Cost as a basis for setting price is easy to apply when it comes to products as it is of great help to set the “first” benchmark., especially when the product is completely new. It is slightly tricky when it comes to pricing pure services. A number of considerations like number of hours/qualification required for the work etc are required to be considered for services.
Let us look at the case of product pricing, first. Instead of calling it “Cost” as a basis of pricing, I think we would be better of calling it a Cost “plus” basis of pricing. Price= Cost of raw materials+ cost of labour to make each such product+overhead charges (administrative, marketing charges, etc) per piece+profit per piece.
Now, two questions:
- How do you decide the overhead charges that have to be allocated to each item?
- How do you decide your profit margin you are going to charge?
To decide the overhead charges per piece we have to get an understanding of the maximum number of pieces that can be produced by the existing setup. The “setup” might include a machine or a group of people producing the product. So, if you have a shop floor space which can accommodate four machines but you have only one today, the maximum you can produce is (say) 100 items per machine. The marketing expenses, however, would be the same at say Rs.10000. So, the per item overhead would be Rs.100. So, should you fix the overhead at Rs.100 or since you can have three MORE machines in that same shop floor in future, you should fix it at Rs.25 [Rs. 10000/(4X100)]?
Some might suggest that you should go for Rs.25 because that improves your chances of more people buying your product. However, if you ask me, I would rather suggest you to see if this “new” product of yours has a close substitute or if it does not have a “fad” factor attached to it . If it has a close substitute or does not have a “fad” factor attached to it then go ahead and fix it at Rs.25 but if you have a product that can be the next big “fad” and solves an amazingly difficult problem, fix it at Rs.100 and over time, as you jack up your capacity you can bring the prices down (a la Nokia Phones).