What is a cost-based pricing strategy?

The cost-based pricing strategy, also known as “cost-plus pricing”, “markup pricing”, and “break even pricing” is based on adding a fixed cost to the cost of producing a product.

Imagine yourself running a small ecommerce business that sells t-shirts. You want to use cost-based pricing strategy to cover your production costs and make a set amount of profit on each sale. To produce a t-shirt you have to spend $2 on materials, $5 on labor and you have a fixed cost of $3, overall the cost of producing a t-shirt is $10. You’ve decided that you want the profit margin of your t-shirts to be 30%, in this case to reach the given profit margin you would have to charge $13 from your customers for the t-shirt.

Who is cost-based pricing strategy for?

Cost-based strategy is favored by many new and small sized ecommerce businesses due to the simplicity of it. Cost-based pricing also allows retailers to easily price multiple products based on a desired profit margin.

An American clothing retailer Everlane is being very open about their use of cost-based pricing. On their website they give concrete examples of how their products are priced. For a “Modern loafer” the company pays $18,25 for materials, $29,16 for labor, $1,47 for transport, and $4,75 for duties which totals in $54. So the total cost for Everlane for producing a single “Modern loafer” is $54 and the company has set a retail price of $168 for the product.

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Pros & Cons

Despite being a relatively easy-to-use pricing strategy, cost-based pricing isn’t the best choice for all situations. To determine whether this pricing strategy is right for your business or not, you need to consider its pros and cons. By doing so, you’ll be able to decide if the pros will outweigh the cons for your particular case.

Pros of cost-based pricing strategy

1. Great for bulk pricing

Some retailers have thousands of products to price, and doing this one product at a time is not an option. Not to mention lots of new products coming in all the time, which makes the process even more complicated.

If this sounds like your business, cost-based pricing could be the solution you’re looking for.

Just set a profit margin as a percentage, multiply by each product’s cost, and you’re done. This will save the cost of the decision making that you would need with other pricing methods. Another option is of course to use some sort of pricing automation software, such as Sniffie in which you can set complex strategies and let the computer take care of the rest.

2. Requires less information

Pricing products the “right way” requires lots of information. You need to know everything from the product’s cost to the current market demand for that product. With cost-based pricing, all you need to know is how much the product costs. And by how much it costs, we mean the total cost, including all the operational fees. While doing in-depth research before pricing a product is generally a good idea, it’s not possible —nor feasible— in all industries. And that’s where this pricing strategy truly shines.

Cons of cost-based pricing strategy

1. Promotes operational inefficiency

For any business, lowering the operational and manufacturing costs of any product means increased revenues. That’s the optimal scenario though because when you’re using cost-based pricing, this is hardly the case.

Since you’re multiplying your cost by a profit margin anyway, lowering costs won’t make much difference. You’re making 30%, regardless of the costs. In fact, if the costs are higher, your profit margin should increase as well. Unless the competition is fierce enough to make efficiency a must, using this pricing strategy could provide an incentive for being inefficient.

2. Can lower your profit margins

While bulk pricing is a great idea when you’re selling hundreds of different products, it’s a bad idea for other products. If you’re selling something that’s considered unique or innovative, people might be willing to pay more for it than you think. If you use cost-based pricing with such products, you could be leaving money on the table.

For businesses with few products that people are willing to pay a premium for, cost-based pricing isn’t the right pricing strategy.

Important considerations for successful use of cost-based pricing strategy

Even though the strategy seems like a straightforward solution for all your pricing needs, this pricing strategy isn’t as simple as it sounds. If you want to make the most out of markup pricing, there are a few considerations that you should keep in mind. By doing so, you’ll ensure the best outcome when using this technique.

1. Operational costs

When calculating the cost of a product, many businesses might overlook the operational cost. Since this entire pricing method is based on knowing the exact price of your product, not taking these costs into consideration can cause all sorts of problems.

In addition to the wholesale or manufacturing cost of a product, you should factor in different costs that you must incur to sell that product. These can be shipping costs, store rent, and even the wages you pay for the staff operating the store.

For some businesses, these costs can add up pretty fast and when they’re not accounted for, your actual profit margin might be much lower than what you’ve initially calculated. And for some products, you might even be losing money on each unit you sell.

2. Your competitors’ prices

Even though markup pricing is based on your actual cost per product and your profit margin, there are lots of competitors out there. If you want your products to sell well, you should keep an eye on your competitors, and the prices of your products.

If the cost of your products is too high, you might end up with prices that are too high to compete. In this case, you’ll need to lower either the cost of the product or your profit margin to stay competitive.

3. Market demand

Price changes have a direct effect on product demand. Before you set the profit margin that you’re going to use with your markup pricing, you should consider the impact of the final price on the demand for your products.

If analyzing the impact of your new prices on demand is feasible, you should do this as a part of your pricing process. By doing so, you’ll avoid any unwanted customer reactions to your new prices.

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Conclusion

For businesses with lots of products that need to be priced fast, cost-based pricing —also known as markup pricing — is the most promising pricing technique they can use. It can be used to price products in a fast and scalable way with clear profit margins.