Cost-based pricing is one of the most popular pricing models businesses use to lock profits into the products (and services) they sell. This article explains what cost-based pricing is; why you should consider using it; and how to implement this pricing model in your business (with taxes and fees included).
What is cost-based pricing?
Also known as “markup” pricing, this method involves adding all the expenses that go into developing, obtaining, delivering, storing, and selling the products in your inventory. Thereafter, you add a percentage markup on top and set that as the official sales price.
This markup is your profit.
What are the benefits of cost-based pricing?
One of the main advantages of cost-based pricing is that it helps you determine the minimum price you can charge for a product and still cover 100% of your costs.
Note: This doesn’t necessarily mean you’ll sell every unit. In fact, you might need to reduce your markup to attract more buyers. If you never charge less than what it cost to develop and sell your products, you’ll never take a direct loss.
Another benefit of cost-based pricing is that you can gain deeper insights into your operations. For example, the simple act of calculating all of your expenses can help you identify ways in which to cut costs – whether this means:
- Buying from a cheaper supplier
- Using less-expensive packaging
- Letting employees work remotely
- Discontinuing a product
Cost-based pricing also appeals to many businesses due to its simplicity. At its core, you’re buying low and selling high. Whereas the concept is simple, cost-based pricing requires calculating your expenses accurately – segmented into:
- Variable costs that depend on how many units you sell. Labor and materials fall into this category.
- Fixed costs that remain constant regardless of how many units you sell. Rent, utilities, and other overhead expenses all qualify as fixed costs.
This involves a lot of calculations, which is one common complaint about cost-based pricing. Worse still, you must recalculate prices whenever your variable costs change.
Below are two additional drawbacks:
- This pricing model isn’t aligned with actual demand – meaning there’s no guarantee anyone will buy at the price you select.
- This model isn’t aligned with actual supply. Other vendors in your space could be selling the same items for more, which means you’re leaving money on the table. Your competitors could also be selling the same items for less, which means you are losing market share.
Cost-based pricing (with taxes included)
No one enjoys paying taxes, but it’s the cost of doing business. Since it is a cost, it’s worth including in the cost-based pricing formula below:
(Variable + fixed costs) / (# of units sold over 12 months) = avg. per unit cost
You then multiply the per unit cost by your markup percentage to determine your sales price. If your unit costs $1 to produce, for example, a 10% markup would make that item retail for $1.10. Though whereas many businesses only focus on direct costs such as material and labor, your prices will be more accurate if you include the full range of expenses that you pay – including taxes:
- Sales/VAT taxes are normally based on units sold – making this a variable cost. This is technically true of income taxes, too, since your liability changes in proportion to how much you sell. Setting this as a fixed cost is often easier.
- Payroll and employment taxes are fixed for most businesses. Though if you hire seasonal workers and can segment your taxes by month, it’s possible to make these variable costs as well.
- Property taxes are fixed – as are excise and self-employment taxes.
Although they don’t count as taxes – expenses such as fees, interest, and penalties can be treated as fixed costs for a year. Be sure to include these in your calculations.
Like all pricing methods, cost-based pricing has its pros and cons. Depending on your business, it might not be the best strategy for determining your final market prices. Given its simplicity and the business insights this method delivers, it may be worth consulting with a financial adviser to see if cost-based pricing might work for you.
Mihir Korke is Head of Acquisition at Clover Network, a leader in small business credit card processing and POS systems. Clover specializes in restaurant, retail, and personal and professional service payment solutions. With desktop and mobile POS systems, contactless payments, solutions for curbside pickup and online ordering, loyalty and rewards, Clover has multiple solutions to meet your business’s needs.