What Is Cost-Based Pricing? Cost-Based Pricing Strategies

A cost-based pricing method uses production costs to determine the final selling price of a product. Companies that implement a cost-based pricing strategy do so to earn a steady revenue and cover manufacturing and production costs. Unlike value-based pricing, cost-based pricing does not prioritize the product's perceived value. Cost-based pricing is one of several effective pricing strategies, including value-based pricing, competitor pricing, and premium pricing.

There are two main types of cost-based pricing strategies.

• Cost-plus pricing: The cost-plus pricing strategy, also known as a markup pricing strategy, works by adding the unit cost plus a fixed profit percentage (aka markup percentage) to set the final selling price. The profit percentage represents how much the company expects to profit after the total cost of the product (including labor, manufacturing, and overhead costs). For example, if a company has a target profit of twenty percent, they will add a markup percentage to their products to reach that goal. This is standard practice in the retail industry, where high shipping and manufacturing costs threaten profit margins, ultimately increasing the price of a product.
• Break-even pricing: A company that uses a break-even pricing strategy makes neither a profit nor a loss on goods or services sold. To calculate the price of a product using the break-even pricing model, one adds variable costs with fixed costs and divides it by unit sales and desired profits. New companies, hoping to gain market share, may use a break-even pricing approach in the short term.

There are several notable advantages of cost-based pricing strategies.

1. 1. Guaranteed revenue: Cost-based pricing is one of the few pricing methodologies that ensure that a company will make a profit or at least break even, as all of their overhead costs are covered by the final selling price of a product. Furthermore, companies can establish price floors and price ceilings should they need to adjust prices due to rising production costs or to keep up with competitors.
2. 2. Simple to understand: A cost-based pricing strategy makes sense to customers. Most consumers understand that fluctuating market conditions and rising production costs cause price increases. However, for companies to be successful in this approach, they must be transparent with customers and gain their trust.
3. 3. Easy to implement: Many companies implement a cost-based pricing strategy because it’s easier to calculate than a value-based pricing strategy. Value-based pricing relies on the perceived value of a product and can require costly and time-consuming market research. On the other hand, cost-based pricing is purely based on calculating a percentage that will ensure a profit after production costs, making it much easier to choose the best price.

Consider some of the potential disadvantages of cost-based pricing strategies.

1. 1. Different prices from competitors: The cost-based pricing approach does not consider what other competitors in the market are charging for similar products or services. If a company sells its product for much less than the market rate, it may lose out on profits. Conversely, if it sets a higher price, say due to one expensive element, it may lose customers.
2. 2. Ignores customers’ perceived value: By only considering cost, a company ignores the customer’s willingness to pay. If the value of the product for consumers is higher than the price the company sets, it may have been able to charge more without losing customers.
3. 3. Inefficient manufacturing: Since companies know their cost of production will be covered, they may not feel the incentive to streamline production and bring down manufacturing costs.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by business luminaries, including Robin Roberts, Chris Voss, Sara Blakely, Daniel Pink, Bob Iger, Howard Schultz, Anna Wintour, and more.