Q&A - Outline what is meant by cost-based pricing

Cost-based pricing involves setting a price by adding a fixed amount or percentage to the cost of making or buying the product. In some ways this is quite an old-fashioned and somewhat discredited pricing strategy, although it is still widely used. After all, customers are not too bothered what it cost to make the product – they are interested in what value the product provides them.

The most common method of cost-based pricing is cost-plus (or “mark-up”) pricing. It is widely used in retailing, where the retailer wants to know with some certainty what the gross profit margin of each sale will be.

Here is an example of cost-plus pricing, where a business wishes to ensure that it makes an additional £50 of profit on top of the unit cost of production.

Unit cost: £100
Mark-up: 50%
Selling price: £150

How high should the mark-up percentage be? That largely depends on the normal competitive practice in a market and also whether the resulting price is acceptable to customers.

For example, in the UK a standard retail mark-up is 2.4 times the cost the retailer pays to its supplier (normally a wholesaler). So, if the wholesale cost of a product is £10 per unit, the retailer will look to sell it for 2.4x £10 = £24. This is equal to a total mark-up of £14 (i.e. the selling price of £24 less the bought cost of £10).

The main advantage of cost-based pricing is that selling prices are relatively easy to calculate. If the mark-up percentage is applied consistently across product ranges, then the business can also predict more reliably what the overall profit margin will be.

The main disadvantage is that cost-plus pricing may lead to products that are priced un-competitively. Another potential issue is that firms may experience changes in their production costs which are not then reflected in the selling prices offered, leading to lower profit margins.