Cost Based Pricing Approach

Cost-Based Pricing (Cost-Plus Pricing)

The simplest pricing method is cost-plus pricing—adding a standard markup to the cost of the product. Construction companies, for example, submit job bids by estimating the total project cost and adding a standard markup for profit. Lawyers, accountants, and other professionals typically price by adding a standard markup to their costs. Some sellers tell their customers they will charge cost plus a specified markup; for example, aerospace companies price this way to the government.

To illustrate markup pricing, suppose any manufacturer had the following costs and expected sales:
Then the manufacturer's cost per toaster is given by:

Unit Cost = variable Cost + Fixed Cost
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Price - Variable Cost

The manufacturer's markup price is given by:

Markup Price = Unit Cost
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(1-desired return on sale)

Do using standard markups to set prices make sense? Generally, no. Any pricing method that ignores demand and competitor prices is not likely to lead to the best price. Markup pricing works only if that price actually brings in the expected level of sales. Still, markup pricing remains popular for many reasons. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing—they do not have to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar and price competition is thus minimized. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers earn a fair return on their investment but do not take advantage of buyers when buyers' demand becomes great.