Cost Based Pricing strategies
Importance of Costs in pricing
• Costs information indicates whether the product can be
made and sold profitably in any price.
• Apart from the production costs, costs for selling,
marketing, distribution and general administrative costs are
very adequate to determine the profitability of a project.
• The most commonly used method to set prices is the “cost
plus” and “mark up pricing” strategies.
• Cost for pricing must deal with the future.
Cost Classifications
• It is important to clarify what is meant by direct
and indirect:
– Directly traceable or attributable costs:
Cost that can be readily determined as contributing to
the product or service’s cost.
– Indirect traceable costs
Cost that can be objectively traced to a segment or
product categories.
Cost Classifications
• Common costs support a number of
activities or profit segments and cannot be
objectively traced to a product or segment
based on a direct physical relationship to
that product or segment
• Opportunity costs reflect the “cost” of
not choosing the best alternative or
opportunity
Cost Classifications
• Cash costs can lead to cash (or out-ofpocket) outlays or bookkeeping
(depreciation or amortization) entries
• Noncash costs do impact the cash flows but
do not reflect actual monetary outlays in a
particular accounting period
Cost Classifications
• How do costs vary with changes in activity rate?
• DIRECT VARIABLE COSTS:
– Vary directly with activity level;
– the major criterion of a direct variable cost is that it
be traceably and tangibly generated by, and
identified with a particular activity.
– E.g., raw materials, sales expenses, utilities.
Cost Classifications
• How do costs vary with changes in activity rate?
• SEMIVARIABLE COSTS:
– Costs that vary with activity rates, but are not zero at
a zero activity rate. These costs consist of a base
amount that is constant in relation to activity and a
variable amount that varies directly with activity.
– E. g., data processing, supplies, maintenance.
Cost Classifications
• How do costs vary with changes in activity rate?
• PERIOD FIXED COSTS:
– These costs do not vary with activity. They remain
fixed over a period of time due to previous decisions.
Some fixed costs may be traceable to specific
activities by reasonable objective means. Other fixed
costs are general and not easily traceable to an
activity.
Breakeven Concept
One Unit
10,000 units
$20
$200,000
Variable
costs
Fixed costs
16
160,000
2
20,000
Total costs
18
180,000
2
20,000
Sales
Profits
Breakeven Formulas
• Breakeven quantity:
BEQ  FC  [ P  VC]
•
•
•
•
where BEQ = break-even sales quantity
FC = fixed costs
P = selling price
VC = variable costs
BEQ  $20,000  [$20  16]
BEQ  5,000
Breakeven Formulas
• Breakeven sales revenue
BES  FC  PV
• where BES = break-even sales revenue
• FC = fixed costs
• PV = Profit-Volume Ratio:
PV  [ P  VC]  P
PV  [$20  16]  $20  0.20
BES  $20,000  0.20  $100,000
Break-Even Analysis
 A change in fixed costs affects only the breakeven point
 A change in the price and/or variable costs
affects both the break-even point and the PV
 An increase in prices and/or decrease in
variable costs can offset an increase in fixed
expenses (assuming volume remains
unaffected)
Limitations of Break-Even
Analysis
The assumption that variable costs remain
proportional to volume at all output levels
The assumption that price is constant over
relevant volume levels
Costs used the in the analysis may be
relevant over a limited range of volume
Cost-Plus Pricing (Mark up
pricing)
1. Cover costs




Material
Labor
Capital resources
Marketing
variable
costs
fixed costs
2. Mark-up
 Targeted return for shareholders
 Costs + mark-up = Sales price
$1.00 + $0.50 = $1.50 (50% markup)
Mark up price
MUP = UC/(1- ROS)
MUP = Mark up price
UC = Unit Cost
ROS = Expected return on sales
UC= VC + FC/ Unit sales(not dollars)
• Cost based pricing method does not take into consideration
supply/demand, or even market status.
• It is purely based on the cost of the production of the product
dollars per unit of final product (raw materials, manual
labour, etc..).
Target return pricing
TRP = UC + ( R x I)/ US
TRP = Target return price
UC = Unit cost
R = Expected return on investment
I = Invested capital
US = Unit sales expected
Pricing method whereby the selling price of a product is calculated to
produce a particular rate of return on investment for a specific volume
of production.
The target pricing method is used most often by public utilities, like
electric and gas companies, and companies whose capital investment
is high, like automobile manufacturers.