Examples, definitions and strategies for cost-based pricing.
Whereas customer-value perceptions set the price ceiling, costs set the floor for the price that the company can charge. Cost-based pricing involves setting prices based on the costs for producing, distributing and selling the product plus a fair rate of return for its effort and risk. A company’s costs may be an important element in its pricing strategy.
Some companies, such as Ryanair and Walmart, work to become the ‘low-cost producers’ in their industries. Companies with lower costs can set lower prices that result in smaller margins but greater sales and profits. However, other companies – such as Apple, BMW and Steinway – intentionally generate higher costs so that they can claim higher prices and margins. For example, it costs more to make a ‘handcrafted’ Steinway piano than a Yamaha production model. But the higher costs result in higher quality, justifying that eye-popping €50,000 price. The key is to manage the spread between costs and prices – how much the company makes for the customer value it delivers.
Types of costs
A company’s costs take two forms: fixed and variable. Fixed costs (also known as overheads) are costs that do not vary with production or sales level. For example, a company must pay each months bills for rent, heat, interest and executive salaries – whatever the company’s output. Variable costs vary directly with the level of production. Each PC produced by HP involves a cost of computer chips, wires, plastic, packaging and other inputs. Although these costs tend to be the same for each unit produced, they are called variable costs because the total varies with the number of units produced. Total costs are the sum of the fixed and variable costs for any given level of production. Management wants to charge a price that will at least cover the total production costs at a given level of production.
The company must watch its costs carefully. If it costs the company more than its competitors to produce and sell a similar product, the company will need to charge a higher price or make less profit, putting it at a competitive disadvantage.
Costs at different levels of production
To price wisely, management needs to know how its costs vary with different levels of production. For example, suppose Nokia built a plant to produce 1,000 mobile phones per day. The image below shows the typical short-run average cost curve (SRAC).
It shows that the cost per mobile phone is high if Nokia’s factory produces only a few per day. But as production moves up to 1,000 mobile phones per day, the average cost per unit decreases. This is because fixed costs are spread over more units, with each one bearing a smaller share of the fixed cost. Nokia can try to produce more than 1,000 mobile phones per day, but average costs will increase because the plant becomes inefficient. Workers have to wait for machines, the machines break down more often and workers get in each other’s way.
If Nokia believed it could sell 2,000 mobile phones a day, it should consider building a larger plant. The plant would use more efficient machinery and work arrangements. Also, the unit cost of producing 2,000 mobile phones per day would be lower than the unit cost of producing 1,000 units per day, as shown in the long-run average cost (LRAC) curve.
In fact, a 3,000-capacity plant would be even more efficient. But a 4,000-daily production plant would be less efficient because of increasing dis-economies of scale – too many workers to manage paperwork slowing things down, and so on. A 3,000-daily production plant is the best size to build if demand is strong enough to support this level of production.
Costs as a function of production experience
Suppose Nokia operates a plant that produces 3,000 mobile phones per day. As Nokia gains experience in producing mobile phones, it learns how to do it better. Workers learn shortcuts and become more familiar with their equipment.
With practice, the work becomes better organised, and Nokia finds better equipment and production processes. With high volumes, Nokia becomes more efficient and gains economies of scale. As a result, the average cost tends to decrease with accumulated production experience.
Thus, the average cost of producing the first 100,000 phones is Thus, the average cost of producing the first 100,000 phones is €10 per phone. When the company has produced the first 200,000 mobile phones, the average cost has fallen to €8.50. After its accumulated production experience doubles again to 400,000, the average cost is €7. This drop in the average cost with accumulated production experience is called the experience curve (or the learning curve).
If a downward-sloping experience curve exists, this is highly significant for the business. Not only will the business’ unit production cost decrease, but it will decrease faster if the company creates and sells more during a given time period. But the market has to stand ready to buy the higher output. And to take advantage of the experience curve, Nokia must get a large market share early in the product’s life cycle. This suggests the following pricing strategy: Nokia should price its mobile phones low; its sales will then increase and its costs will decrease through gaining more experience – and then it can lower its prices further.
