Definition: Cost based pricing is a process of setting the price as a result of adding a profit margin to the cost of the product/service. This pricing method guarantees that certain profit is obtained above total cost.
What Does Cost Based Pricing Mean?
When determining prices for products and services, companies commonly apply cost based pricing. This means to fix prices by calculating total cost and then adding a pre-defined percentage as profit margin. For example, if the manufacturing cost of a computer is US$1,000 and the price is defined like cost plus 10%, when the manufacturer sells a computer to the distributor charges US$1100. This is US$1,000 plus a $100 of profit.
This method considers the company’s internal situation but it does not provide information about the external environment. Setting a price based only in costs incurred could be inefficient when the product is well positioned in the market. In that scenario, the company might increase the price to take advantage of a favorable, but surely temporary market condition. If the price based in costs seems too high, the company should implement a cost reduction strategy or maybe it should study the possibility to reduce its profit margin.
James Hill created a firm to design and manufacture furniture and furnishing pieces by using recycled materials. The firm’s products can be produced at very low cost because most of the materials are obtained for free. Marketing and sales are made through e-commerce platforms, which keeps sale expenses to a minimum. To set prices, Mr. Hill wanted to apply cost based pricing with a 20% margin above cost. Since costs averaged US$20 per piece, unit prices were around US$24.
However, a friend realized that many environment-concerned customers were willing to pay much more for such innovative and creative designs. After doing some market research, this friend recommended James to monitor offers shown by a popular furniture brand, and identify comparable items in terms of functionality and size. The firm, therefore, used cost based pricing to set the floor price and brand’s prices to set the ceiling price.