 × 25%) = $100 + $25 = $125

Given the 25% markup, the selling price is $125, so the company manages to break even and cover all production costs while achieving a profit of $25 per unit sold, which implies a 25% profit margin.

Markup Pricing Formula

Markup pricing calculates the selling price by adding a predetermined markup to the cost of goods sold (COGS).

Where:

• Selling Price ➝ The final price at which the product is sold to customers.
• Cost Price ➝ The cost incurred to produce or purchase the product.
• Markup Percentage: Percentage added to the cost price to determine the selling price.

For example, If the total cost of production is $50 and the target markup percentage is 20%, the product is sold at $60.

• Selling Price = $50 + ($50 × 20%) = $50 + $10 = $60.00

If the product selling price is set at $60, each purchase yields $10 in profit per unit.

Break-Even Pricing Formula

Break-even pricing determines the price at which total revenues equal total costs, ensuring no profit or loss.

Where:

• Fixed Costs ➝ The costs that remain constant regardless of production or sales levels (e.g., rent, salaries, utility bills, insurance).
• Unit Sales ➝ The total number of units expected to be sold in a given period.
• Variable Cost per Unit ➝ The Costs that fluctuate with production levels for each unit (e.g., raw materials, direct labor).

For instance, if fixed costs are $10,000, expected sales are 1,000 units and variable cost per unit is $5:

• Selling Price = ($10,000 ÷ 1,000) + $5 = $10 + $5 = $15.00

The break-even price is $15, ensuring costs are covered without profit or loss.

Target Profit Pricing Formula

Target profit pricing sets the price to achieve a specific profit target.

Where:

• Fixed Costs ➝ The costs that remain constant regardless of production or sales levels.
• Target Profit ➝ The desired profit the company aims to achieve per product sale.
• Unit Sales ➝ The expected number of units to be sold.
• Variable Cost per Unit ➝ The cost that varies with production levels for each unit.

If fixed costs are $10,000, target profit is $5,000, expected sales are 1,000 units and variable cost per unit is $5:

• Selling Price = ($10,000 + $5,000) ÷ 1,000 + $5 = $20.00

The target profit price is $20, ensuring all costs are covered and achieving a $5,000 profit.

Cost-Based Pricing Calculation Example

Suppose we’re tasked with setting the price of products on behalf of a company that manufactures custom electronics.

The total cost to produce a smartphone is $300, which includes $200 for raw materials, $80 for labor, and $20 for overhead expenses.

The company aims to achieve a 25% markup on the cost price to ensure profitability. The markup percentage is applied to the total cost to determine the selling price.

Given those parameters, the markup amount, expressed in dollar figures, is as follows.

• Markup = $300 × 25% = $75.00

Since the total production cost is $300, the next step is to add the $75 markup, so the selling price of the smartphone comes out to $375.

• Selling Price = $300.00 + $75.00 = $375.00

The company will sell each custom smartphone for $375, ensuring that all production costs are covered and a profit of $75 per smartphone is achieved.

The other product for which we must set the price is a laptop, where the total cost of production is $800, with $500 for raw materials, $250 for labor, and $50 for overhead expenses, and the company applies a 30% markup:

• Markup Amount = $800.00 × 30% = $240.00

The selling price of each laptop is equal to the cost of production plus the markup, which comes out to a selling price of $1,040 per unit.

• Selling Price = $800.00 + $240.00 = $1,040.00

If the laptop is sold at $1,040, the profit earned per laptop sale is $240.

Cost-Based Pricing: What are the Pros and Cons?