Some companies have built successful strategies around the experience curve. However, a single. minded focus on reducing costs and exploiting the experience curve will not always work. Experience curve pricing carries some major risks. The aggressive pricing might give the product a cheap image. The strategy also assumes that competitors are weak and not willing to fight it out by meeting the company s price cuts. Finally, while the company is building volume under one technology, a competitor may find a lower-cost technology that lets it start at prices lower than those of the market leader, who still operates on the old experience curve.
The simplest pricing method is cost-plus pricing (or mark-up pricing) – adding a standard mark. up to the cost of the product For example, construction companies will submit job bids by estimating the total project cost and adding a standard mark-up for profit. Lawyers, accountants and other professionals typically price by adding a standard mark-up to their costs. Some sellers tell their customers they will charge cost plus a specified mark-up; for example, aerospace companies often price this way for governments.
Then the manufacturer’s cost per toaster is given by the following:
Now suppose the manufacturer wants to earn a 20 per cent mark-up on sales. The manufacturer’s mark-up price is given by the following:
The manufacturer would charge dealers €20 per toaster and make a profit of €4 per unit. The dealers, in turn, will mark up the toaster. If dealers want to earn 50 per cent on the sales price, they will mark up the toaster to €40 (€20 + 50% of €40). This number is equivalent to a mark-up on cost of 100 per cent (€20/€20).
Does using standard mark-ups to set prices make sense? Generally, no. Any pricing method that ignores demand and competitor prices is not likely to lead to the best price. Still, mark-up pricing remains popular for many reasons. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing; they do not need to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar, so price competition is minimised. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers earn a fair return on their investment but do not take advantage of buyers when buyers’ demand becomes great.
Break-even analysis and target profit pricing
An alternative cost-oriented pricing approach is break-even pricing (or a variation called target return pricing) (see Figure 1.0 below). The firm tries to determine the price at which it will break even or make the target return it is seeking.
Target return pricing uses the concept of a break-even chart, which shows the total cost and total revenue expected at different sales volume levels. Figure 1.0 shows a break-even chart for the toaster manufacturer discussed above. Fixed costs are €300,000 regardless of sales volume. Variable costs are added to fixed costs to form total costs, which rise with volume. The total revenue curve starts at zero and rises with each unit sold. The slope of the total revenue curve reflects the price of €20 per unit.
The total revenue and total cost curves cross at 30,000 units. This is the break-even volume. At €20, the company must sell at least 30,000 units to break even, that is, for total revenue to cover total cost. Break-even volume can be calculated using the following formula:
If the company wants to make a profit, it must sell more than 30,000 units at €20 each. Suppose the toaster manufacturer has invested €1,000,000 in the business and wants to set a price to earn a 20 per cent return, or €200,000. In that case, it must sell at least 50,000 units at €20 each. If the company charges a higher price, it will not need to sell as many toasters to achieve its target return. But the market may not buy even this lower volume at the higher price. Much depends on price elasticity and competitors’ prices.
The manufacturer should consider different prices and estimate break-even volumes, probable demand and profits for each. This is done in Table 2.0 below.
The table shows that as price increases, the break-even volume drops (column 2). But as price increases, the demand for toasters also decreases (column 3). At the €14 price, because the manufacturer clears only €4 per toaster (€14 less €10 in variable costs), it must sell a very high volume to break even. Even though the low price attracts many buyers, demand still falls below the high break-even point, and the manufacturer loses money. At the other extreme, with a €22 price, the manufacturer clears €12 per toaster and must sell only 25,000 units to break even. But at this high price, consumers buy too few toasters, and profits are negative. The table shows that a price of €18 yields the highest profits. Note that none of the prices produce the manufacturer’s target return of €200,000. To achieve this return, the manufacturer will have to search for ways to lower the fixed or variable costs, thus lowering the break-even volume.