A Balanced Assessment of Cost-based Pricing
Cost-based pricing has substantial pros and cons. To use it effectively, entrepreneurs & managers need a complete, balanced understanding of this pricing method.
Have you heard of the British artist Jack Vettriano’s painting, the Singing Butler? Every art critic and informed art lover despises it. Yet, it is widely regarded as the most popular British artwork. Its last sale price was over a million dollars.
Cost-based pricing is a lot like the Singing Butler. Virtually every manager (and every single business school student) professes to hate cost-based pricing. Yet, it remains by far the most widely used way to set prices.
Many government- and B2B buyers mandate cost-based pricing. As one example, one large infrastructure services company that I know bids for multi-year, multi-billion dollar contracts that require quoted prices explicitly to be derived from costs. In retailing, a markup of 100% on the wholesale cost of merchandise is so common, they have a name for it: keystone pricing.
Two Cost-based Pricing Variations: Markup and Cost-Plus
There are at least two distinct forms of cost-based pricing. Both calculate costs and multiply them by a markup factor. The difference lies in which costs are included in the calculation and how they are allocated to each unit.
Markup pricing is common in consumer industries like restaurants and retailers. With it, the seller chooses a markup factor and applies it only to some or all variable costs. For example, a bar may buy bottled beer from its supplier by the case at a cost of $0.85/ bottle. To calculate the sale price, it may use a markup factor of 5X, a convention for bars. It will price the beer at $0.85 x 5, or $4.25 per bottle.
Cost-plus pricing (also known as full-cost pricing) is more common in B2B industries. It considers all costs, not just variable costs in calculating the price. In addition to all variable costs, the company calculates all fixed costs it expects to incur and allocates them to the units it expects to sell. A concrete example should help to illustrate how cost-plus pricing works.
Imagine a small pharmaceutical company that has spent $1 million in R&D costs to develop a new vaccine. It is submitting a bid to supply the government with a million doses, its entire annual production. To produce these doses, the company expects to incur $500,000 in fixed costs and a further $1 per dose of variable costs to produce and distribute the vaccine. The contracting process calls for marking up costs by 20%. In this scenario, here’s how the calculation of the cost-plus price will work out:
Cost-plus pricing is trickier than markup pricing. It requires more assumptions. The company must estimate all fixed costs for a defined duration in advance. What’s more, it must predict how many units it will sell over that period. Only then can it calculate the fixed costs to be allocated to each unit. The markup factor used in cost-plus pricing calculations is usually lower than the factor used in markup pricing because it is applied to all costs, fixed and variable, and not just variable costs.
Further, notice that in the calculation in the table, we have allocated all R&D costs ($1,000,000) to the government contract. If the vaccine is sold to other customers, then the company will have to estimate how much of the R&D costs to allocate to the government contract vs. other future sales. This will lower the cost-based price correspondingly. Depending on the allocation (and the assumptions behind it), the quoted price could change significantly.
The Disadvantages of Cost-Based Pricing
Managers dislike cost-based pricing for legitimate reasons. There are significant limitations to relying only on cost-based pricing to set prices. Some reasons are obvious, but others are a little more complicated. Let’s consider each one.
1) It discourages efficiency and rewards bloat.
Cost-based pricing violates a fundamental principle of good management practice, that efficiency and productivity increases are good for everyone – the company and its customers alike. With cost-based pricing, there is a disincentive to be efficient and to lower costs. Other things being equal, reducing costs will decrease company revenues and total profits. Letting costs run will raise prices, boosting revenues and profit.
Business consultant Anna Masker described a time when she worked with a B2B company that used cost-plus pricing to quote prices for complex industrial jobs. She noted that one year, when the business changed its manufacturing process and generated significant savings in labor costs, “the [pricing] system used the cost-plus model, so with lower costs, the final price was lower, ultimately passing all the cost savings on to customers. For this company, it meant hundreds of thousands of dollars of lost revenue—and profit.”
Any pricing method that encourages inefficiencies rewards bloated cost structures, and penalizes efficient, lean ones, is problematic.
2) It is divorced from customer value or reference prices.
