How to Use Cost-Oriented Pricing Approach for Your Business
Cost-oriented pricing approach is a method of setting the price of a product or service based on the cost of production, distribution, and selling. It is also known as cost-based pricing or cost-plus pricing. In this article, we will explain what cost-oriented pricing approach is, how it works, what are its benefits and drawbacks, and how to apply it to your business.
KEY TAKEAWAYS
Cost-oriented pricing approach is a method of setting the price based on the cost of production, distribution, and selling.
Cost-oriented pricing approach can ensure profit, but it can also ignore market demand and customer value.
Cost-oriented pricing approach can be applied by calculating the total costs, determining the desired profit margin, and setting the price.
What is Cost-Oriented Pricing Approach?
Cost-oriented pricing approach is a pricing strategy that accounts for the costs of manufacturing, shipping, and selling the product, while also including a reasonable rate of return to cover the company’s costs and risks. The price of the product can be easily calculated by totaling the expenses, to which the target profit is then added to figure out the ultimate selling price.
There are two main types of cost-oriented pricing approach:
Cost-plus pricing
This is the simplest approach to figuring out a product’s price. In the cost-plus pricing approach, the price is determined by adding a fixed percentage (also known as a markup) of the entire product’s cost (as a profit). For example, say company N pays $80 per unit to produce a product. It decides to add $40 per unit to make a profit. The final cost of the company’s product in such a scenario would be $120. Average cost pricing is another name for this pricing strategy, which is popular in manufacturing companies.
Break-even pricing
This is a more sophisticated approach to setting the price of a product. In the break-even pricing approach, the price is determined by calculating the point at which the total revenue from selling the product equals the total cost of producing it. This point is known as the break-even point, and it represents the minimum price that the company needs to charge to avoid losses. For example, say company N pays $80 per unit to produce a product, and it sells 1000 units per month. The break-even point for this product would be $80 x 1000 = $80,000. This means that the company needs to sell the product at least at $80 per unit to cover its costs. Any price above this point would generate a profit for the company.
Benefits of Cost-Oriented Pricing Approach
Some of the benefits of using cost-oriented pricing approach are:
- Ensured profit: By adding a markup or a target profit to the cost of production, the company can ensure that it makes a profit from selling its products.
- Easy to understand: Cost-oriented pricing approach is simple and straightforward to implement, as it only requires knowing the costs and the desired profit margin.
- Flawless implementation: Cost-oriented pricing approach does not depend on external factors such as market demand, customer preferences, or competitor prices. Therefore, it can be applied consistently and uniformly across different products and markets.
Drawbacks of Cost-Oriented Pricing Approach
Some of the drawbacks of using cost-oriented pricing approach are:
- Ignorance of competitors’ prices: Cost-oriented pricing approach does not take into account how other companies are pricing their products in the same market. This can result in overpricing or underpricing the products, leading to loss of customers or revenue.
- Ignores the perceived value of the customer: Cost-oriented pricing approach does not consider how much value the customer assigns to the product or service. This can result in missing out on opportunities to charge higher prices for products that have high perceived value or customer loyalty.
- Inefficient manufacturing: Cost-oriented pricing approach can create an incentive for inefficient production processes, as it allows the company to pass on any increase in costs to the customers by raising prices. This can reduce the motivation for improving quality or reducing waste.
How to Apply Cost-Oriented Pricing Approach to Your Business
If you want to use cost-oriented pricing approach for your business, here are some steps you can follow:
- Calculate your total costs: The first step is to calculate your total costs of producing, distributing, and selling your product or service. This includes both fixed costs (such as rent, salaries, utilities) and variable costs (such as raw materials, packaging, shipping).
- Determine your desired profit margin: The next step is to decide how much profit you want to make from selling your product or service. This can be expressed as a percentage of your total costs or as a fixed amount per unit.
- Set your price: The final step is to set your price by adding your desired profit margin to your total costs. You can use either cost-plus pricing or break-even pricing methods depending on your goals and preferences.
TIP
Cost-oriented pricing approach can be a good option for businesses that have high production costs, low competition, or high customer loyalty.
Cost Oriented Pricing Approach: A Brief Overview
Cost oriented pricing approach is a pricing method that is based on the cost of production, manufacturing, and distribution of a product. Essentially, the price of a product is determined by adding a percentage of the manufacturing costs to the selling price to make a profit. There are two main types of cost oriented pricing strategies: cost-plus pricing and break-even pricing.
Cost-plus pricing is the simplest approach to figuring out a product’s pricing. In this method, the price is calculated by adding a fixed percentage (also known as a markup) of the entire product’s cost (as a profit). For example, say company N pays $80 per unit to produce a product. It decides to add $40 per unit to make a profit. The final cost of the company’s product in such a scenario would be $120.
Break-even pricing is another method that aims to cover the total costs of production and distribution, but without adding any profit margin. This method is used when a company wants to gain market share or enter a new market by offering low prices. For example, say company M pays $100 per unit to produce and distribute a product. It decides to sell the product at $100 per unit, which means it will break even and not make any profit or loss.
Global Demand for Cost Oriented Pricing Approach
The global demand for cost oriented pricing approach depends on various factors, such as the nature of the product, the level of competition, the customer preferences, and the economic conditions. Generally, cost oriented pricing approach is more suitable for products that have low differentiation, high competition, low customer loyalty, and stable costs. For example, commodities like oil, gas, wheat, and sugar are often priced using cost oriented pricing approach.
However, cost oriented pricing approach has some limitations and drawbacks that can affect the global demand for this method. Some of these are:
- It ignores the value that customers perceive from the product and their willingness to pay.
- It does not consider the prices and strategies of competitors, which can lead to underpricing or overpricing.
- It does not encourage innovation and efficiency in production and distribution, as it focuses on recovering costs rather than creating value.
- It can result in lower profits or losses if the costs increase or the demand decreases.
Therefore, cost oriented pricing approach may not be the best option for products that have high differentiation, low competition, high customer loyalty, and variable costs. For example, luxury goods, niche products, innovative services, and customized solutions are often priced using value based pricing approach, which focuses on the value that customers perceive from the product rather than the costs of production.
FREQUENTLY QUESTIONS
Q1: What is cost-oriented pricing approach?
A: Cost-oriented pricing approach is a pricing method that is based on the cost of production, distribution, and selling of a product or service.
Q2: What are the types of cost-oriented pricing approach?
A: The two main types of cost-oriented pricing approach are cost-plus pricing and break-even pricing.
Q3: What are the benefits of cost-oriented pricing approach?
A: Some of the benefits of cost-oriented pricing approach are ensured profit, easy to understand, and flawless implementation.
Q4: What are the drawbacks of cost-oriented pricing approach?
A: Some of the drawbacks of cost-oriented pricing approach are ignorance of competitors’ prices, ignores the perceived value of the customer, and inefficient manufacturing.
Q5: How to apply cost-oriented pricing approach to your business?
A: To apply cost-oriented pricing approach to your business, you need to calculate your total costs, determine your desired profit margin, and set your price.
References:
https://zenodo.org/record/894118
https://www.yalelawjournal.org/note/amazons-antitrust-paradox
http://www.investopedia.com/terms/p/predatory-pricing.asp
http://www.opc.gouv.qc.ca/en/consumer/topic/price/en-prix-indique-en-magasin/absence/double-etiquetage/
https://hbr.org/2018/09/the-good-better-best-approach-to-pricing
https://priceva.com/blog/cost-based-pricing
https://www.wallstreetmojo.com/cost-based-pricing/
https://blog.hubspot.com/sales/cost-based-pricing
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