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Pricing your products and services can be a tricky business. If you charge too little, you might not make a profit. But if you charge too much, you could drive away customers.
Cost-based pricing is one option that can help you strike the right balance.
What is Cost-Based Pricing?
In a nutshell, cost-based pricing (or cost-plus pricing) is when you set the price of a product or service based on your total product’s costs. This includes things like the cost of materials, labor, and overhead, sales, marketing — all your costs.
Then, to come up with the final selling price, you add a percentage markup for your profit margin.
For example, say you make widgets and the your total cost for making the widget is $10. And, let’s say that you want to make a 30% profit on each sale. So, you’d add 30% of $10 (that would be $3) and your selling price would then be $13.
Advantages of Cost-Based Pricing
- It’s EASY: The most obvious benefit of cost plus pricing is that it’s easy — assuming you know your costs or can trust your costs.
- No research required: Cost plus pricing is a popular pricing strategy because you only need to know your costs. You don’t need to do customer research or competitive research.
- Predictable profits: Another benefit is that cost-plus pricing guarantees that you’re going to meet your desired profit margins.
Disadvantages of Cost-Based Pricing
- It doesn’t take industry pricing into account: Cost plus pricing is 100% internally focused and doesn’t take into account what others in the industry are charging.
- You might leave money on the table: Because you aren’t considering overall value that you provide with your product or service above costs, you could be losing money.
- Difficult to raise prices or run promotional campaigns: Cost plus pricing strategies hamper your ability to raise prices or run promotional campaigns because they can eat into your profits.
Cost-Based Pricing vs Value-Based Pricing
While cost-plus pricing is relatively straightforward, value-based pricing is more nebulous.
Value-based pricing means setting your prices based on the perceived value of your product or service to the customer, rather than on the cost of producing it. For example, you might charge more for a luxury item that has a high perceived value to customers, even though it may not have a high production cost.
How to Use Cost-Plus Pricing to Get a Value-Based Price
No matter what pricing strategy you use, you should definitely use a cost-based pricing method as part of your overall pricing strategy.
I like to look at a cost-based price as a price floor, a sort of ideal area where I would like the price to be.
But from there, you HAVE to move toward a value price. The best way to do that is answer a few of these questions:
How does your calculated cost-based price compare to the industry price?
If your markup pricing is higher than the industry average, you need to do an analysis to find out why. Are your costs higher? If so, why is that? Is your profit margin reasonable? Can you afford to take less in profits?
Dig into this and make a list of all the things that are impacting the cost of your product. The reasons for this price being higher may actually end up being great selling points and features that you need to share with your customers.
If your markup pricing is lower than the industry average: Again, make a list of why you think your price is lower. In this case, if you went with this price, you would be leaving money on the table with this selling price, so there is room there for you to add additional value and charge more.
What price do you want to charge and how would you justify it?
In your heart, you have a price that you want to charge. What is that and how does it compare to the baseline price you came up with using your cost based pricing strategy?
What are your competitors charging or how much does an alternative cost?
Do some research and make a list of competing offers or alternatives that your customers can buy. Focus in on the features. Then compare them to yours and see what the difference is.
How can you quantify the value that you bring to your customers?
This is one of my favorites. Make a list of values that your product or service brings to your customer and put a cost number on it. For example, if your product saves time, how much time will customers save? Then place a value of that time in dollars i.e $50/hr. Maybe your product replaces other more expensive products, or maybe your product provides results quickly, how much will that save them. Place dollar values on all of those and see where that lands your price.
Cost Based Pricing Example
You might be surprised to learn that cost-based pricing is used by a wide variety of businesses. Here are just a few examples:
Manufacturers: A lot of manufacturers default to cost-plus pricing.
Auto Repair Shops: Many auto repair shops use cost-based pricing, charging an hourly rate for labor. This allows them to cover their costs and make a profit, without overcharging customers.
Hair Salons: Hair salons typically charge based on the cost of the services they provide. For example, a haircut may cost $40, while color services may cost $80. This allows them to cover their costs and make a profit.
Restaurants: Restaurants often use cost-based pricing when determining menu prices. They take into account the cost of ingredients, labor, and other expenses, then add a mark-up to make a profit. This ensures that they are able to cover their costs and make a profit.
As you can see, cost-based pricing is used by a wide variety of businesses. This pricing method allows businesses to cover their costs and make a profit, without overcharging customers. So, if you’re ever wondering how businesses determine their prices, cost-based pricing is often the answer.
When to Use a Cost-Based Pricing Strategy
There are a few occasions when cost-based pricing is the best strategy:
1. When you have a low production cost and a high perceived value.
2. When you’re the only game in town and you have a monopoly on the market.
3. When you want to focus on profit maximization rather than market share.
FAQs About Cost-Plus Pricing
What is Markup?
The markup is the percentage that is added to the unit cost of a product to get the selling price of the product. To calculate markup, subtract the unit cost from the sales price and divide that number by the unit cost. Then multiply by 100 to find the percentage.
Why is a value-based pricing strategy better than cost-plus?
There are a few reasons why value-based pricing is better than cost-plus:
1. It takes into account the perceived value of your product to the customer.
2. It accounts for the competition.
3. It allows you to charge more than your competitors if your product has a higher perceived value.
What is break even pricing?
The break-even price is the point at which your total revenue equals your total costs. To find your break even price, divide your total costs by the unit margin.
For example, if it costs you $10 to produce a widget and you want to make a profit of $2 per widget, your break-even price would be $12 (10/2 = 12).
What is target profit pricing?
What are some other types of pricing strategies?
There are a few other types of pricing strategies that you might want to consider:
1. Skimming – This involves setting a high price for your product at first, then gradually lowering the price as demand decreases.
2. Penetration – This is the opposite of skimming and involves setting a low price at first to attract customers, then gradually raising the price as demand increases.
3. Bundling – This involves selling multiple products or services together at a discounted price.
4. Loss leader – This is when you sell a product at a loss in order to attract customers who will then purchase other, more profitable items.
5. Product line pricing – This is when you set different prices for different products in your product line.
No matter what type of pricing strategy you choose, make sure to keep the perceived value of your product in mind. Customers should always feel like they’re getting a good deal, otherwise they’ll go somewhere else.