Cost-Based Pricing
Cost-based pricing is the act of pricing based on what it costs a company to make a product. In addition, a company must also consider factors such as its competition, applicable government regulations, the cost of production and the customers. Cost-based pricing involves setting a price such that:
Price = (1+ Percent Markup)(Unit Variable Cost + Average FixedCost) .
Cost-based pricing is included in what is considered the "3 C's" of pricing. Advanced pricing analysis actually views the 3 C's as describing a set of constraints that pricing strategies must overcome to succeed.
Practical Implementation Problems
A company must know its costs. For example, consider the hypothetical company Diamond Deliveries. The bicycle division, which management thought of as Diamond's core business, generated just 10% of total revenues and barely covered its own direct labor and insurance costs. Diamond was charging customers $4.69 per job. However, with fully allocated costs of $9.24 per job, the company was losing $4.55 every time a cyclist picked up a package .
Diamond Deliveries bikes
Our hypothetical company, Diamond Deliveries, delivers packages on bicycles.
Costs are a function of sales, which are in turn a function of prices. This makes the calculations of costs, sales, and prices circular. Imagine a firm whose average costs decrease with sales. If it sells less, its costs go up. A remedy would be to increase prices in this situation, but a time of declining sales is hardly the right environment for a move such as this. Next, imagine a firm that runs at small-scale capacity. If it sells more, its costs go down. However, pricing at average cost for small-scale capacity means that the firm may never discover this.
Cost-based pricing is misplaced in industries where there are high fixed costs and near-zero marginal costs. Distributing fixed costs can be difficult, since products affect fixed costs in different ways. Activity-based pricing is better than regular cost-based pricing in such situations.
Rather than asking what prices firms need to charge in order to cover their costs and achieve their profit objectives, firms should ask how their pricing strategy will affect their cost structure.