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What is cost-based pricing and how does it work?

What is cost-based pricing?

Cost-based pricing is when companies set prices based on their costs of doing business. However, they usually also consider other factors such as demand, competitor’s prices, product differentiation, and value. It can be used as a long-term pricing strategy or as a short-term tactic to improve its profits.

Cost-based pricing

How does cost-based pricing work?

The company first sets a target profit margin. The target profit margin is the percentage of the final selling price that a company wants to receive as a profit.

Next, they calculate their costs of doing business. These costs include the cost of materials, distribution, and product development.

Then, they put all of this information into a simple formula that calculates the price of the product:

Let’s say you have a company called Prodco Ltd. which makes a product called Product X. Prodcos costs of making Product X are as follows:

Variable costs:

  • Direct material – $3
  • Direct labor – $7
  • Variable overheads – $5

Fixed Costs:

  • Materials – $4
  • Labor – $8
  • Overheads – $3

Based on our calculations, Prodco Ltd.’s costs of making Product X are $30 (the fixed costs + variable costs), and they need to make at least a 25% pre-tax profit to remain in business.

How much should Prodco Ltd. price their product?

Based on their business costs, Prodco Ltd. should price Product X at $37.50 ($30 + 25%).

The benefits of using this strategy:

– It prevents a company from making a loss on their product. If the company sets the price at $30, it would have lost $7.50 ($30 – 25% profit margin).

– The strategy allows companies to increase their profits over time as they find ways to decrease their costs of doing business. The company has the freedom to raise their prices as long as they are still making a 25% pre-tax profit.

Companies need to use this strategy when competition isn’t that strong or in slow economies when they have more flexibility in setting the price of their product.

The disadvantage of using this strategy:

  • If a company is not competitive in the market and has to set prices at a high price relative to other companies, they may lose customers, which can be detrimental for their business.
  • Or it’s selling at too low of a price, and they miss out on more significant profits. For example, if the market price is $50, then Prodco Ltd. is underpricing their product. Which can even hurt your brand. (Considered low-quality goods because of the low price.)

Who should use this strategy?

  • Companies that are just starting in the market and don’t have much competition yet.
  • Companies with high variable costs. For example, companies that manufacture products.
  • Companies with fluctuating demand for their products can raise prices when demand is high and lower them when demand is low.

Cost-based pricing versus market-based pricing

A company that uses cost-based pricing will set prices based on their costs of doing business.

A company that uses cost-based pricing will set prices based on their costs of doing business. #costbasedpricing Click To Tweet

Whereas a company that uses market-based pricing determines the price of their product based on what consumers are willing to pay for it in the market. The company will try to find the price where demand meets supply.

Conclusion:

Setting prices using cost-based pricing is a long-term strategy that companies should use when the market conditions are right because it removes incentives to drop their prices. Otherwise, they will be stuck with high fixed costs, which can hurt them in the long run.

So, what is cost-based pricing? It’s setting prices according to your costs of doing business.

What is market-based pricing? It’s setting prices according to what the market currently demands.

Who should use cost-based pricing? Companies with high fixed costs, fluctuating demand, or no competition in the market should consider using it.

Who should use market-based pricing? Companies that are already competitive in the market and have low fixed costs should consider using it.