Cost-based pricing completely ignores three key decision inputs into pricing decisions – customer value, reference prices, and the value proposition. This can be dangerous, and in some cases, even fatal for the business. Here’s one example that illustrates why.
Consider a homebrewer who has just spent a significant amount of effort and savings to develop a recipe for a pale ale beer and acquire the requisite licenses to make and sell beer. Now he makes a batch of beer to sell at a music festival. Because of his small scale, and the specialized ingredients in his recipe, his total costs come out to $7 per 20 oz. bottle of beer. If this entrepreneur were to use cost-based pricing and mark up his costs by a reasonable factor of 40%, he would end up with a price of $10 per bottle for his pale ale. How successful do you think his venture would be when beer drinkers can buy an excellent glass of pale ale for $4 or $5?
A competitor may enjoy a formidable cost advantage in which case the company’s cost-based price will be too high to be effective. Or a customer may be willing to pay far more, in which case the cost-based price will be too low, letting profit go uncaptured. Either way, cost-based price provides only an incomplete picture. Without considering customer valuation and prices of other available options, the pricing decision may go completely off-base.
3) It creates a false sense of complacency.
Managers and entrepreneurs gravitate towards cost-based pricing because of the “We can’t lose” belief. They believe that at worse, they will be able to cover their costs. This is perhaps the most dangerous misconception of all. To see why, let’s return to our pharmaceutical company example. Now, instead of the expected million vaccine doses, let’s assume that the firm is only able to deliver 500,000 doses because of an ingredient shortage. Recall the dose price was set at $3, based on total cost estimates of $2.50 per dose and a markup of 20%.
Because of lower sales, the company will now have to allocate its fixed costs over the smaller actual sales base. While the estimated fixed costs, based on expected sales of a million doses were $1.50 per dose ($1,500,000/1,000,000), the actual fixed costs were $3 per dose ($1,500,000/500,000). Adding variable costs of $1/dose, the company will have spent $4/dose to fulfill its contract and supply the vaccine. Because the contracted price is $3 per dose, set at the beginning of the contract, the company will end up losing $1/dose, or a total of $500,000 from the sale.
Cost-based prices provide no guarantee of covering costs or earning a profit for the company. Because sales volume has to be guesstimated beforehand and fixed costs are allocated based on this forecast, they can turn out to be too high or too low depending on how many units are sold. This, in turn, can lead to prices that are too low, or too high, respectively. Cost-based pricing can easily result in a devastating loss; like everything else in life, there are no guarantees.
4) It is difficult to define costs accurately.
Related to the limitation of false complacency is the fact that many businesses find it difficult to define costs accurately. Retail consultant Dale Furtwengler recounts the following story:
“In the early years of my consulting work I picked up a client that had been losing money for two consecutive years and was experiencing severe cash flow problems. They were using cost-plus pricing. What went wrong? They didn't define their costs well. They had included production costs in the operating expense category, consequently when they added the traditional industry profit margin to their production costs their prices were too low to cover their costs.”
This sort of miscalculation is common and occurs for various reasons. As Furtwengler points out, many managers have difficulty categorizing costs accurately, use incorrect or subjective bases for the allocation of costs, and are deliberately given over-estimates from production departments to give themselves a margin for error. Another reason is that many businesses cannot lock in costs for lengthy periods, The unforeseen fluctuations in costs can throw off cost-based pricing calculations.
The Benefits of Cost-Based Pricing
Managers, especially professionally-trained ones, tend to be biased against cost-based pricing. They may be better served by considering some of the substantial benefits of cost-based pricing because in particular contexts, using it may result in the best and most effective pricing decision. Let’s consider each benefit.
1) It is simple.
Perhaps the greatest virtue of cost-based pricing is its simplicity. The only method simpler than this is to mechanically peg your prices to a competitor’s prices. And even there, you would need some way to find out your competitor’s prices regularly. The value of cost-based pricing’s simplicity cannot be understated, especially for small businesses. Using a five-dollar calculator, a retail frontline employee or a bartender can apply a markup factor in seconds and calculate the price to charge customers. Any other method would be far more cumbersome to execute.
2) It is easy to explain and justify.
