Guide to Understanding Cost-Based Pricing (With Formulas)

By Indeed Editorial Team

Published June 17, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Cost-based pricing is one of many ways a company can set the price of the goods or services it sells. Finding the right pricing model for a company is important for optimizing its profits. Understanding how to assess the best way to price goods is paramount when helping a business, and your career in finance, thrive. In this article, we define cost-based price models, delve into their advantages and disadvantages, explain the types of cost pricing methods, detail their formulas, and contrast cost- versus value- pricing.

What is cost-based pricing?

Cost-based pricing is one of several ways to determine the price to charge for your goods and services. The cost model uses the amount the company pays to make that product or to perform a service. It applies this as a baseline around which to determine how much to charge for the item.

A cost-based approach is best when you use it in conjunction with other pricing methods. Some products have a low margin but yield a high reward, drawing customers to purchase higher-margin items. When you use it correctly, you can optimize a company's overall profits, not just those on a single item.

Read more: What Is the Capital Asset Pricing Model? (With Formula)

Advantages and disadvantages of cost models

As with any pricing model, there are benefits and drawbacks to using cost-focused pricing approaches. These include:

Advantages

Using cost-based pricing gives companies several benefits when setting their prices. Through quantitative data, businesses can ensure that the sales price covers the cost it takes to produce the item. It shows clear returns on investment on each item, enabling businesses to identify high-cost, low-return items, then trade them for items of better value.

Disadvantages

The cost approach has some downsides, mostly because it can cause discrepancies between the business price and the market rate. If the cost of production is higher, as it usually is in smaller companies, it means prices are higher. Because companies use cost to determine the sales price, there is less incentive to reduce the cost of production as the extra expense passes to the end consumer.

Types of cost pricing

These are the four main types of cost-focused pricing:

Break-even pricing

When companies use break-even strategies, it's to determine the price of an item with no markup. It enables companies to assess the fundamental cost of goods by including fixed expenses, like the raw materials, and variable expenses, like machine time. It allows businesses to know the bare minimum they can charge while covering all the costs of production. Anything over the break-even price is a profit.

Target profit

This type of cost pricing approach suits companies that want to make a certain profit from their goods or services. Target profit is a useful tool for smaller businesses or service-oriented industries. For instance, if an electrician wants to earn $500 per every circuit breaker board they replace, it uses this number, combined with the cost of the service on its own, to determine the price for customers.

Markup

Many retail merchants, both in-store and online, rely on a markup model. When a business purchases an item that requires resale by liaising between the supplier and end-user, it marks up the price to profit. Consider a clothing store that purchases from large manufacturers at a discounted rate due to the wholesale purchase. The store assesses the total cost of each article of clothing, including transportation and storage, then adds a percentage when setting the consumer price. Customers get access to a clothing outlet, rather than dealing with a warehouse. In turn, the retail store profits from the sale.

Cost-plus

Cost-plus pricing is one of the most prevalent approaches to price modelling. This is because it relies on an easy metric to find, the total cost of goods sold (COGS). This number serves as the baseline for goods and services pricing. A business determines a percentage that it expects as a return on the selling of products or services. That percent combines with the production, storage, and distribution expenses. It can help determine an appropriate selling price by pricing the item, so the company receives the revenue it requires to earn its fixed return on investment (ROI).

Read more: How to Calculate the Cost of Goods Manufactured (COGM)

Pricing model formulas

Each approach to cost pricing methods has an exact formula to determine the selling price. In each equation, the p-value equals price. The formulas are as follows:

Cost-plus pricing formula

P = (Cost of one unit) + (Expected return percentage)

The cost-plus equation takes the amount it costs to produce a single item your company sells. It takes that fixed value and adds it to the percentage the business expects in return. You can determine the profit margin percentage value of the item by comparing it to industry standards. For example, if you spend $10 to make an item and expect a 10% rate of return, then you set the cost to $11.

Read more: What Is Cost Engineering? (Definition and Benefits)

Markup pricing formula

P = Cost per item + Rate of markup

The markup pricing involves determining the amount it costs to produce a single unit of an item. The second step is subtracting the percentage return you seek from one to determine your markup. Divide the cost to produce a unit from the markup value. This determines the price of goods.

For instance, consider having an item that costs $20 to produce, per unit. If you want to markup the price by 10%, you get a markup rate of 90%, or 0.9. The price works out to $22.22. In this situation, you know the exact percentage by which you increase the cost of an item.

Target profit pricing formula

P = (Total cost + Projected return on investment percentage) ÷ (Number of units sold)

The target pricing approach aims to represent all the costs associated with making the item. This method accounts for any operational costs, including machine time and employee salary. This is effective retrospectively, and you can use the target approach to make changes. Because it relies on knowing the total units sold and the costs of production, it only offers historical insight.

For example, consider a company that makes balls and produces 1,000 in year one. Using the sales information from that year, the business knows that it cost $1,000 to make these balls, including operational costs and labour. With a projected ROI of 20% and sales of 900, the target price is $13.33 per ball. If the company set a price of $15 for that year, the profit is higher than expected. Conversely, if the company only charged $12, it knows to increase the price the following year.

Break-even pricing formula

P= (Variable cost + Fixed cost) ÷ (Total sales value + Total profit)

Break-even pricing assists businesses in determining how much it requires to earn on a sale, including the price to store, manufacture, and actually sell goods. It combines variable and fixed costs, then divides that figure by the sum of the total sales value and the total profit. The result is learning the price of an item, without any markup.

For example, consider a company that builds desks doing its annual financial reports. It cost the company $10,000 in fixed prices and $4,000 in variable expenses. The business made total sales of $30,000 and a profit of $10,000. The break-even price for a unit is $0.35. Anything that the company charges over that amount is a profit.

Read more: How to Calculate Net Profit Margin (With Examples)

Difference between value- and cost-based pricing

Value-focused pricing considers the real value, whether financial or intrinsic, of a product or service to determine its pricing. By analyzing the efficiency of production, sales volume, or customer satisfaction, companies can determine the value of the product. For example, a dentist may spend only an hour performing a filling, but the fundamental value of the service contributes to determining the price.

Related: How to Use the Value-Based Pricing Model (With Benefits)

Cost-focused price models use the production expense to determine prices. Businesses assess the total cost of making and selling their inventory. While some methods consider variable expenses, not just fixed ones, the cost approach can neglect qualitative, unforeseeable circumstances. Instead, it sets a baseline and ceiling on appropriate pricing, helping companies determine profitable and competitive prices.

Related: What Is a Competitive Price? Understanding Pricing Strategy

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