Cost oriented pricing

From CEOpedia | Management online

Cost-oriented pricing is a pricing strategy where a company sets the price of a product or service based on the cost of producing it, plus a markup for profit. This method of pricing takes into account the cost of materials, labor, and overhead expenses associated with producing a product or offering a service, and then adds a markup to determine the final price. The markup is typically a percentage of the total cost and is used to cover expenses and generate a profit. This pricing strategy is often used by companies that have a low margin product or service and a high fixed cost.

Examples of cost-oriented pricing

Here are a few examples of cost-oriented pricing:

  • A grocery store that produces its own brand of cereal may use cost-plus pricing, adding a markup to the cost of production to determine the final price of the cereal.
  • A car manufacturer may use full cost pricing, taking into account all the costs associated with producing a car, including materials, labor, and overhead, and then adding a markup to determine the final price.
  • A consulting firm may use target return pricing, setting a price that will generate a specific profit margin or return on investment.
  • A small business that produces handmade jewelry may use break-even pricing, setting a price that will exactly cover the costs associated with producing each piece of jewelry.
  • A software company may use value-based pricing, considering the perceived value of their software to the customer, in addition to the cost of production, to set a fair price for the product.

These are just a few examples of how cost-oriented pricing can be used in different industries. The specific pricing strategy that a company chooses will depend on its production costs, target market, and overall business objectives.

Types of cost-oriented pricing

There are several different types of cost-oriented pricing, including:

  • Full cost pricing: This method takes into account all the costs associated with producing a product or offering a service, including both fixed and variable costs. A markup is then added to the total cost to determine the final price.
  • Target return pricing: This method sets a price that will generate a specific profit margin or return on investment. Companies may use this method to ensure that they are reaching a certain level of profitability.
  • Break-even pricing: This method sets a price that will exactly cover all of the costs associated with producing a product or offering a service. This type of pricing is often used to price new products or services that are being introduced to the market.
  • Cost-plus pricing: This is a very basic cost-oriented pricing strategy where a company adds a markup to the cost of production to determine the final price.
  • Value-based pricing: This pricing strategy takes into account not only the cost of production but also the perceived value of the product or service to the customer. It aims to set a price that is fair for both the company and the customer, by considering both production costs and customer demand.

These are the types of cost-oriented pricing strategies. However, it's worth noting that companies may use a combination of these strategies depending on the product or service being offered, the target market, and the overall business objectives.

Cost oriented pricing specification

As the name suggests, the basis for determining the price are the costs incurred by the company to provide the product or service. In general, companies want to set a price high enough to cover costs and make a profit[1].

Two types of costs can be included: fixed costs and variable costs. Fixed costs are the costs incurred by an enterprise to maintain a business that do not change depending on changes in sales volume. For example, restaurants must invest in buildings, kitchen equipment and tables before serving customers. Variable costs are the costs associated with running a business that change depending on changes in the volume of sales. For example, restaurants incur costs related to food, work and cleaning, which are directly related to the level of sales[2].

The procedure for determining the price in cost-oriented pricing typically involves the following steps:

  1. Determine the cost of production: This includes both fixed and variable costs, such as materials, labor, and overhead expenses.
  2. Calculate the markup: This is typically a percentage of the total cost of production and is used to cover expenses and generate a profit. The markup can be calculated based on the desired profit margin or return on investment.
  3. Determine the final price: The final price is determined by adding the markup to the total cost of production.
  4. Adjust the price if necessary: The company may need to adjust the price based on the perceived value of the product or service to the customer, the competition, and the target market.
  5. Monitor and adjust: Once the price is set, the company should monitor the sales and adjust the price if necessary. This step is important to ensure that the price is fair for both the company and the customer.

It is worth noting that different cost-oriented pricing strategies may have variations in these steps. For example, in value-based pricing, the perceived value of the product or service to the customer is taken into account before determining the final price. In break-even pricing, the company aims to set a price that will exactly cover all the costs of production, and in target return pricing, the company sets a price that will generate a specific profit margin or return on investment.

