Cost Based Pricing
What is Cost Based Pricing?
Cost-based pricing is a prevalent pricing strategy. Used by businesses of all sizes, it can be defined as the practice of determining prices based entirely on the cost of the goods and services being sold, rather than taking into account any other influential factors.
There are two main types of cost-based pricing. These are commonly referred to as cost-plus pricing and break-even pricing. In this article, we’ll explain what these terms mean,how they work in this article, advantages and drawbacks, and other factors worth considering with cost-based pricing.
Cost Based Pricing Methods
Cost-based pricing methods typically fall into one of two categories. These are the most common forms of cost-based pricing:
Cost-plus pricing is amongst the simplest pricing strategies out there, but it can be quite effective. Often also known as ‘markup pricing’ it is based on the fundamental idea of selling something for more than you spent creating it.
Organizations that use this model work out production costs and then add a profit margin to get to a final selling price. However, there’s a reason this method is looked down upon with some skepticism. Cost-plus pricing fails to take product demand and competitor pricing into account, which opens up the door to potential miscalculations and missed profit opportunities.
Learn how DeLaval, a full service manufacturer and distributor of dairy and farming machinery, moved from a cost-plus pricing system, to a value-based pricing strategy and methodology by partnering with Vendavo.
Break-even pricing, also often referred to as target-return pricing, is another version of cost-based pricing.
When businesses use a break-even pricing strategy, they determine their selling price by working out the product manufacturing cost, to discover the break even selling point. Companies can then determine how many products have to be sold before the company breaks even, to become profitable.
The Advantages of Cost Based Pricing
Despite reservations from some camps, there are several undeniable benefits to cost-based pricing. Not only is it an easy pricing strategy to adopt, but when implemented correctly, it also enables businesses to start making a profit quickly. Here are a few reasons to explore cost-based pricing in more detail.
Leads to Profit
Cost-based pricing uses the cost of the product as the key factor in determining its price. So, it will always lead to a profit when the product is sold, as the cost is fully covered along with the desired profit margin.
Simple to Calculate and Implement
There are no complex calculations to pour over in cost-based pricing strategies. The two most commonly used options involve elementary mathematics, keeping demands on business owners’ time and energy to a minimum.
Stabilizes Prices and Reduces the Risks of a Price War
Cost-based pricing can help to stabilize pricing, limiting the risk of harmful situations such as price wars with competitors.
While a business is unlikely to get into a price war with its competitor using cost-based pricing, it’s also unlikely to be able to attract consumers with tempting offers and low prices using this strategy. Revenue and opportunities are often left on the table, leading to some of the drawbacks of a cost-based-only strategy.
Drawbacks of Cost Based Pricing
No pricing strategy is without its downsides, and cost-based pricing is no exception. As mentioned earlier, this method of pricing is often criticized . There are many risks involved in cost-based pricing but we’ll focus on competition, demand, and efficiency:
Not Competitor Aware or Demand-Aware
Cost-based pricing overlooks the competition entirely, which can be a significant mistake. If a company uses cost-based pricing exclusively, it risks being undercut by its competitors and losing out on business.
A business using cost-based pricing may also make pricing decisions that prove to be off the mark, alienating consumers and sending them to the competition.
It’s also possible that cost-based pricing strategies are lower or higher than consumers are willing to pay. This means the company loses out on potential profit and opportunities simply because it hasn’t given enough weight to overarching market conditions.
Discourages Efficient Pricing and Cost Containment
Cost-based pricing will only work if prices remain attractive to customers. Businesses using this strategy need to bear in mind that production costs need to remain fairly low and stable, or selling prices need to increase for the strategy to yield a profit. Unfortunately, this can lead to struggles with cost containment with teams buying into the myth that cost-based pricing will cover any additional expenditure in the production process.
Markup prices are typically based on a forecasted volume of sales, so these figures must be calculated accurately. Any miscalculations here could have disastrous consequences in terms of profitability, leading to prices that are either too high or too low to bring in a healthy profit margin.
Companies using cost-based pricing methods must have the right data to be able to forecast appropriately and avoid the costly risks associated with errors in the planning stages. Volatile and changing markets affect these forecasts as well leading to losses with the inability to adapt pricing quickly and as needed.
So, When is Cost Based Pricing Worth It?
Cost-based pricing works for some companies. For example, it’s used by businesses that are focused on transparency in their pricing structures. It can also work effectively when companies are looking to become cost leaders.. Cost-based pricing builds trust and loyalty amongst customers.
But with many different pricing strategies out there, cost-based pricing is far from the go-to option for most companies. While it’s a popular choice and it works for some businesses, more holistic approaches to pricing can often lead to maximized results – particularly in sectors where competition is incredibly fierce.
Intelligent pricing software and AI-driven pricing technology give businesses the edge when planning and executing pricing strategies. Solutions like these cut out the guesswork, giving companies the insights they need to make pricing decisions every time.
When market research and conditions, historical data, and demand are all taken into account, the perfect price can be calculated far more accurately, helping companies to reach their full potential. Get in touch with our team to find out more about leveraging AI to optimize prices and profits.