The method of cost-based pricing (also called mark-up pricing or cost plus pricing) discussed in this article is based on the full-cost method.
What is cost-based pricing?
Cost-based pricing is a strategy used by businesses to set the selling price of a product.
- Businesses calculate the unit cost to purchase or manufacture each product.
- The amount of profit they would like to achieve for each product is then added to the cost.
- This additional profit, the amount more than the unit cost, is called a ‘markup’.
- The markup is a percentage of the unit cost of each product.
- The unit cost and the markup are added together to determine the selling price.
Calculating cost-based pricing
Retailer (markup pricing):
The unit cost for each dress a clothing retailer purchases from a manufacturer is £25. The clothing retailer adds a markup of 120%.
- Unit cost per dress = £25
- The markup per dress = £30
- The selling price for each dress = the unit cost per dress + the markup per dress
- Selling price = £25 + £30 = £55
Manufacturer (cost plus pricing):
In some cases, the unit cost needs to be calculated first before a markup can be added. For example, a mineral water manufacturer has annual fixed costs of £45 000. It produces 150 000 units of bottled water each year. The variable costs for each unit are £0.5. The manufacturer sets the selling price by adding a markup of 250% to each bottle of water.
- Fixed costs per unit: £45 000 / 150 000 = £0.3
- Costs per unit = £0.3 + £0.5 = £0.8
- A markup of 250% of £0.8 = £2
- Selling price = £2.8 (add the cost per bottle of water and the markup)
The benefits and drawbacks of using the cost-based pricing method
Benefits of cost-based pricing
Some benefits to cost-based pricing include:
- An easy calculation. Marketers can quickly calculate and make decision based on how much mark-up they would like on each product.
- The company is focusing on covering costs. It is likely that a profit will be made after costs have been covered.
- Suppliers may be able to convince customers that it is necessary to increase prices in order to cover costs.
Limitations of cost-based pricing
Some drawbacks to cost-based pricing include:
- Setting a price without considering the competition’s pricing strategy. If the competition sets their prices lower than the business using the cost-based pricing method, demand for the competitor’s products will be higher.
- Not all costs are easy to calculate. Some costs may increase faster than expected, resulting in an incorrect pricing strategy.
- There may be unexpected changes in demand. Sales might be low due to unforseen circumstances such as an economic downturn, or changing customer tastes and preferences.
- Not market oriented. Businesses should conduct market research to identify how much the customer is willing to pay.
Watch the video and answer the questions below.
What costs did business owners say were increasing?
Inventories, supplies, (raw) materials, fuel and labour costs.
What was causing these costs to increase?
Inflation / inflationary costs
What costs caused the manufacturer from Wisconsin to increase his prices, in other words, to pass on the costs to the consumer?
His supplier was increasing the price of raw materials weekly (a cost to the manufacturer). Also finding and keeping qualified employees.
How does this situation show one of the limitations of cost-based pricing?
It may be very difficult to calculate costs. Under inflationary conditions, prices may change quickly resulting in the original mark-up not covering costs.
Take the cost-based pricing quiz
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