Advantages of cost oriented pricing

Cost-oriented pricing has several advantages, including:

  • Predictability: By basing the price on the cost of production, companies can predict their expenses and profits more accurately. This helps them to budget and plan for the future.
  • Simplicity: Cost-oriented pricing is a simple and straightforward pricing strategy. It is easy to understand and implement, which makes it a popular choice among companies.
  • Fairness: By considering the costs of production, companies can ensure that they are charging a fair price for their products or services.
  • Transparency: By basing the price on the cost of production, companies can be more transparent with their customers about how they determine the price.
  • Cost Control: By considering the costs of production, companies can be more efficient in managing their expenses and controlling their costs, which can help them to increase profitability.
  • Flexibility: Cost-oriented pricing can be easily adjusted to reflect changes in production costs, which can help companies to remain competitive in the marketplace.
  • Helps in Break-even analysis: By considering the costs of production, companies can be more efficient in determining the break-even point, which is the point at which the revenue from a product or service equals the costs of production.

Cost-oriented pricing is a simple and straightforward pricing strategy that can be effective for companies with low-margin products or services. By basing the price on the cost of production, companies can ensure that they are charging a fair price and can predict their expenses and profits more accurately.

Its strength are its straightness, acceptability and cohesion with a target rate of return on investment and the price stability in general. The simplicity of this method lies in the fact that it requires no other effort than reading the accounting or financial documentation[3].

Another important advantage of cost-oriented pricing is to defend price discrimination based on justification of costs, as repeated in the Robinson Patman Act. The seller may establish that the price difference is due to a different quantity sold or another method, there for other transport costs. What is more, the concept of costs and cost savings is an important justification for volume rebates, because cost savings per unit sold arise from savings corresponding to transport costs.

As this method is simple, retailers, wholesalers and some producers use it to set prices. In addition to its simplicity, a cost-oriented approach can produce the desired results aproximately in short time. Because this method does not need going beyond the physical boundaries of the enterprise, the company's accountant or financial analyst can get the necessary cost data in a reasonably short time[4].

Weaknesses of cost oriented pricing method

Cost-oriented pricing has several weaknesses, including:

  • Limited profitability: By basing the price on the cost of production, companies may not be able to charge as much as they could if they took into account other factors, such as customer demand or market conditions. This can limit their profitability.
  • Lack of market focus: By focusing solely on the cost of production, companies may not take into account how the market perceives their product or service and what customers are willing to pay for it. This can lead to prices that are too high or too low, which can negatively impact sales.
  • Inflexibility: Cost-oriented pricing may not allow for much flexibility in pricing, making it difficult to respond to changes in the market or to take advantage of opportunities to increase prices.
  • Not suitable for high-value products: Cost-oriented pricing may not be suitable for high-value products or services, as the customer may be willing to pay more than the cost of production.
  • Inability to increase prices: If the company is facing increased costs, cost-oriented pricing may make it difficult to increase prices to maintain profitability.
  • Can lead to underpricing: By focusing on the cost of production, companies may not take into account the perceived value of the product or service to the customer, which can lead to underpricing.
  • Doesn't consider external factors: Cost-oriented pricing doesn't take into account external factors such as competition, market trends, or customer demand, which can lead to a lack of competitiveness or missed opportunities.

Cost-oriented pricing has several weaknesses that can limit profitability, responsiveness to market conditions, and competitiveness. It's important for companies to consider other factors, such as customer demand, market conditions, and competition when setting prices, in addition to their production costs.

Main weak points of cost-oriented pricing is the lack of consideration of market demand, various competitors' pricing strategies and market purchasing potential[5].

The price an individual customers are willing to pay for a given product may have little to do with the cost of making it. Studies of consumer behavior have provided significant evidence that consumers,as a completely rational buyer, can consciously choose a product or service which is at a higher price, even if substitutes at a lower price may be available as a second option. The calculation of unit costs under the cost-oriented approach requires an estimation of sales volumes. The basic assumption here is that the estimated sales volume will actually materialise at the price level resulting from this cost plus approach.Another disadvantage of this method is that it uses incorrect or distorted cost information. The use of such information can seriously undermine both competitiveness and profitability. The main problem is costing one product in a company that produces many products[6].

Footnotes

  1. ↑ Reid R (2009) p. 563
  2. ↑ Reid R (2009) p. 563
  3. ↑ Atmanad (2009) p. 416
  4. ↑ Nessim H (2017) p. 51-52
  5. ↑ Prakashan N (2006)s.49
  6. ↑ Nessim H (2017) p. 53-56


Cost oriented pricing — recommended articles
Marginal pricing — Market based price — Step fixed cost — Fixed cost — Cost per unit — Competition-based pricing — Competitive parity — Price setting — Factors affecting pricing

References

Author: Jakub Stachów

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