How to Use Cost Oriented Pricing Strategy for Your Business
Cost oriented pricing strategy is a method of setting the price of a product or service based on the cost of producing it, plus a markup for profit. This strategy is popular among manufacturing companies, as it ensures that they cover their expenses and earn a reasonable return. In this article, we will explain what cost oriented pricing strategy is, how to calculate it, and what are its benefits and drawbacks. We will also provide some examples of cost oriented pricing strategy in action, and answer some frequently asked questions about this topic.
Key Takeaways
Here are the main points to remember about cost oriented pricing strategy:
Cost oriented pricing strategy is a method of setting the price of a product or service based on the cost of producing it, plus a markup for profit.
There are two types of cost oriented pricing strategy: cost-plus pricing and markup pricing.
Cost oriented pricing strategy ensures that you cover your production costs and earn a steady profit, but it also has some drawbacks, such as ignoring the demand and value of your product or service in the market, and not considering the prices and strategies of your competitors.
To use cost oriented pricing strategy effectively, you need to do your market research, monitor your competitors, optimize your production processes, and communicate your pricing strategy to your customers.
What is Cost Oriented Pricing Strategy?
Cost oriented pricing strategy is a pricing method that takes into account the total cost of producing a product or service, and adds a percentage or a fixed amount of profit to it. The total cost includes the variable costs (such as materials, labor, and utilities) and the fixed costs (such as rent, depreciation, and salaries) that are incurred in the production process. The profit margin can be determined by the company based on its target return on investment, market conditions, or industry standards.
There are two main types of cost oriented pricing strategy: cost-plus pricing and markup pricing. Cost-plus pricing is when the company adds a percentage of the total cost as profit to the selling price. For example, if the total cost of producing a product is $100 and the company wants to earn 20% profit, the selling price will be $120 ($100 + 20% of $100). Markup pricing is when the company adds a percentage of the variable cost as profit to the selling price. For example, if the variable cost of producing a product is $80 and the company wants to earn 50% markup, the selling price will be $120 ($80 + 50% of $80).
How to Calculate Cost Oriented Pricing Strategy?
To calculate cost oriented pricing strategy, you need to follow these steps:
- Identify the variable costs and fixed costs of producing one unit of your product or service. Variable costs are those that change with the level of output, such as materials, labor, and utilities. Fixed costs are those that remain constant regardless of the level of output, such as rent, depreciation, and salaries.
- Add up the variable costs and fixed costs to get the total cost per unit.
- Decide on your desired profit margin or markup percentage. This can be based on your target return on investment, market conditions, or industry standards.
- Multiply the total cost per unit by (1 + profit margin) if you are using cost-plus pricing, or multiply the variable cost per unit by (1 + markup percentage) if you are using markup pricing.
- The result is your selling price per unit.
For example, suppose you are producing a widget that has a variable cost of $10 and a fixed cost of $5 per unit. You want to use a cost-plus pricing strategy with a 25% profit margin. Here is how you would calculate your selling price:
- Total cost per unit = Variable cost + Fixed cost = $10 + $5 = $15
- Profit margin = 25%
- Selling price per unit = Total cost per unit x (1 + Profit margin) = $15 x (1 + 0.25) = $18.75
Benefits of Cost Oriented Pricing Strategy
Some of the benefits of using cost oriented pricing strategy are:
- It ensures that you cover your production costs and earn a steady profit.
- It is easy to understand and implement, as it only requires basic accounting information.
- It allows you to adjust your prices according to changes in your costs or your desired profit margin.
- It can help you compete on price with other companies that use similar pricing methods.
Drawbacks of Cost Oriented Pricing Strategy
Some of the drawbacks of using cost oriented pricing strategy are:
- It ignores the demand and value of your product or service in the market, which can lead to overpricing or underpricing.
- It does not consider the prices and strategies of your competitors, which can affect your market share and profitability.
- It may encourage inefficient production practices, as it does not incentivize you to reduce your costs or improve your quality.
- It may not reflect your brand image or positioning, as it does not differentiate your product or service from others.
