This is the first in a series of blog posts about different types of pricing strategies. Why? Because everywhere I go these days, I see people who need help with how to set prices. I promise to make it as exciting as I possibly can!
In a recent blog, ‘How To Set Prices To Seriously Increase Profit‘, I indicated that pricing was a large and complex issue for many organizations. The complexity stems from a variety of sources, including customized price structures by customer, responsibility for price discounts not centralized within the company and potential misinterpretation over how and when to use the broad range of pricing strategies available.
I thought it might be helpful to expand on the various types of product pricing strategies over a series of posts. The cost-based pricing strategy is arguably the least exciting, but it happens to be first on the list, and therefore the subject of this post. Cost-based pricing strategies use the cost of production as a baseline upon which to make pricing decisions.
What is the product cost?
Go make friends with the accounting department! Responsibility for setting prices could benefit from a better understanding of accounting methodologies by discovering the components involved with the Cost of Goods Sold, the impact volume will have on the over or under absorption of overhead and the resultant effect on the profit and loss.
Let’s assume that your company uses a traditional costing system to determine the Cost of Goods Sold or Product Cost. In such a system, the product cost would be made up of the actual Direct Labour and Materials, while Overhead would be estimated on some basis, such as planned volume and allocated to the product.
Note that this system does not take into account any non-factory overheads such as investments in marketing or selling and/or general and administrative costs. These costs must be covered from the Gross Margin generated.
Setting the price
In a cost-based pricing model, the price is determined by adding a profit element to the cost of making the product. This could be a fixed amount per unit, or more likely, a percentage. I promised you some excitement in this blog, so here’s the math, using the framework above and some fictitious costs:
Direct Materials =$2.50 per unit
Direct Labour =$1.50 per unit
Overhead Allocation =$0.50 per unit
Product Cost =$4.50 per unit
Here’s the impact on Gross Margin $’s and %’s at several fabricated selling prices:
Selling Price $13.50 per unit $9.00 per unit $7.00 per unit
Product Cost $04.50 per unit $4.50 per unit $4.50 per unit
Gross Margin ($) $09.00 per unit $4.50 per unit $2.50 per unit
Gross Margin (%) 66.7% 50.0% 35.7%
Impact of this strategy
I don’t know about you, but when I look at the margins above, I automatically migrate to the highest selling price and resultant margin. In fact, the greatest advantage of a cost–based pricing strategy is the business knows its costs are being covered. Cost–based pricing is a simple strategy, and it’s still widely used because of this.
However, there are weaknesses to this internally focused strategy. It does not take important external factors into consideration. For example:
- Consumer or customer demand – Setting prices without understanding how customers or consumers value your product will often leave money on the table. If your company had an internal margin target of 50%, you would quite logically price your product at $9.00 in the hypothetical example above. However, if you had consumer insight that indicated a $13.50 price point would be acceptable, you would double the gross margin generated.
- Competition – Conversely, setting prices without a true understanding of competitive pricing, may place your business proposition in jeopardy. You could find your prices are too high, resulting in a rollback and/ or a re-evaluation of market or channel viability.
Certainly you need to know your costs, and how they are derived, before developing pricing. While a cost–based strategy will help you on the cost side, it is a myopic strategy as it fails to consider important external influences.
Relying solely on a cost–plus approach reminds me of an H.L. Mencken quote:
“For every complex problem, there is a solution that is simple, neat and wrong.”
Our next blog will look at competitor-based pricing strategies.