Cost-Based Pricing: Strategies And Formulas (With Examples)

By Indeed Editorial Team

Published 12 October 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

The pricing process helps a business finalise the price at which it plans to sell its products and services. Many businesses that produce and sell goods or services use the costs as the basis for setting the selling prices. Learning about such pricing techniques and various associate formulas can help you plan the prices to meet your organisation's revenue goals. In this article, we define cost-based pricing and its four different strategies, discuss the advantages of this pricing technique, look at various formulas for calculating it and share example pricing calculations using these formulas.

What Is Cost-Based Pricing?

Cost-based pricing is a method businesses utilise to establish the selling prices of goods and services. This approach to pricing allows them to establish prices according to the cost associated with producing goods or providing services. This pricing technique includes several methods of calculating selling prices. Each pricing method focuses on the costs of production as the basis for deciding the suitable price that has the potential to result in high customer satisfaction and improve the company's financials. The following are four different pricing strategies that focus on cost:

Cost-plus pricing

Cost-plus pricing is a method which uses the total cost of goods sold (COGS) as the primary basis for pricing goods and services. Businesses use a fixed percentage that represents the expected return for price calculation. They add this percentage with the total expenses associated with production, storage and distribution or sales to decide on a reasonable selling price.

Related: 9 Pricing Tools To Consider (With Definition And Examples)

Markup pricing

Most retail businesses use a markup pricing strategy. Retailers purchases items for resale and add a certain percentage to the cost to decide the selling price. For example, a retailer that sells kids' clothing adds a certain percentage of the cost of the clothes it sells to finalise a selling price at its store. Companies that use markup pricing set selling prices that allow them to profit and appeal to the customer market.

Related: What Is Price Skimming? A Definitive Guide With Examples

Target profit pricing

Target profit pricing uses a company's profit goal to calculate a selling price for goods or services. For example, if an electrician has a target profit goal of ₹500 for every compressor replacement service they sell, they can add this fixed amount to the total costs associated with providing both the parts and repair service to establish a final price for customers.

Break-even pricing

The break-even pricing technique allows companies to find the minimum price of goods that covers the associated costs of production and distribution. This approach gives businesses an easy starting point for selling prices by first calculating the total production cost, then using a cost-plus or markup technique to decide the final selling price.

Related: What Is A Break-Even Point? Examples And How To Calculate It

Advantages Of Cost-Based Pricing Technique

Pricing based on costs offers numerous benefits to businesses that use it to set selling prices. The following are a few of its significant advantages:

Is easy to calculate

Pricing strategies based on cost are attractive to businesses, as they are easy to calculate and understand. You can simply add a markup to the production cost or establish a price based solely on the production cost. Regardless of which of the four methods you choose, it covers the production and overhead expenses.

Ensures predictable profit

Pricing based on costs can also ensure a steady profit margin. This is one of the few pricing strategies which ensure suitable profit. If you price your goods and services relative to their production costs, the per unit generated revenue provides a predicted net profit regardless of the market conditions.

Related: What Is Revenue? Definition, Types, Examples And More

Can make it easier for customers to accept price increases

Occasionally, it may become necessary for a business to raise the prices of its products or services. A price increase may discourage most customers. If you specify the rising production costs as a reason, this can make it easier for the customers to understand and accept the price increase.

Related: What A Pricing Analyst Career Path Is And How To Pursue It

Various formulas for deciding selling prices based on cost

For each of the four methods of deciding selling prices based on cost, you can calculate your selling price using the following formulas, where SP represents the selling price:

Cost-plus pricing formula

SP = Cost per unit + Desired return%

The cost-plus formula considers the cost per unit a business pays and adds the fixed percentage of expected return to decide the selling price. For instance, if a business spends ₹100 to manufacture one item and has a fixed 25% expected return rate, then the selling price the company sets is ₹125.

Markup pricing formula

SP = Cost per unit + Markup rate

Markup pricing uses this formula where the markup rate is (Cost per unit) / (1 − Desired sales return). It is important that businesses know the desired return rate to calculate the markup percentage before calculating the final selling price. For example, if a business has a desired sales return of 20% on each sale, it can calculate the markup rate and then use it to find the markup pricing.

Target profit pricing formula

SP = (Total cost + Target profit%) / (Units sold)

In the target profit pricing formula, the total cost represents all operational expenses related to producing and selling an item. Businesses add a percentage of the projected return on total cost and divide this total by the number of products they sell.

Break-even pricing formula

SP = (Variable cost + Fixed cost + Desired total profit) / (Total number of units for sale)

The break-even pricing formula can help a company determine how much earnings are necessary to cover the costs of producing, storing and selling a product. The business can then add this value to the total cost to determine a suitable selling price. They add the variable and fixed costs associated with operations and then divide them by the sum of expected profit and the total number of product sales.

Related: Calculating Break-Even Analysis In Excel: A Complete Guide

Pricing Calculation Examples Based On Cost

Consider the following examples to help you calculate the selling price with each formula:

Example using the cost-plus pricing formula

Assume a manufacturing company wants to set a selling price for a new mobile cover it produces. Using the cost-plus pricing formula, the business calculates an appropriate selling price when its cost for producing one device is ₹150 and its expected return is 30%:

SP = (Cost per unit) + (Desired return%) = ₹150 + 30% = ₹195

With this cost-plus pricing calculation, the business sets the selling price for the new mobile cover at ₹195 per item.

Example using the markup pricing formula

Consider a retail business that purchases sweaters for ₹15 per sweater and resells them. Using the markup pricing formula, the business can find an effective selling price to generate profit and cover its COGS. First, the retailer determines the markup rate using the formula (Cost per unit) / (1 − Desired sales return) :

Markup for sweaters = (Cost per unit) / (1 − Desired sales return) = (₹15) / (1 − 25%) = (₹15) / (1 − 0.25) = ₹15 / 0.75 = ₹20

This means that the business sets a markup amount of ₹20 for the sweaters. Then, the business uses this value in the markup pricing formula to get the selling prices for the sweaters:

SP for sweaters = Cost per unit + Markup price = ₹15 + ₹20 = ₹35

With the markup pricing formula, the business sets its selling prices at ₹35 per sweater.

Example using the target profit pricing formula

Assume a service provider wants to set a price for its cleaning services, so it uses the target profit pricing formula to determine the most appropriate price for this service. If the company knows it sells an average of ten cleaning services per period, it uses this in the formula when its total costs of providing services are ₹250 per service and its projected percentage of returns is about 30% of the ₹2,500 returns:

SP = (Total cost + Total projected profit%) / (Units sold) = (₹2,500 + 30%) / 10 = ₹3,250 / 10 = ₹325

The service provider decides that ₹325 per cleaning session is a suitable selling price.

Related: What Is Implicit Cost And Explicit Cost? (With Examples)

Example using the break-even pricing formula

Consider a manufacturing business that wants to use the break-even pricing method to cover the costs of production and generate a minimum desired profit for each sale. Using the break-even pricing formula SP = (Variable cost + Fixed cost) / (Total unit sales + Profit), the business can determine the selling price of its new product. It uses the following details to find the break-even pricing point of its product:

  • The variable costs are ₹4,500.

  • The fixed costs are ₹3,000.

  • The total number of units for sales is 300.

  • The desired total profit is ₹1,500.

Using this information in the formula, the business calculates the selling price:

SP = (Variable cost + Fixed cost + Desired total profit) / (Total number of units for sale) = (₹4,500 + ₹3,000 + ₹1,500) / 300 = ₹9,000 / 300 = ₹30

This means the business can set a base price of at least ₹30 per item to break even and get the desired profit.

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