Cost-Based Pricing Advantages

• Simplicity ➝ The cost-based method is relatively straightforward and easy to implement, as it relies on quantifiable costs. The simplicity makes the strategy accessible for businesses of all sizes, including small to mid-sized businesses (SMBs) to large enterprises. The approach eliminates the need for complex calculations or extensive market research, allowing companies to quickly determine their pricing strategy.
• Ease of Communication ➝ The cost-based method provides a clear and transparent pricing structure that can be easily communicated to stakeholders.
• Cost Coverage ➝  The pricing strategy is cognizant of the break-even point, thereby ensuring that all production costs are covered (and reducing the risk of incurring losses). By incorporating fixed and variable costs into the pricing model, businesses can benefit from more financial stability and maintaining a net positive cash flow profile, as the selling price will cover the expenses incurred during production.
• Risk Management ➝ The pricing method provides a buffer against unexpected underperformance and cost increases, which ensures that the company remains profitable even in challenging economic conditions and unfavorable developments in the market (i.e. headwinds).
• Stable Profit Margins ➝ The cost-based pricing strategy facilitates the generation of a consistent profit margin, which can be adjusted based on cost variations. The stability in profitability allows businesses to project their future performance for internal planning with greater accuracy, which improves the odds of reaching long-term financial goals and making informed investment decisions. Furthermore, the ability to adjust profit margins based on cost variations ensures that the business remains competitive and profitable, even as production costs fluctuate.
• Predictability ➝ Cost-based pricing offers predictability in pricing, which can be beneficial for both the company and its customers. For the company, the method simplifies budgeting and financial forecasting, as the pricing is directly linked to known cost figures. For customers, the approach provides a consistent and transparent pricing structure, which can enhance trust and loyalty. Predictability can also contribute toward long-term contracts and agreements with 3rd parties.

Cost-Based Pricing Disadvantages

• Ignores Market Conditions ➝ The cost-based pricing method does not consider external factors such as market demand, competition, and customer perception. As a result, the pricing may not align with what customers are willing to pay, potentially leading to lost sales. The method also fails to account for competitive pricing strategies, which could make the product less attractive in the market. Additionally, the value that customers place on the product is overlooked, which could result in missed opportunities for higher profit margins.
• Potential for Overpricing ➝ High production costs can drive up the selling price, making the product less appealing to price-sensitive customers. If costs are high, the resulting price may be uncompetitive, leading to reduced sales (and lower sales volumes coincide with reduced market share). In highly competitive markets, customers may opt for cheaper alternatives, further impacting the company’s revenue. Overpricing can also damage the brand’s reputation, as customers may perceive the offering as a poor trade-off.
• Inflexibility ➝ Fixed markup percentages may not adapt well to changes in market conditions or competitive pressures. The rigidity in pricing can hinder the company’s ability to respond to dynamic market environments, such as shifts in customer preferences or new entrants in the market. The company may also be limited in its ability to capitalize on emerging opportunities or mitigate risks associated with economic downturns. Inflexibility in pricing can lead to missed opportunities for growth and innovation, as the company may be unable to adjust its pricing strategy to stay competitive.
• Limited Customer Insight ➝ Cost-based pricing focuses primarily on internal cost structures, neglecting valuable customer insights. The approach does not take into account customer preferences, purchasing behavior, or perceived value, which are critical factors in successful pricing strategies. As a result, the company may miss out on opportunities to tailor its pricing to better meet customer needs and expectations. The lack of customer-centricity can lead to lower customer satisfaction and loyalty, ultimately impacting the company’s long-term success.

Cost-Based Pricing vs. Competition Pricing: What is the Difference?

• Competition-Based Pricing ➝ The competition pricing strategy (or competition-based pricing strategy) sets prices based on the prices set by competitors in the market. Businesses analyze the pricing models of key competitors and set prices that are competitive within the market. Competition-based pricing is more adaptable to market changes and competitive actions, allowing businesses to quickly adjust their prices in response to shifts in market demand, competitor pricing strategies, and other external factors.
• Cost-Based Pricing ➝ In contrast, the cost-based pricing strategy is internally focused on production costs. The selling price is calculated by adding a specific markup to the total cost of producing or purchasing the product, ensuring that all costs are covered and a profit margin is achieved. However, cost-based pricing may lag in responding to external factors, as it primarily relies on internal cost structures and may not account for changes in market demand, competition, or customer perception.

