Boost Your Bottom Line: Expert Tips for Cost-Based Pricing

Katherine Hatter
Oct 20, 2023
8 min read

Updated: Jan 3, 2024

Welcome to part two of our series: "Tuning Your Pricing Strategy: A 5-Part Guide." This series aims to provide you with a roadmap of pricing strategies and examples to develop optimal pricing.

If you missed it, check out part 1, which includes:

Top 10 reasons to tune your pricing strategy
Parallels between pricing activities and arcade game, Whac-A-Mole
Definitions of foundational pricing terms
Recommended homework to identify what pricing models you should build

colorful map explaining each part of 5 part pricing series; this article is #2 in series and focuses on "cost-based pricing" — Currently, we're at #2 on roadmap of series, "How to Win the Pricing Strategy Game"

Managing Costs is Important (Although Customers Don’t Care)

While customers mainly focus on your value compared to other competitors, it's critical to keep your expenses in check. Why? Costs have a direct impact on your profitability, which in turn impacts your organization's ability to deliver value – both in the short and long term. Later this series, we'll drill into the many ways value can be delivered when we examine pricing strategies related to customer value and competitors.

You might wonder why the first pricing strategy that we're diving into during this series is cost based pricing. Well, here are a couple reasons:

It is a critical pricing strategy to evaluate, because if you are losing money while selling products/services, your organization's sustainability is probably uncertain.
Cost based pricing is one of the most straightforward pricing strategies.
Competitors with a cost structure that results in more profit have an advantage in making strategic investments.

A Guide to Analyzing Cost-Based Pricing

This article discusses how to analyze cost based pricing using examples throughout. While service-oriented companies (such as consulting firms) and businesses with narrow profit margins (like restaurants) rely heavily on this pricing approach, it is crucial for all organizations to gain a complete understanding of costs and profits by product/service.

Next, take a moment to review the image below, which depicts cost challenges in classic arcade game "Whac-A-Mole" format. Then, consider the following questions:

What moles has your organization faced recently that have challenged its cost structure?
Does your organization have a clear understanding of its current cost economics regarding products/services and customers compared to sales revenue?

Whac-a-Mole game format explaining cost challenges such as "technology investments"

My Cost-Based Pricing Credentials & Commitment to Making This Topic Graspable

As a CPA with dual majors in finance and accounting and over two decades of experience in company finance, I’m confident that I can contribute useful insights on a topic that many find daunting. While this topic is heavy on math, I strive to simplify complicated concepts so everyone can follow along. Even a brief look through these concepts can be helpful. (If you prefer to skip this article for now, don't worry, you can subscribe to our series so you don't miss out on anything.)

Subscribe to Series

Key Cost-Based Pricing Objectives & Metrics

The "cost-based pricing" strategy involves determining the cost of a product or service and then adding a markup to that cost to arrive at a sales price. While this may seem simple, the intricacies of this approach get tricky!

The main objective of cost-based pricing is to ensure that the selling price of a product or service covers all costs associated with it, both variable and fixed, while also generating a reasonable profit margin. Here are some further details:

Cover all costs: This includes direct costs such as materials (i.e. coffee for cup of cold brew) and labor (i.e. barista ) as well as indirect costs such as marketing (i.e. paid social media campaigns) or back office technology.
Achieve a reasonable profit margin: While covering all costs is important, an organization also needs to actually make a profit to sustain itself; cost-based pricing aims to mark up the total cost to achieve a reasonable profit margin.

two sided scale with prompt, "$ price vs cost?" related to cost based pricing

The Power of Cost-Based Pricing: A Guide to Analysis

Costs can vary drastically, even if two companies sell the exact same product; this may be due to differences in automation levels, geographic location, etc. For example, one company may produce furniture using robotic automation, while another may rely on manual labor resulting in higher variable costs. The same concept relates to fixed costs where one company pays for office rent in Manhattan and the other doesn't have a corporate office. Let’s run through a simple example of cost-based pricing analysis and key metrics, starting with paragraph format and followed by spreadsheet format...