Equally useful is the fact that cost-based pricing can be explained and defended easily to customers. Because of its long history, everyone knows the logic behind markups. The cost-based pricing method comes pre-packaged with a reasonable explanation for why prices are what they are. For example, there is security in telling customers, “We mark up the merchandise in our store by 40% to cover all our costs, pay our employees a fair wage, and earn a reasonable profit so we can stay in business, create jobs, and support our community.” What can be more reasonable than this?
The clothing brand Everlane has made the disclosure of its cost-based pricing formula a strong differentiator and portrays its “radically transparent” pricing as a badge of honor. For every garment it sells, Everlane provides a detailed breakdown of costs for materials, labor, duties, and transport, along with its markup. This way, customers can easily verify Everlane’s emphasis on paying fair wages to its workers and actively endorse this value by buying its products.
Note, however, that this type of transparency can become a double-edged sword. When costs go down, sharp-eyed customers will expect prices to follow suit and notice if the seller discloses outdated or inaccurate cost information. There is more leeway in the consumer space as consumers are slow to know or react to cost changes. (How many Everlane shoppers actually read and remember the cost breakdown?)
3) It is inherently fair.
Cost-plus pricing is the very antithesis of value-based pricing, which strives to discover differences between customers’ economic valuations and exploit them by customizing prices. Value-based pricing is price discrimination. Just consider the consumer outrage generated by Uber’s surge pricing, Coca-Cola’s dynamic vending machine pricing based on outside temperature, or the variable rate pricing of electric utilities. In all these cases, many customers saw the seller’s value-based pricing moves as nothing more than gouging. Cost-plus pricers don’t face this risk. Sure, they may underprice their products for some customers, but they will sleep peacefully at night, knowing customers consider their prices to be fair. Cost-based pricing is price homogenization.
4) It stabilizes market prices.
When all the key competitors in a market have similar cost structures, and they all use cost-based pricing, the amount of risk associated with pricing decisions is lowered for everyone. Prices remain stable, particularly when the higher-cost suppliers in the market offer corresponding higher-quality products and lower-cost providers offer lower-quality products. Companies are less likely to engage in price wars if they base their prices primarily on costs instead of competitors’ prices. Sleepy industries tend to be stable and profitable ones as long as everyone slumbers equally. However, note that this can change dramatically if a new competitor enters with a cost advantage, or an incumbent innovates down to a lower-cost structure. Then all bets are off. Also, see #6.
5) It encourages customers to use factors other than price in buying decisions.
For consumers, cost-based prices are consistent with their expectations. Most of us (reasonable folks) expect to find lower service quality with low prices to match when we walk into an Aldi or Walmart store, and higher service quality and more upscale and expensive products in Whole Foods. Because of this well-known pattern, when the major players in a particular industry use cost-based prices, customers will base their purchase decisions on the product’s quality to a greater degree rather than focusing only on the price. The logic they will use is: Do I want full service and pay a higher price, or do I want barebones service in exchange for a lower price?
6) It’s the most effective way to execute a cost leadership strategy.
When the company has unique competencies that enable an advantageous cost structure relative to competitors, it can use cost-plus pricing to create and deliver the most enticing value proposition of all. It becomes a cost leader, and its low costs, the resulting low prices, and superior customer value become its brand identity. Costco has maintained market leadership using this principle for decades. The company mandates that nothing in its stores will be marked up by more than 14% (15% for its private-label products). It publicizes this pricing policy widely. It combines this pricing strategy with other business model features such as a spartan store environment, limited assortments, and bulk buying, to create the compelling narrative that the customer is going to get amazing deals at Costco.
The Main Takeaway
As this list shows, managers need a more balanced perspective when evaluating the suitability of cost-based pricing for their business. Everyone is crazy for value-based pricing but there is a gritty common sense and logic associated with cost-based pricing that is indisputable. And there are tangible benefits from it that accrue to the company that uses it and also to the industry as a whole. For a company with a cost advantage or an interest in using transparent pricing to differentiate itself, cost-based pricing is a tool to implement strategy. For a seller interested in conveying that its prices are fair and for building customer trust, cost-plus pricing is a credible pricing policy. And for industries that are ravaged by price wars, cost-based pricing offers respite. At a minimum, managers need to incorporate cost-based pricing as one input into their pricing models.