Cost based pricing, also known as cost plus pricing, is one of the simplest ways to set a selling price. We start with what a product or service costs us, add a markup and arrive at the price we charge the customer.

Simple does not automatically mean best. Cost plus pricing is popular because it is straightforward and easy to understand, but it also has limitations. If we focus only on our costs, we can ignore what customers value, what competitors charge and whether those costs should be challenged in the first place.

In this episode, we look at how cost based pricing works, how fixed and percentage markups are calculated, what the markup needs to cover, and the advantages and disadvantages of using this approach.

About this episode

Cost plus pricing has been used by manufacturers, retailers and other businesses for a long time.

The basic idea is easy to follow:

Cost + markup = selling price

However, the quality of the answer depends on the numbers we put into the calculation.

First, we need to understand what the product or service really costs. Then we need to decide what markup to add and what that markup is expected to achieve.

That is where cost based pricing becomes more interesting than simply adding a percentage to a number.

What does cost mean in cost based pricing?

Before we calculate a selling price, we need to decide what we mean by cost.

For a manufacturer, that can include direct materials, direct labour and other costs that vary with production.

There are also overheads to consider. These might include factory rent, machinery costs, supervision, quality control and other resources needed to keep the operation running.

Together, these give us a fuller picture of what it actually costs to produce an item.

For a retailer, the starting point may be the cost of buying the stock that will eventually be sold.

The principle is the same. We need a sensible cost figure before adding anything on top.

If the cost number is wrong, the selling price built from it will also be unreliable.

How does cost plus pricing work?

Using a fixed markup

One option is to add a fixed amount to the cost of each item.

In the episode, we start with the total profit we want to make and divide that by the expected number of units.

For example, if we want to make 100,000 of profit across 100 products, the required markup would be 1,000 per product.

That fixed markup is then added to the cost of each item to arrive at the selling price.

The basic calculation is:

Selling price = cost + fixed markup

Using a percentage markup

Another common approach is to add a percentage to cost.

Suppose a product costs 5,000 and we decide on a 20% markup.

The markup is 1,000, giving us a selling price of 6,000.

Another way to calculate that is:

5,000 × 1.20 = 6,000

Businesses may also use different markup percentages across different product groups rather than applying one percentage to everything.

That can be important because products do not necessarily have the same costs, demand, customer value or profit potential.

What does the markup need to cover?

The markup is not simply a reward added on top of cost.

It also needs to help support the wider business.

That can include delivery, IT, staff, sales, accounts, advertising, marketing and the amount you need to take from the business yourself.

So when we decide on a markup, the real question is whether the resulting selling price generates enough profit to support the business as a whole.

For a wider explanation of why that matters, see What Is Profit? Gross Profit and Net Profit Explained.

Advantages of cost based pricing

The biggest advantage is simplicity.

Cost plus pricing is easy to understand and relatively easy to calculate.

Most business owners can understand the idea of identifying a cost and adding something to it.

It also gives us a clear financial starting point. We know the selling price has been built from the underlying cost rather than chosen completely at random.

That simplicity helps explain why the method remains popular.

However, reliable does not necessarily mean it is the best pricing method for every situation.

Disadvantages of cost based pricing

It can stop us challenging our costs

One of the biggest weaknesses is that we may simply accept our existing cost base.

If last year’s costs are inefficient and we add a markup to them this year, the selling price simply carries those inefficiencies forward.

That can make the business uncompetitive.

We should remain cost conscious. That does not mean slashing and burning. It means asking whether we can work more efficiently, improve productivity and remove costs that do not add value.

Customers do not buy our costs

Customers are rarely interested in how much something cost us to make.

They are interested in whether it solves their problem, whether it is useful and whether it represents value for money.

That creates a weakness in cost based pricing because the calculation starts inside the business rather than with the customer or the market.

Our broader guide to Pricing Strategy: 6 Ways to Price Products and Services looks at how customer value, competitors and business objectives can influence the pricing method we choose.

A standard markup may leave profit behind

Using the same percentage across every product can also be restrictive.

Some products may support a higher markup. Others may operate in more competitive markets.

A uniform percentage ignores those differences.

So even if cost plus pricing is our starting point, we should still look at demand, customer value and the market before settling on the final selling price.

Working out overheads can be difficult

Another challenge is deciding how much overhead belongs to each product or service.

Rent, staff, equipment, software and other shared business costs do not always fit neatly into one product.

If those costs are allocated poorly, the cost figure behind the pricing decision may be misleading.

Cost based pricing versus target costing

Cost based pricing starts with the cost and works forward to the selling price.

There is another way to approach the same problem.

With target costing, we start with the price the market is prepared to accept and the profit we want to make. We then work backwards to find the cost the business can afford.

That makes the two methods useful contrasts.

Cost plus pricing asks:

What price do we need if this is what it costs us?

Target costing asks:

What can it afford to cost us if this is the price the market will accept?

Markup and margin are not the same thing

This is an important distinction.

Markup compares profit with cost.

Margin compares profit with selling price.

So even though the two are connected, the percentages are not interchangeable.

The basic relationships are:

Markup percentage = profit ÷ cost × 100

Profit margin percentage = profit ÷ selling price × 100

If you want to explore the relationship further, see our guide to Gross Profit Explained.

Use the free calculator

You do not have to do all the number crunching manually.

Our free profit and discount calculator can help you explore pricing, profit and discount scenarios using your own numbers.

Use it alongside a clear understanding of your costs, the profit you need and the market you are selling into.

FAQs

What is cost based pricing?

Cost based pricing starts with the cost of producing or providing a product or service and adds a markup to arrive at the selling price.

Is cost based pricing the same as cost plus pricing?

Yes. The terms are commonly used for the same basic approach: calculate the cost and then add an amount or percentage on top.

How do I calculate a percentage markup?

Multiply the cost by the markup percentage and add the result to the original cost. For example, a cost of 5,000 with a 20% markup produces a selling price of 6,000.

What are the advantages of cost based pricing?

It is straightforward, familiar and easy to calculate. It also provides a clear financial starting point for setting a selling price.

What are the disadvantages of cost based pricing?

It can encourage us to accept inefficient costs, ignore customer value and market conditions, and apply the same markup to products that may have very different profit opportunities.

What is the difference between markup and margin?

Markup measures profit against cost. Margin measures profit against selling price. They describe the same profit from two different financial perspectives.

Episode Timecodes

00:00 – What cost plus pricing means
01:44 – Understanding the cost behind the product
02:53 – Markup and the pricing calculator
03:14 – Calculating a fixed markup
04:24 – Using a percentage markup
06:42 – Problems with cost plus pricing
08:09 – Why the method remains popular
08:31 – The difference between markup and margin

Related episodes

Key takeaway

Cost based pricing is popular because it is simple.

Start with a reliable understanding of your costs. Then decide what markup you need and what that markup is expected to cover.

However, do not stop there.

Challenge your costs, understand what customers value and look at what is happening in the market. A price that works mathematically still needs to work commercially.

Most importantly, remember that markup and margin are different. Know which number you are using before making pricing and profit decisions.

Plan it, Do it, Profit.

Further Support

If you want to test the numbers behind your pricing decisions, use our free profit and discount calculator.

If you need help understanding your pricing, costs, profit or wider business numbers, you can contact us for an initial chat.

You can also watch more practical finance and business support on the I Hate Numbers YouTube channel, or listen and follow on Apple Podcasts.

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Cost Based Pricing Explained: How Cost Plus Pricing Works