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

• Pricing Strategy: 6 Ways to Price Products and Services
• How to Price Using Target Costing
• Gross Profit Explained

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 plus pricing is one of the oldest and most reliable methods of pricing that manufacturers and retailers have used. And my reliable, reliable doesn't necessarily mean it's the best one, but it's the one that most manufacturers and most retailers can identify. You take the cost of your product, add something to that product, what we call a markup, and thereby you arrive at the selling price.

If you happen to be VAT registered or registered for sales taxes, add on the relevant amount to cover that sales tax off VAT, and that becomes the price to your customer. Now, in this week's podcast, I'm gonna be looking in more detail what cost plus pricing is, how we go about applying a markup and how we calculate that markup percentage and the merits as well as the weaknesses of

cost plus pricing. You are listening to the I Hate Numbers Podcast with Mahmood Reza. The I Hate Numbers Podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now here's your host, Mahmood Reza.

Hi folks. My name is Mahmood. I'm an accountant and business finance coach, and I've been running my businesses, I Hate Numbers for over 27 years, and in those 27 years, I've helped thousands of business owners not only make more profit in their businesses, not only increase their financial awareness, but also to win those battles that goes on between their ears, which we all have experience of, to save time,

to save tax and have the businesses that are an aspiration for all of us. Let's crack on with the podcast. Now, cost plus pricing, the first thing we need to focus on is what we mean by cost. Now, if your company was a manufacturer and making, let's say dresses, then the cost of each dress that you manufacture will be made up of the direct material costs, the direct labor, and the variable overhead.

Let's assume that's $10. And then also we have to work out what is the overhead cost for each unit as well. And that overhead, by the way, will be typically things like the rent on the factory area, the depreciation of the machinery, any supervisory cost, there might be any quality inspection. And let's assume that the cost for that is also $10.

So together, the full cost of the manufacturer of each dress is $20. A similar process would apply to a retailer. The stock they buy in, the price they pay for that item of stock is their full cost. Now the next thing we do, having got that basis of cost, we then add something to that, hence the phrase cost plus.

And what this requires us to do is to identify a markup. Now to identify a markup, and if you're thinking like, gosh, there's more mass, more number crunching to be done, fair, not, there'll be a link in the show notes here to a product pricing calculator free to use, where you can just type in your numbers, add in a desired markup and it'll work out the selling prices for you.

So the calculator is really powerful and I'd recommend you check it out. So remember, check out the show notes. The link will be in there. So let's look at how we calculate fixed markups. Now to figure out the markup for cost plus pricing, we look at the total profit that we require, that we desire, and we divide it by the volume, the number of items being produced.

So let's say in our fictional example, we want to earn a hundred thousand dollars on making a hundred electrical cars. Let's call these electrical cars, electric. That's really quite an original name. So what we've got, we look at the level of profit that we wish to earn, which is a hundred thousand. We look at the number of items that we are producing, and in this example, it was a hundred.

Therefore, the markup is a thousand dollars per item. So each product that we make, we add a thousand dollars to the cost to give us the sales price. And that's as simple as that. Take the cost of the item and the desired profit figure that we wish, and those two figures together become the selling price. Now, as a footnote, if you are registered for sales taxes and your clients, your customers are consumers, they will also have to pay the V A T.

So typically we're gonna add the V A T and make that a VAT inclusive price. If your customers are not VAT registered, or more importantly if they are businesses and you are VAT registered, then you can quote the selling price without the VAT being included. Alternatively, you might wish to set a cost plus percentage. Quite common that companies, instead of adding a dollar figure, a sterling figure or a currency figure to the cost will add a percentage to it as well.

Now, in the same principle, we figure out the percentage we'd like to apply, and the good thing is by the way, we may have categories of products and we can apply different percentages to each one. I've seen many businesses apply a uniform percentage across the board and bear with me as we explain why that may be a hinderance

to maximizing the profit that you make in your business. So let's assume our desired profit percentage, our markup percentage is a cool 20%. Now, in our fixed products that we're making, our electrical vehicle, let's assume our desired markup is 20%. So if the product costs, let's say, $5,000, we take 20% of that, that gives us a thousand, and that's a thousand dollars

we add to it as well. If you want it as a calculation, and remember, you've got the online tool that's there for your disposal. You go 5,000 times 1.2, and that gives you $6,000. That's the price. Now a question to consider here is what's that markup for? Well, that markup is not only making a profit over the cost of manufacturing or the cost of buying in that goes towards covering all the additional resources, all the additional overheads we have in our business.

So we will have cost of delivery, we'll have an IT function, perhaps, we'll have the cost of our other staff members, our sales team, our accounts team. Let's not forget the accounts team. You'll have advertising, marketing. You are required to draw a salary and some reward out the company for yourself. So that markup has to cover all of those elements.

Now, you may see some flaws already in this approach here, and I'm going to reinforce those in a few moments. So we talked about what cost plus pricing is. We talked about deciding which cost that we adopt. We've talked about fixed markups, expressed in currency, in dollars, in sterling, we've talked about percentages being used

instead, either of them have their merits. Now let's consider the problems. The problems are of cost plus pricing is, there is no incentive to challenge the cost. You take the cost of what you're doing, you may have costs that are built up from the previous year. You just add a a certain percentage to it, and what you may find is that you become uncompetitive.

Customers don't really care what things cost you to make or to provide. They're interested in does it have utility, does it solve a problem, and is it value for money? The danger in adding percentages, cost plus pricing is that you could become uneconomic. You could become uncompetitive, and also there is no incentive to challenge

and to re-look at your cost base, I'm a big fan of challenging costs. Not to a jewel necessarily, but actually saying, these are my costs. Can I be more efficient? Are there opportunities to reduce non-value added items from there? And we always should be cost conscious, not slashing and burning, but making sure that where we can, we've got productivity being built in,

we've got efficiency and we're reflecting and challenging those costs as much as possible. Another problem with cost plus pricing is, is the identification of the required level of overhead in each our product. A topic for another podcast here can sometimes make it a challenge. Having said that, it is still a very popular method used by thousands of businesses, not just in the UK, but all over the world.

Its merits are it's straightforward and easy. And in the world of business, things that are easy, things that are straightforward to apply, always have a rounding sound of success with business owners and those people in their teams. It's straightforward. The calculations are relatively okay, and most people can identify with a concept of a markup.

Now, folks, before we wrap this show up, just please note that markup and margin are two completely different concepts. Markup is where we take the profit and we link it to the cost. Margin, and please check out the show notes for previous podcast episodes on this, is relating that profit to the selling price of your item.

Folks, I hope you've got some value from this podcast. I'd love it to get your feedback, your comments. Obviously I'd love it if you subscribe, if you feel there's somebody out there who could benefit from listening to this podcast. I love it if you could share it with them. And until next week, folks, get your head down, have a look at your pricing, and look at your costs and look at what your pricing structure would be, applying cost plus pricing.

And don't forget our online calculator tool. Till next week, folks, be sanguine. We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.