Cost-Based Pricing Methods
The Cost-Plus Foundation
Cost-based pricing starts from production costs and adds a margin to determine price. Despite significant limitations, cost-based methods remain widely used because they're simple to calculate and explain, they ensure cost recovery on each unit sold, they provide a defensible rationale for prices, and they require minimal market research.
However, cost-based methods have a fundamental flaw: they ignore the customer. A price calculated from costs bears no necessary relationship to what customers are willing to pay. You might underprice dramatically (leaving money on the table) or overprice dramatically (losing sales to competitors or customer indifference). Costs set floors, not optimal prices.
Use cost-based methods as a starting point and reality check, but never as a complete pricing solution.
Method 1: Markup Pricing
Markup pricing adds a standard percentage to cost. But 'markup' can mean two different things, and confusion between them is a common source of error.
Markup on Cost
Markup on cost expresses the margin as a percentage of cost:
Price = Cost × (1 + Markup%)
🔢 Markup on Cost Example
Your product costs $60 to produce. You want a 50% markup on cost.
Price = $60 × (1 + 0.50) = $60 × 1.50 = $90
Your margin is $30, which is 50% of your $60 cost.
Markup on Price (Margin)
Markup on price—also called margin or gross margin—expresses the margin as a percentage of the selling price:
Price = Cost ÷ (1 - Margin%)
🔢 Markup on Price (Margin) Example
Your product costs $60 to produce. You want a 40% margin (markup on price).
Price = $60 ÷ (1 - 0.40) = $60 ÷ 0.60 = $100
Your margin is $40, which is 40% of your $100 price.
Converting Between Markup and Margin
A common mistake is confusing these two measures. 50% markup on cost is NOT the same as 50% margin. Here's how to convert:
Margin% = Markup% ÷ (1 + Markup%)
Markup% = Margin% ÷ (1 - Margin%)
Markup on Cost
Equivalent Margin
Margin on Price
Equivalent Markup
25%
20%
20%
25%
33.3%
25%
25%
33.3%
50%
33.3%
33.3%
50%
100%
50%
50%
100%
Method 2: Cost-Plus Pricing
Cost-plus pricing allocates all costs—variable and fixed—to products, then adds a profit margin. This is common in government contracting, construction, and custom manufacturing where prices are explicitly tied to costs.
Price = Full Cost per Unit × (1 + Profit Margin%)
The challenge is determining 'full cost per unit.' Fixed costs must be allocated across units, and different allocation bases yield different unit costs—and therefore different prices. Common allocation approaches include dividing total fixed costs by expected unit sales, allocating based on direct labor hours, machine hours, or other activity measures, and using activity-based costing to trace costs more precisely.
🔢 Cost-Plus Example
Variable cost: $60/unit
Fixed costs: $300,000/year
Expected sales: 10,000 units
Target profit margin: 20%
Allocated fixed cost: $300,000 ÷ 10,000 = $30/unit
Full cost: $60 + $30 = $90/unit
Price: $90 × 1.20 = $108
Note the circularity problem: per-unit fixed cost depends on volume, but volume depends on price, which is what you're trying to determine. If you set price at $108 but only sell 8,000 units, your actual per-unit fixed cost was $37.50, not $30—and your realized margin was lower than planned.
Method 3: Target Return Pricing
Target return pricing sets price to achieve a specified return on investment. This explicitly incorporates capital requirements and return expectations.
Price = Unit Cost + (Target Return × Invested Capital) ÷ Expected Sales
🔢 Target Return Example
Unit cost: $50
Invested capital: $1,000,000
Target ROI: 15%
Expected sales: 50,000 units
Required return: $1,000,000 × 15% = $150,000
Return per unit: $150,000 ÷ 50,000 = $3.00
Target price: $50 + $3 = $53
At this price and volume, the company achieves its 15% return target.
Target return pricing is useful when capital investment is significant and return requirements are explicit—equipment manufacturers, facilities-intensive businesses, and regulated utilities often use this approach. But it shares the circularity problem: if volume doesn't meet expectations, actual returns will differ from targets.
Limitations of Cost-Based Methods
Cost-based methods have significant drawbacks that limit their usefulness:
- They ignore demand: Customers don't care what your costs are. A product that costs $100 to make isn't worth $120 to customers who can get the same value for $80 elsewhere.
- They create circular logic: Per-unit costs depend on volume, volume depends on price, but you're using costs to set price.
- They don't capture value: A product providing enormous customer value will be underpriced if costs are low. You leave money on the table.
- They provide no competitive insight: Prices are set without reference to alternatives customers face.
- They can encourage cost inefficiency: If profits are guaranteed as a percentage of costs, there's less incentive to control costs. Cost-based methods are most appropriate for commodity products where market prices anchor to industry costs, custom work where each project is unique and cost-plus is standard practice, government contracts that require cost-based pricing, and as a floor to ensure minimum profitability.
Key Takeaways
- Cost-based methods are simple and ensure cost recovery but ignore customer value and market realities
- Distinguish between markup on cost and margin on price—they're different calculations
- Target return pricing explicitly incorporates investment and return requirements
- Use cost-based methods as floors and reality checks, not as complete pricing solutions