Cost-based pricing means that the price is set based on the organization’s costs for 1) development, 2) production and 3) distribution of the product,. And 4) its administration. Plus, a reasonable profit margin.
In text books, two costing methods are typically suggested. Full costing that takes all resource consumption into consideration. It is used for long-term decision making, to make sure that all resource consumption is funded. Most often full costing is based on direct costs for material and labor, and an (almost) arbitrary allocation of fixed and variable overhead costs. The estimated cost for developing, producing and delivering a product marks the lowest possible price the company can charge for the product, if it wants to survive in the long run. Contribution costing, on the other hand, is used in short-term decision making to see how high the incremental costs are in a specific deal. It is called contribution, since the difference between the price and the incremental cost, yields a margin that contributes to funding the fixed costs. Contribution costing indicates the lowest possible price when offering a product on the margin.
Among consultants and in pricing literature cost-based pricing is often considered old-fashioned or even misleading. The price should not be based on costs, but rather what the customer is prepared to pay. Preferably, willingness to pay should correlate with the value of the product to the customer.
Cost-based pricing can still be relevant
Yet, costs are still important. In the long run it is important that the price is not set lower than the full cost. If that is true for all products in the portfolio, the company will eventually run into bankruptcy. Hence, costing is still important, even though the actual price level should also be affected by other factors than that.
Also, there are many markets where cost-based pricing is still the norm or even mandated. When selling within corporations or network organizations, the parties may have decided to use cost-based prices internally to reduce the “air” (i.e. layers of margins) in the forecasts. The upstream suppliers in the value stream charge for their full costs, while the market-facing entity that is closest to the customer sets a price that is based on the customer’s willingness to pay. Hence, the true profit arises in the final step in this value stream. All partners in the value stream, that do not meet the customer, will use a cost-based price. Also, in more regulated “markets”, cost-based pricing may be mandated (for example when the public sector is charging for services). One such example is pricing of public water and waste management services, where very advanced full costing models are used to calculate the correct cost per year (the cost per year is difficult to calculate since the lifetime of a sewage system is very long, sometimes more than 100 years, and may need unplanned and urgent maintenance depending on how it is constructed).
In summary; despite consultants’ and pricing literature’s advice to avoid costs as a basis for pricing, we argue that there are several situations when it is important to “know what it costs” and that it sometimes even may be reasonable to set the price based on the costs.