Influence of Costs on Price

There are expenses related to the production, marketing, and distribution of all products. In addition, there are many costs related to the daily operations of a business. These costs influence the price set for products because a profit is made only after all of the expenses are paid. There are two basic types of expenses: fixed and variable.

A fixed expense is an amount paid on a regular basis related to the operation of a business. Once fixed expenses are paid, typically monthly or yearly, nothing is due until the next billing cycle. These expenses are necessary to run a business and are usually predictable. They are not affected directly by the number of products produced or sold. Examples of a business’s fixed expenses may include rent, insurance, salaries, and loan payments.

A variable expense is a cost that changes based on factors related to producing and selling a product. Variable expenses will continue to occur as long as a business is producing product and generating sales. As production levels fluctuate, variable expenses will also change. The more a business produces and sells, the higher its costs will be. The less a business produces and sells, the lower its costs will be. Examples of variable expenses may include the cost of raw materials needed to produce goods, the cost of production labor, shipping costs, and sales commissions.

Pricing strategically is a balancing act because both profit and sales goals are important. To make a profit, prices must be set high enough to cover the costs. However, if the product is priced too high, customers and sales may be lost. If the price is set too low, the costs related to the products may not be covered, which means the company could lose money.

Cost-based pricing is a pricing strategy that sets the selling price by adding the desired amount of profit per unit to the cost of producing each unit. The first step in cost-based pricing is to accurately determine the actual cost of the item for the business. The price of the product must cover the expenses related to a product for the company to make a profit. For manufacturers, price has to cover the cost of making goods and marketing them to customers. For retailers, the price has to cover the cost of buying goods and reselling them to consumers.

Markup is the desired amount of profit added to the cost of a product to determine the base price. The base price of a product is the general price at which the company expects to sell the product. The selling price, or the actual price the customer pays for a product, may differ from the base price if it is adjusted to remain competitive. The following equation expresses cost-based pricing.

cost + markup = base price

Markup can be expressed as a dollar amount or as a percentage. Percentage-markup, keystone-pricing, and dollar-markup methods are three approaches that can be used.

Percentage-Markup Method

Using a percentage markup is the most common way to determine a base price. Management decides the percent of profit necessary for each item. The percentage markup for each product is turned into a dollar figure and added to the cost. Most retail businesses use the percentage-markup method because it guarantees a consistent level of profit. The following formula is used to determine base price when using the percentage-markup method.

(cost × percentage of markup) + cost = base price

In the previous example, the cost for lawn mowers is $245 each. Suppose the company’s business model states that it must make a 40 percent profit on all sales. To achieve a 40 percent markup, each $245 lawn mower needs to be priced at $343.

$245 cost × 40% markup = $98

$98 + $245 cost = $343 base price

Keystone-Pricing Method

Keystone pricing is a pricing method in which the total cost of a product is doubled to determine its base price. Many businesses use keystone pricing because it is an easy way to create a 100-percent markup on the cost. The formula for keystone pricing is as follows.

cost × 2 = base price

For example, using the keystone-pricing method, the base price for the $245 lawn mower is $490.

$245 cost × 2 = $490 base price

Dollar-Markup Method

Companies that use the dollar-markup method determine a specific dollar amount that must be made, above product costs, for each product sold.

cost + dollar markup = base price

Suppose the company decides it must make $155 after costs on each mower. Using the dollar-markup pricing method, the base price is $400.

$245 cost + $155 dollar markup = $400 base price