Cost based pricing includes calculating the cost of a product and then adding a percentage markup to come up to a selling price. It further appears in two forms, such as, direct cost pricing and full cost pricing.
Full Cost Pricing: This pricing method takes account of both fixed and variable costs and adds a percentage markup.
Direct Cost Pricing: Under this pricing method, a percentage markup is added to variable costs but this could to a loss over the longer run and is therefore used during periods when competition is high. This particular method does not take demand into account and there is no way of ascertaining if potential customers will purchase the product at the price calculated by the company.
Cost-plus pricing method is a way of companies determining the profit they will earn and is or in other words how much profit they will maximize. Eventually, prices are set that cover the cost of production sufficient profit margin is extrapolated for the company to earn its rate of return in target. Furthermore, it is effective when information pertaining to demand and costs is not easily available since this additional information obtaining which could be expensive is vital for generating accurate estimates of marginal costs and revenues. As a result the cost based pricing method is usually considered a rational approach as far as maximizing profits is concerned as it relies on arbitrary costs and markups.
Below is a cost based pricing model explained in simple steps:
The advantages of cost based pricing include:
- As discussed above, it is simple as it easily enables the company to determine the product price although defining the overhead allocation method is needed to maintain consistency while calculating the prices of multiple products.
- Profits are assured.
- Price hikes can easily be justified citing increase in costs.
The disadvantages of cost based pricing include:
- It ignores replacement costs as the method is based on historical costs which could have changed over a period of time. Prices should be based on what the market is willing to pay.
- It ignores competition as competitors maybe benefitting through different pricing methods and eventually passing on the benefit to their customers. As a result, the market share is impacted and the company could end up charging a price which is either too high or too low.
- Product cost overruns maybe expected as the product designers feel there is no incentive to develop a unique product for the target audience. This pricing method can be said to be more appropriate for convenience or unsought products.