Cost Oriented Pricing Strategy Examples
Here are some examples of companies that use cost oriented pricing strategy:
Everlane
Everlane is an online clothing retailer that uses a transparent cost-plus pricing strategy. It shows its customers how much it costs to produce each item, including materials, labor, transportation, and duties. It then adds a fixed markup to calculate its selling price. For example, a cashmere sweater that costs $42 to make sells for $100 on its website.
Walmart
Walmart is a retail giant that uses a markup pricing strategy. It buys products from suppliers at low prices, and adds a small markup to sell them at competitive prices. For example, a pack of batteries that costs $1.50 to buy from a supplier sells for $1.97 at Walmart.
Starbucks
Starbucks is a coffee chain that uses a cost-plus pricing strategy. It calculates the cost of each drink, including the ingredients, labor, overhead, and taxes. It then adds a profit margin to determine its selling price. For example, a latte that costs $1.40 to make sells for $3.65 at Starbucks.
Tips
Here are some tips for using cost oriented pricing strategy effectively:
- Do your market research to understand the demand and value of your product or service, and adjust your prices accordingly.
- Monitor your competitors’ prices and strategies, and differentiate your product or service from theirs.
- Optimize your production processes to reduce your costs and improve your quality.
- Communicate your pricing strategy to your customers, and highlight the benefits and value of your product or service.
Cost-Oriented Pricing Strategy and Global Demand
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. There are two main types of cost-oriented pricing: cost-plus pricing and break-even pricing. Cost-plus pricing adds a fixed percentage of the total cost as a profit margin, while break-even pricing sets the price to cover the total cost and achieve a target profit.
Cost-oriented pricing is one of the most widely used approaches because it takes into account limited and clear variables, such as production, shipping, and selling costs. It also ensures a consistent profit margin and easy implementation. However, it also has some drawbacks, such as ignoring the competitors’ prices, the customers’ perceived value, and the market demand.
Global demand
Global demand is the total amount of goods and services that consumers around the world want to buy. Global demand is influenced by many factors, such as income levels, preferences, prices, exchange rates, and economic conditions. Global demand can affect the profitability and sustainability of cost-oriented pricing strategies.
For example, if global demand for a product increases due to higher income levels or preferences, a cost-oriented pricing strategy may not capture the full potential of the market. The company may be underpricing its product and leaving money on the table. On the other hand, if global demand for a product decreases due to lower income levels or preferences, a cost-oriented pricing strategy may not adjust to the changing market conditions. The company may be overpricing its product and losing customers to competitors.
Therefore, cost-oriented pricing strategies should be used with caution and flexibility when dealing with global demand fluctuations. Companies should monitor the market trends and customer feedback regularly and adjust their prices accordingly. They should also consider other pricing strategies, such as value-based pricing or competition-based pricing, that take into account the customers’ willingness to pay and the competitors’ actions.
Frequently Asked Questions
Q1: How is a cost oriented price calculated?
A cost oriented price is calculated by adding a percentage or a fixed amount of profit to the total cost of producing a product or service.
Q2: What is usually the first step in cost oriented pricing?
The first step in cost oriented pricing is to identify the variable costs and fixed costs of producing one unit of your product or service.
Q3: What are the limitations of a cost oriented pricing strategy?
The limitations of a cost oriented pricing strategy are that it ignores the demand and value of your product or service in the market, it does not consider the prices and strategies of your competitors, it may encourage inefficient production practices, and it may not reflect your brand image or positioning.
References:
https://hbswk.hbs.edu/item/is-performance-based-pricing-the-right-price-for-you
https://priceva.com/blog/cost-based-pricing
https://blog.hubspot.com/sales/cost-based-pricing
https://ceopedia.org/index.php/Cost_oriented_pricing
https://www.masterclass.com/articles/cost-based-pricing
https://priceva.com/blog/cost-based-pricing
https://blog.hubspot.com/sales/cost-based-pricing
https://ceopedia.org/index.php/Cost_oriented_pricing
https://www.masterclass.com/articles/cost-based-pricing
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