General Pricing Strategies

Cost-Based Pricing

Just as it sounds, cost-based pricing identifies the overall fixed, variable, and indirect costs of production and prices that product accordingly.

LEARNING OBJECTIVES

Grasp the concept of pricing based on overall costs, and identify the various cost inputs involved

KEY TAKEAWAYS

Key Points

When all operational fixed and variable costs are measured, and indirect costs are also compensated for, a price point can be determined based on overall price.
Often referred to as cost-plus pricing, some firms (excepting non- profits ) will add a margin on top of the overall cost-based pricing to ensure profitability for stakeholders.
Differentiating between fixed, variable, and indirect costs is a central consideration for cost-based pricing strategies.
This model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.

Key Terms

cost-based pricing: This pricing strategy focuses on measuring all of the costs involved in producing a given product, and pricing that product according to those costs.

Pricing on Cost

Cost-based pricing is a fairly straight-forward concept, where the organization understands the operation costs of producing a given good and prices that good as close to this cost level as possible. It is often referred to as cost-plus pricing, as the firm (unless it is a non-profit organization) must retain some value or profit from the sale. This markup can be set at a fixed percentage, such as 5%. If a given good will cost $10 to develop, a perfect cost-based pricing would be to sell it at $10. A cost-plus pricing model at 5% would be to sell the product at $10.50.

Determining Cost

While the concept of cost-based pricing is quite simple, the accurate measurement of cost can sometimes be a bit complex. There are fixed costs, variable costs, and indirect costs that all must be factored into the overall calculation. Each of these costs are impacted differently by volume, and as a result, cost-based pricing may fluctuate over time. This creates some requirements for projecting volume, basing cost off of a certain volume and understanding the potential in variance.

Fixed Cost

Fixed cost changes over time, for the simple reason that each additional unit produced will lower the average cost per unit relative to fixed investments. Take, for example, an investment in a machine for $10,000. The machine can produce 10,000 units in a year. At maximum capacity, this machine will cost $1 per unit. However, the demand is not high enough to produce at this capacity. Instead, it is only producing 5,000 units a year. Now the cost per unit is $2.

Variable Cost

The variable cost is consistent for each new unit, and as a result is not sensitive to overall volume (in most cases). What this means is that producing 1 unit will cost $5, and producing 10 units will cost $50, 100 units $500.

Indeed, sensitivity to volume is often one of economy of scale, which is to say that purchasing inputs for production may even become cheaper the higher the quantity that is produced. As a result, variable costs and quantity have a very different relationship than fixed costs and quantity.

This simple chart underlines the relationship between fixed, variable and total cost compared to quantity produced and/or sold.

Quantity : The chart shows the relationship between fixed costs, variable costs, and total costs compared to the quantity produced and/or sold.

Indirect Cost

Complicating the concept of cost-based pricing is the indirect cost of doing business. Many aspects of an organization are not directly related to production, and are therefore somewhat difficult to factor into the overall equation. Salaries of corporate staff, administration costs, legal costs, office costs, utilities, electricity, and other supports must be accurately projected and built into the cost-based pricing model in order to ensure that the organization is properly pricing the product for profitability.

Conclusion

Overall, when a company decides to price goods based on cost, it is important that the internal mechanisms of measurement for fixed, variable, and indirect inputs are highly accurate and developed. This cost method is often considered a low-cost method, as the firm is attempting to forward as much value as possible to the consumer. This model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.