Cost-Based Pricing vs. Value-Based Pricing: What is the Difference?

• Cost-Based Pricing ➝ Cost-based pricing focuses on covering costs and achieving a profit margin. The method ensures that all production costs are covered, reducing the risk of losses. Cost-based pricing is straightforward and easy to implement, as it relies on known cost figures. However, the method does not consider external factors such as market demand, competition, and customer perception. As a result, cost-based pricing may lead to potential overpricing if costs are high, making the product uncompetitive. Note that fixed markup percentages may not adapt well to changes in market conditions or competitive pressures.
• Value-Based Pricing ➝ Value-based pricing sets the prices of goods and services based on the perceived value to the customer. The strategy is more responsive to market demand and customer willingness to pay. Value-based pricing allows companies to set prices based on the benefits and value perceived by the customer, potentially leading to higher profit margins. However, value-based pricing requires a deep understanding of customer needs and market conditions, which can be complex and time-consuming. The strategy also involves continuous market research and analysis to stay competitive. Despite the complexity of the strategy and moving pieces with regard to the competitive landscape, value-based pricing can result in better alignment with customer expectations and increased customer satisfaction.

Cost-Based Pricing Example: Walmart

Walmart, one of the largest retail chains in the world, employs a cost-based pricing strategy to maintain its competitive edge and ensure profitability.

By focusing on minimizing production and operational costs, Walmart can offer products at lower prices than many of its competitors.

The strategic approach and understanding of the market continue to allow Walmart to attract price-sensitive customers and maintain a high volume of sales, which is critical for its business model (i.e. economies of scale).

Walmart’s robust supply chain and efficient logistics system play a significant role in its market-leading low prices, and those savings flow down to its customer base.

For example, Walmart’s Great Value brand offers a wide range of products, from groceries to household items, at lower prices compared to national brands. By producing these items in-house or sourcing them from cost-effective suppliers, Walmart can control production costs and offer competitive prices.

Walmart also implements cross-docking in its distribution centers, where products are directly transferred from inbound to outbound trucks without being stored in the warehouse. The reduction in storage costs and efficient supply chain (and distribution) process enables Walmart to sell products at low prices.

The cost-based pricing strategy at Walmart involves calculating the total cost of acquiring and distributing products, including procurement, transportation, and storage expenses. Once these costs are determined, Walmart adds a markup percentage to ensure a profit margin on each item sold.

The markup is carefully calculated to balance competitiveness with profitability, allowing Walmart to offer everyday low prices while still achieving its financial goals.

The company’s purchasing power and strong relationships with suppliers, vendors, and distributors contribute to its ability to negotiate lower prices, further reducing costs.

Walmart’s long-term commitment to cost-based pricing is evident in its operational practices and corporate culture.

The company continuously seeks ways to streamline processes, reduce waste, and improve efficiency across all aspects of its business, similar to Amazon.

For instance, Walmart’s Project Gigaton aims to reduce greenhouse gas emissions in its supply chain by one billion metric tons by 2030. The initiative not only helps the environment but also reduces energy costs, contributing to lower prices for customers.

Walmart leverages technology and data analytics to optimize inventory management and demand forecasting, ensuring that products are available at the right time and place, further minimizing costs and maximizing sales.

While cost-based pricing has been a cornerstone of Walmart’s success, the company also recognizes the importance of adapting to changing market conditions and customer preferences.

Walmart regularly reviews and adjusts its pricing strategy to remain competitive and responsive to external factors.

By combining cost-based pricing with a customer-centric approach, Walmart can continue to offer value to its customers while sustaining its position as market leader in the retail sector.

In closing, the dynamic pricing strategy ensures that Walmart remains a preferred shopping destination for millions of customers worldwide.