Gross Profit Metrics: Basic Example

If a company generates $1 million in revenue and incurs $700,000 in direct costs to produce and sell products (also referred to as “cost of goods sold”), it would result in $300,000 of gross profit; gross margin % would be: $300,000 Gross Profit/ $1,000,000 Revenue = 0.3 or 30%, meaning that for every $1 of revenue, the organization keeps $0.30 as gross profit after accounting for cost of goods sold.

Net Profit Metrics: Basic Example

If this company has $200,000 in indirect expenses, Net Profit is calculated as $300,000 Gross Profit minus $200,000 Indirect Expenses = $100,000 Net Profit; Net profit margin is $100,000 Net Profit / $1,000,000 Revenue = 10%, meaning for every $1 of revenue the organization generated, they keep $0.10 as net profit after all costs.

table that demonstrates key financial metrics related to example described in text

If these costs spiraled out of control (i.e. supply chain challenges) or sales volume was significantly reduced by 75% (i.e. harsh new competition), the organization may face negative margins.

Key Questions for Cost-based Pricing Analysis

Before we jump into a more nuanced example to develop a deeper understanding of how actual cost items drive the aforementioned key metrics, below are some key questions for us to consider:

cost based pricing checklist asking about profitability, opportunities to reduce costs, overhead allocations, breakeven and pricing strategy

Cost-Based Pricing Example: Selling Cheesecake at Pop-Up Market

Let's consider the following scenario. I make cheesecakes and stumble across an opportunity to market them at a pop up event. For simplicity, let’s assume: -location does not have sales tax -transportation is not needed (everything is walkable in the neighborhood)

Below are the main steps related to cost-based pricing analysis:

Calculate all costs associated with producing the product or service, including materials and overhead expenses. (This is extremely important and tedious, so we break it down into many steps.)
Determine desired profit & determine selling price profit decisions may be highly discretionary. Simply, add desired profit to the total cost per unit.

Guidance: When doing pricing analysis, it's important to document all assumptions. For example, eggs may be a critical ingredient and a dynamic cost (i.e. $4 this week and $5 the next week) which then requires frequent tracking.

Let's dive into calculating all the cheesecake example costs and corresponding pricing...

Step 1A: Identify cost drivers. First, list ALL cost drivers to help determine the cost basis for products/services.

Guidance: In this brainstorming exercise, you should lean towards including every item; you can always decide it is not significant later.

Cheese cake pop up cost drivers are listed below and illustrated in the image below:

pop up booth
cheesecake ingredients (i.e. cream cheese, eggs, sugar, vanilla, crust)
packaging for cheesecakes
energy to bake cheesecakes (i.e. oven)
energy to cool ingredients and cheesecakes (i.e. refrigerator)
labor (we're not sure what's required yet)
other (anything else that we might have missed)

bucket with all the cost drivers already listed as text related to the cheesecake cost based pricing example

Step 1B: Determine if each cost is fixed, variable or TBD (to be determined).Take each cost driver from step 1A and determine if it is fixed or variable, so we can eventually perform cost-based pricing calculations.

Guidance: Reference the “cost drivers” visual below and drop each cost driver into the appropriate cost bucket: fixed cost, variable cost, OR TBD.

bucket where all the cost drivers already listed for cheesecake cost based pricing example are categorized as a variable cost, fixed cost, or TBD (to be determined)

You'll note that the pop up booth is categorized as a fixed cost. It does not matter if we sell all the cheesecakes or none, it is still $250. We are uncertain about our human capital needs yet, so that is categorized as TBD.

Step 1C: Decide the specific product(s) or service(s) to allocate costs across.

Guidance: Are we selling a single product or multiple products/services? If more than one, then cost allocations will likely differ for each one and therefore costs (and price) should be calculated separately for each product/service.

Obviously, I am selling cheesecake, but we need to decide the size, shape, and flavors to figure out economics per unit sold. To start, we keep our product simple, it's a 9 inch diameter round plain cheesecake.

plain round cheesecake with crust exemplifies that product for the cheesecake cost based pricing example

Step 1D: Lay out your cost pools for variable cost drivers and underlying actual or estimated costs. This is key to start understanding your variable cost structure.

The first obvious cost pool is “ingredients” for each cheesecake, which will be assigned to units produced (number of cheesecakes) as the cost driver. We need to determine actual or estimated amounts for each ingredient and find a source for quick cost data.

