Cost-based pricing definition

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What is Cost-Based Pricing?

Cost-based pricing is the practice of setting prices based on the cost of the goods or services being sold. A profit percentage or fixed profit figure is added to the cost of an item, which results in the price at which it will be sold. For example, an attorney calculates that the total cost of running his office each year is $400,000 and he expects to achieve 2,000 billable hours in the coming year. This means that his cost per hour is $200. He wants to generate a $100,000 profit for the year, so he adds $50 to each billable hour, resulting in a billing rate of $250 per hour.

Advantages of Cost-Based Pricing

The only advantages of this method are that a business can be assured of always generating a profit, as long as the markup figure is sufficient and unit sales meet expectations, and that it is a simple way to develop prices.

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Disadvantages of Cost-Based Pricing

There are several significant disadvantages associated with cost-based pricing, which are as follows:

  • Non-market pricing. This approach routinely results in prices that diverge from the market rate, so that either the firm is selling at too high a price and is attracting too few customers, or it is selling at too low a price and so is losing profits that customers would otherwise have been happy to pay.

  • Minimal cost control. Cost-based pricing does not force a business to keep its costs under control - instead, costs are simply passed through to the customer. This is a major concern in a highly competitive market, since the business may find that its cost structure becomes bloated in comparison to that of its competitors, so that it is eventually forced to withdraw from the market.

Cost-Based Pricing vs. Market-Based Pricing

A better approach is to adopt market-based pricing, where the firm sets its prices in accordance with the prices being charged by competitors for similar products and services. This form of pricing ensures that a business maximizes its potential profits and also does not price too high, thereby driving away customers.