As a consumer, I value transparency from companies and salespeople that I buy from.
Namely, transparency in how an organization runs and how they decide the price of their products.
One company I've found that does this is Everlane, an ethically sourced clothing retailer.
To generate more sales, Everlane uses a cost-based pricing model to differentiate itself from its competitors -- more on their strategy below.
Sometimes your pricing model can actually be a talking point that helps salespeople generate more sales.
Below, let's review the cost-based pricing strategy, advantages and disadvantages, and a couple of examples.
What is cost-based pricing?
Cost-based pricing is a pricing method that is based on the cost of production, manufacturing, and distribution. Essentially, the price of a product is determined by adding a percentage of the manufacturing costs to the selling price to make a profit. There are two types of cost-based pricing: cost-plus pricing and break-even pricing.
Cost-Based Pricing Strategy
A cost-based pricing strategy is implemented so a company can make a certain percentage more than the total cost of production and manufacturing.
Cost-based pricing is a popular pricing choice among manufacturing organizations.
This strategy has two pricing methods: cost-plus and break-even pricing.
Meredith Hart, content marketer for Owl Labs, says, "A cost-plus pricing strategy, or markup pricing strategy, is a simple pricing method where a fixed percentage is added on top of the production cost for one unit of product (unit cost)."
She adds, "This pricing strategy ignores consumer demand and competitor prices."
To calculate the cost-plus price, you'll need to add the material, labor, and overhead costs and then multiply it by (1 + the markup amount).
The second cost-based pricing strategy is break-even pricing or target-return pricing.
With this strategy, the price of a product is determined by the break-even or target-return cost.
To calculate this, all you need to do is divide the (fixed cost) by the (price - variable cost). Ultimately, this strategy is used to determine how many units a company needs to sell to break even, instead of marking up each individual unit.
Also, if a company has a specific target return in mind, then the formula changes slightly to (fixed cost + target return) / (price - variable cost). This is the formula you'd use to figure out how many units you need to sell to make a certain return on investment.
Both cost-based pricing strategies are appealing to companies because they're simple and ensure that production and overhead costs are covered.
Additionally, it can assure a steady rate of profit. This is one of the only pricing strategies that can guarantee a profit.
However, cost-based pricing methods also have several disadvantages. Let's dive into them below.
Disadvantages of Cost-Based Pricing
Cost-based pricing doesn't consider demand or competition.
Notably, companies need to be aware of the overall costs to sell a product.
If competitors are producing the same product for less, but sell it for the same price, those competitors will make more profits.
So, to keep up, other companies would need to keep costs low or charge a higher price.
Usually, cost-based pricing results in drastically different prices from the market rate. This could mean that a company is selling a product with a price that's way too high or too low.
If a competitor is selling at a higher price and consumers pay for that, that means customers are willing to pay that amount for a product. On the other hand, if you're charging much higher than a competitor, you'll likely get fewer customers.
Either way, the company will lose profits.
Since no company sells its product in a silo, it's almost always important to consider what competitors are doing. This is a simple case of supply and demand.
Additionally, this method could result in an inefficient method of manufacturing and production. Any company that uses cost-based pricing won't need to consider the manufacturing process since the cost is passed to the customer.
And streamlining supplier and manufacturing costs is an important way that a company can reduce costs and increase its profit margins.
Cost-Based Pricing Examples
Although there can be disadvantages, if implemented with strategic forethought, cost-based pricing strategies can lead to customer trust and predictable profits.
In fact, Everlane, the company we mentioned above, bases its entire strategy on cost-based pricing.
The company is marketed as radically transparent with its pricing.
That means they reveal the true costs behind every product they sell -- from materials to labor to transportation. Then, they disclose their price markup.
Here's an example of the calculations, right from its website:
In this example, Everlane uses the cost-plus strategy by marking up its products by two to three times the true cost.
This is used as a marketing and sales tactic because traditional retailers markup products five to six times the true cost.
In another example, let's say that an attorney wants to use the break-even cost-based pricing strategy.
If that attorney calculates that the cost of running their firm is $200,000, and they charge $200 an hour, they know they need to work 1,000 hours to breakeven.
So, if the attorney wants to achieve a 20% return on their costs, they'll need to work an additional 200 hours.
Pricing strategies are an important part of ensuring revenue for your company. Additionally, they can be used as a sales tactic for your salespeople. Sometimes your pricing strategy and transparency can even drive more sales.