January 22, 2017

What is Cost based pricing and how it is applied in the Business world?

Every organization’s aim is to realise profits in the business that it undertakes. This profit is, to a large extent, determined by the selling price of its product or service. It is not always true that a higher selling price leads to greater profits. The demand for a product at every price point is also important to determine the revenue generated and thus the profit.

Two popular ways to determine the selling price of a product are value based pricing and cost based pricing. Let us understand both and then delve a little deeper into cost based pricing.

Value based pricing is the method of determining the selling price of a product based on the perceived value that it will add to its consumers. A product that adds higher value in the lives of its consumers will have a higher selling price. An example of such a product is a car which contributes a lot to the family’s status and happiness. Plus the car uses a lot of technology too. Hence a car has a higher selling price because it gives more value.

A product that adds relatively lower value will be priced lower, example a key chain. Value based pricing is tougher to adopt as it is difficult to accurately predict the value that the consumption of a good or service will add. The value added is very subjective and can differ from person to person and consumer to consumer.

An easier technique is called the cost based pricing. As the name suggests, the selling price of a product under this method is calculated based on the cost of making that product. A certain percentage of the total cost is added as a margin and then the selling price is decided.

For example, let us assume that it costs us Rs. 15,000 to make a smart phone and we want to realise profits of 33% from the sale of every phone. The selling price of this will be 1.33 times the cost price, which means that it will see at Rs. 20,000 in the market.

You can see that cost based pricing is a simpler technique and is easy to calculate depending on the profit goals of the company. Most small businesses use cost based pricing because it is easier to calculate on the go.

Distributors and dealers generally buy products from the company at X price and they calculate a Y price on which they want to sell. The X is the cost to the dealer or distributor, and the amount of money earned between X – Y is the profit. That’s Cost based pricing in simple terms.

Cost based pricing

There are further two distinct types of cost based pricing.

  1. Full cost pricing &
  2. Direct cost pricing

Full cost pricing is a type of cost based pricing where the entire cost, i.e., fixed cost and variable cost are considered before the mark up is put into effect. The variable cost depends on the number of units produced and peripheral costs while the fixed cost is something that one will have to incur irrespective of the number of units being produced. Example of full cost pricing is any consumer durable product which considers the cost of the production of the product (fixed cost with fixed overheads) as well as its variable cost (transportation cost).

Direct cost pricing is a type of cost based pricing where only the variable cost is taken into consideration before being marked up. The fixed costs are ignored here and are considered in the overall break-even calculation that the company does. So, a dealer or distributor will only consider the costs of moving a product from his place to the customers place. If the customer is far away, the high transport price will be considered and overall price will be raised. So the pricing of the end product depends on the variable prices only.

Cost based pricing is used by companies to maximise their profits. Production of the product is increased until the marginal revenue earned (revenue earned due to the sale of every additional product) equals the marginal cost. After this state of economic activity is achieved, the demand curve determines the pricing of the product.

Cost based pricing is easy to put into effect and requires little information. All of the information required is internal to a company and it needn’t spend too much time or money in gaining market and consumer insights.

The flaw of this method of pricing is that it does not take into account the demand at a particular price point and it also assumes that the customers will be willing to buy the product at the particular price point. This cannot be taken for granted.

To ward off these cons, a bit of research and market understanding will have to be done. If this can be done to complement the pricing calculations, cost based pricing can be both simple and accurate to a certain extent.

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About Hitesh Bhasin

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