Guidance: Try to draft initial cost estimates quickly to see what “ballpark” you might be in; then, you can fine-tune underlying assumptions.

table shows ingredient quantities and costs related to cheesecake example, including total raw material costs per cheesecake produced

Next, we consider costs associated with running the oven. It takes 45 minutes to bake each cheesecake. Looking at our gas oven, we can bake at least 6 cheesecakes simultaneously. From google.com, we learn that running a gas oven at 350 degrees costs between $0.10 and $0.23/hour. This cost data results in the calculations below:

table captures unit cost for using oven to produce cheesecakes and how that contributes to variable costs per unit

We think about other variable cost drivers:

Let's ask customers to bring their own bags to mitigate costs (plus our area has a "bag tax").
The cheapest and easiest way to build capacity for cooling ingredients and cheesecakes is to borrow coolers and using ice packs on hand, resulting in $0 costs.

To summarize, variable costs per unit total $9.95 (Calculated as $9.92 for ingredients and $0.03 to run the oven.)

Step 1E: Lay out cost pools for fixed cost drivers and corresponding actual or estimated costs to calculate unit cost economics.

Guidance: Although there is a lot of judgment in fixed cost allocation methods, it’s important to be thoughtful, fair and accurate to make informed decisions about pricing.

Thankfully, our only fixed cost is the $250 pop up booth. We start thinking about how many total units to produce so we can allocate this cost over the # of cheesecakes. To ensure the cheesecakes are fresh, we are only baking for one day for up to 8 hours. Based on this, below are a couple scenarios related to total cheesecake volumes and spreading the $250 of fixed costs:

table captures different cheesecake production levels and how each impacts total cost per unit

If I only produce 32 units, the fixed cost allocations drive up total cost per unit to $17.86 However, with 64 units, we enjoy lower total costs per unit of $13.86. By allocating fixed costs across more units, we have more opportunity to make a decent profit per unit, so we decide to make 64 units.

I haven't factored in my labor yet; however, I estimate that I spend a total of 20 hours between planning and attending the pop up, shopping and baking/distributing. For this event, I will not need any additional labor.

Step 2: Determine desired profit & selling price

If we price the 64 cheesecakes at $25/unit and sell out, I get $713; at $20/unit, we only make $393 (reference table below).

table demonstrates different prices and resulting profitability

I decide that I want $500 profit for my time and want to reduce the risk of leftover cheesecakes by offering a fair price. So, I figure out the selling price to hit that $500 profit target, which is $21.67 for the 64 units, calculated as follows:

Variable cost $9.95/unit times 64 units equals $636.80
Plus fixed costs of $250.00
Equals total costs of $886.80
Add $886.80 total costs plus $500 target profit to get $1,386.80 sales revenue needed
$1386.80 revenue divided by 64 units results in $21.67 price per unit

We can use a formula similar to what is above to calculate what price would result in breakeven (profit of $0) for 64 units.

Are There Opportunities to Reduce Cost Structure?

We can consider:

Shifting from name brand to store brand for sugar, vanilla, and cream cheese
Looking for other vendors for crust because even the store brand is pricey

Important Odds & Ends

Let's briefly touch on a couple items that we didn't cover yet:

If you have staff, it is essential to calculate fully loaded costs (i.e. gross pay plus payroll taxes and benefits) to make sure you are not understating costs and overstating profitability.
Regularly consult with a tax-specialized CPA to avoid unexpected surprises when it comes to tax matters. (Taxes are always changing!)

Where Do We Go From Here?

For your organization’s pricing models (identified in series #1 homework), try to work through a cost analysis process similar to the cheesecake example and work through the checklist questions.
Guidance: Start with the simpler pricing model first to gain momentum and hit the ground running. For example, with the recreational client referenced in the prior article, we started with the food pricing strategy and model, because it was simpler than lodging, which ranged from a tent to an elaborate lodge and involved more cost drivers and complex allocation calculations.
If you have time, talk to your accounting/finance team or other coworkers to make sure you think of all costs; otherwise, you may underestimate your actual costs and therefore overstate your product's profitability.
Look for the next article (#3) in this series, where we focus on value based pricing, which includes understanding customer’s willingness to pay, which will be entirely different than cost.