On paper, cost-based pricing is simple. You combine costs with a markup, and voila, pricing is set.
Many businesses use this pricing model because of its simplicity. But, take a closer look and you’ll see that there are nuances. We break it down here to keep you on the right side of profitability.
The two types of costs for cost-based pricing
Whether you’re manufacturing products or selling a service, bring all of your expenses to the table when building cost-based pricing. Even if you’re strategically selling products at a loss to gain market share, you’ll need to know these costs to understand (and limit) how much you’re losing on every sale.
You can break your costs into costs directly associated with your product (also known as cost of goods sold, or COGS), as well as costs indirectly associated with your product that cover your overall business operations and infrastructure. For the purposes of calculating a cost-based price, most businesses break these costs down into fixed and variable costs.
These are expenses that don’t change. They’re largely unassociated with the actual production and movement of your products, but these costs should be accounted for in pricing to ensure you’re operating at a net profit at the end of the day. Common examples include taxes, rent, loans, leases, licenses, insurance, utilities, and marketing to promote your products or generate sales opportunities.
As you might have guessed, here we see costs that fluctuate or change. Variable costs cover most, if not all, of your COGS. Rise or fall of costs here depend largely on the quantity of units made and sold.
Labor wages, incentive-based bonuses, goods transportation, distribution, materials procurement, and manufacturing costs are good examples. When calculating cost-based prices, you’ll need to know all of your variable costs to determine your total costs per unit.
With variable costs changing over years, months, or even days, you’ll need to develop processes and safeguards to make sure your costs stay in line with profitability. Supplier shortages, volume-based discounts, freight carrier rates, and many other factors may lead to pricing pivots.
A good start is to build transparency, visibility, and processes into each branch of your company. This will help financial leaders identify changes impacting overall costs and profitability. To circumvent some of these issues, businesses often look to form partnerships with transportation providers, suppliers, and other partners to establish fixed volume-based pricing to lock in rates.
Markups for cost-based pricing
After understanding costs comes the fun part: determining how much you can profit per unit sold, or the markup percentage. Should your markup be 60%? Maybe 25%? Some retailers swear by a 50% “goldilocks” markup that’s just right. The truth is that there’s no de facto percentage. Each business should go through the cost-based pricing process to determine the sweet spot between covering costs and growth goals without scaring customers into the arms of the competition.
Benefits and risks for cost-based pricing
There’s no one-size-fits all pricing strategy -- you need to find what works for your business. So what makes cost-based pricing a good fit, and what are some of the downsides of this pricing method?
- It’s a relatively straightforward formula.
- Calculations can account for all internal business costs.
- Markup percentages can ensure profitability.
- Due to simplicity, it may be easier to pivot for cost adjustments.
- May help identify areas where you can reduce costs or add efficiencies.
- Doesn’t account for high or low customer demand.
- Competitor pricing and economic trends do not impact pricing.
- Savings from negotiated rates with suppliers and partners are passed to customers as a lower price tag, instead of additional profits for the business.
As a simpler formula, cost-based pricing may be a good fit for smaller businesses with fewer resources to manage and adjust the pricing strategy.
It’s also important to note that while cost-based pricing doesn’t account for external factors such as competitor pricing or demand, that doesn’t mean your business needs to price with blinders on. Comparing prices with competitors and talking to customers about their budget gives you critical touchpoints to validate your pricing strategy before going to market.
Important calculations for cost-based pricing
As we mentioned, you’ll need to build all your costs into pricing. The math is simple, but things can get deceptive quickly if you’re not looking under every couch cushion and cost center to give yourself accurate data.
Start by achieving figures for variable and fixed costs per unit. Then, add them together for a total cost per unit. When you put total cost with your markup, you have your cost-based price per unit. Rather than dusting off your algebra skills, you can use our formulae below.
The variables include raw materials, packaging, labor, manufacturing, and shipping.
Here you want to collect all costs, but the key is to do this within the specific context of the volume you’re producing. After all, the cost of producing 500 widgets will be much different than producing 50,000. You can set volume based on monthly, yearly, or any other increments. Just be sure to set consistent increments across all products you’re pricing.
Variable Costs = Total Variable Costs / Volume of Units
Just like variable costs, you can calculate total fixed costs by collecting all of your company’s overhead that hasn’t been factored as a variable cost. Then, divide it by your units produced (keeping your time increment the same as when you did your variable cost calculations). This gives you the fixed costs per unit you can build into pricing.
Fixed Costs = Total Fixed Costs / Volume of Units
This is where you may want to experiment to find the right balance between profits and competitiveness in the market.
Markup % = (Selling Price Per Unit - Total Cost Per Unit) / Cost Per Unit
You’ll notice that we haven’t offered a calculation for selling price. Some companies double their costs (resulting in a 100% markup), but every company is different.
Break even analysis
Knowing your total costs per unit and markup percentage won’t do much good if you have not sales targets to achieve revenue goals. That’s where you’ll need break even quantities (BEQ) for your cost-based pricing. Of course you likely want to do better than making back your expenses, but this is a baseline to build from. You can use break even analysis for monthly or yearly projections, but be sure to adjust your data accordingly.
BEQ = Fixed Costs / (Price Per Unit - Cost Per Unit)