Cost-Based Pricing (Cost Plus Pricing)

Introduction

Cost-based pricing, also known as cost-plus pricing, is a pricing strategy where a business calculates the cost of producing a product or providing a service and then adds a predetermined percentage of profit to determine the selling price. This method ensures that all production costs are covered while allowing for profit generation.

Key Points

• Cost Calculation: Cost-based pricing begins with a thorough calculation of all the costs associated with producing or delivering a product or service. This includes direct costs (e.g., materials and labour) and indirect costs (e.g., overhead and operating expenses).

• Profit Margin Addition: Once the total cost is determined, a specific profit margin percentage is added to establish the final selling price. For example, if a product costs £10 to produce, and a 30% profit margin is desired, the selling price would be set at £13.

• Coverage of Costs: Cost-based pricing ensures that the selling price covers all production costs, ensuring that the business does not operate at a loss. It provides a safeguard against underpricing.

• Competitiveness: While cost-based pricing guarantees cost recovery and profit, it may not always be competitive. It does not consider external factors such as competitor pricing or market demand, which can influence a customer's willingness to pay.

Example

A bakery uses cost-based pricing to determine the selling price of its cakes. If a cake costs £5 to make (including ingredients, labour, and overhead) and the bakery aims for a 40% profit margin, the selling price is set at £7. This pricing strategy ensures that the bakery covers its costs and earns the desired profit on each cake sold.

In summary, cost-based pricing involves calculating the cost of production and adding a predetermined profit margin to set the selling price. While it guarantees cost recovery and profit, it may not always align with market conditions or competitor pricing, potentially impacting a business's competitiveness.