Imagine you’re about to launch an ecommerce store selling drinkware products—you’ve already identified a target audience and developed a unique eco-friendly water bottle that you’re confident will stand out in the marketplace. But one important question remains: How should you price your new products?
Pricing your goods and services properly can make the difference between a healthy profit margin and a failing business. One of the most straightforward pricing methods is called full-cost pricing, and it uses a simple formula to ensure a positive profit margin. Here’s how this pricing method works and how to decide if it can benefit your company.
What is full-cost pricing?
Full-cost pricing is a method that incorporates all associated costs of a product or service, including a profit markup. This approach requires consideration of both direct costs, like raw materials, and indirect costs, such as overhead and marketing expenses, to determine pricing.
By taking into account all the direct costs connected to the manufacturing process as well as the indirect costs of running a business (like rent), full-cost pricing helps merchants and manufacturers identify a selling price that covers every expense.
Example of full-cost pricing
Say you’re launching an ecommerce company to manufacture and sell mobile phone cases and you want to figure out how to sell them with the full-cost pricing method.
Your market research tells you that you may be able to sell 10,000 units in the first year. You then calculate all direct costs associated with manufacturing: $40,000 for raw materials, $40,000 for labor, $10,000 for shipping expenses, and $10,000 for production equipment. You then calculate indirect costs for the year: $20,000 for rent, $10,000 for insurance, $5,000 for utilities, and $5,000 for marketing. You also keep $10,000 aside for miscellaneous overheads. Divide your total costs ($150,000) by the total number of units you plan to manufacture—in this case, 10,000 cases—to find your cost per unit:
$150,000 / 10,000 = $15 per unit
Next, calculate your ideal profit margin. Assuming you want to make a profit of 40%—meaning $6 extra on top of each $15 unit—your full-cost price will be $21 per phone case.
Advantages of full-cost pricing
Here are some of the main advantages of the full-cost pricing model:
Useful for reporting
The full-cost pricing method complies with generally accepted accounting principles (GAAP), a set of standards maintained by the Financial Accounting Standards Board (FASB), a non-profit focused on improving the transparency and consistency of financial reporting. Having a detailed list of your complete costs is also important for bookkeeping.
Prioritizes earning profit
The full-cost pricing strategy prioritizes earning a profit margin and making back all of the costs associated with creating and selling a product or service. Ecommerce merchants and business owners can use full-cost pricing to ensure that their prices are high enough to earn a profit. By identifying a price that you know will earn back your costs, you can create distribution plans with the confidence that you are covering your full expenses.
Creates a justifiable price
Using the full-cost pricing method with a reasonable markup, you can use the costs associated with a product to validate its price—especially if you sell high-ticket items like electronics. If you can justify a more expensive price for a particular item, you can build brand equity, a term used to describe the perceived value of a particular brand, product, or service.
A domestic clothing manufacturer, for instance, might justify its higher prices by emphasizing fair wages as part of its brand identity.
Disadvantages of full-cost pricing
There are also disadvantages of the full-cost pricing model to keep in mind when you’re choosing which pricing method is best for your business:
Difficult to account for variations
Full-cost pricing involves knowing the exact expenses associated with each product—something that’s easier said than done. If you have multiple product lines sold at different price points, it can be difficult to determine how rent, utilities, and administrative costs need to be split between them.
In these cases, management teams can use an allocation process to assign specific costs to products, activities, or departments, which can result in a more precise accounting process.
Can create misleading profit margins
When you account for overhead expenses and divide those by the number of goods you think you’re going to sell, you’re making a calculation based on what you think sales are likely to be. But what if not all your items sell? If you manufacture 10,000 cellphone cases but only 7,000 sell, your overhead costs per unit sold go up and may be higher than your sales price.
Ignores competition and price elasticity
Businesses operating in a highly competitive market can experience a lack of accuracy with the full-cost pricing model since it does not consider the pricing choices of direct competitors or the unique customer demand for particular products. For example, you could use the full-cost pricing model to calculate the direct and indirect costs for a product only to discover that your competition is charging substantially more or less for similar products.
Similarly, full-cost pricing does not take into account price elasticity—a ratio used to determine how much the demand for a particular product will change based on its price. If you want to optimize your prices for the specific market you’re in, the full-cost pricing method can have limitations.
Differences between full-cost and variable-cost pricing
One of the most popular alternatives to full-cost pricing is variable-cost pricing, a pricing method that sets a sales price proportionally with how much a company produces or sells. The price is determined by adding production cost (determined by sales volume) plus an added markup. Here are some of the key differences between full-cost pricing and variable-cost pricing:
Scope
Whereas full-cost pricing takes into account the total cost of direct and indirect expenses, variable costing only includes direct costs, such as raw materials, direct labor, and production costs. Full-cost pricing includes fixed costs, such as insurance and rent, while variable pricing focuses singularly on the expenses that go directly into producing a specific good or service. Since variable-cost pricing is directly tied to the costs of production, it fluctuates greatly based on the number of units produced and distributed.
Level of complexity
Variable-cost pricing is simpler than full-cost pricing since it includes only direct expenses, such as production expenses. Businesses with little to no overhead can benefit from a basic variable-cost pricing model, whereas companies with complex operations that incur a range of overhead costs can create a more accurate picture of their total expenses through a full-cost pricing method.
Accuracy
Full-cost pricing can provide a more holistic picture of what it costs to run a business compared to the variable-cost method. However, full-cost pricing also has its limitations. Businesses running complex operations in competitive markets can benefit from using more sophisticated pricing strategies, such as dynamic pricing, which takes into account customer demand, supply, and price elasticity. Another alternative is penetration pricing, which involves setting your initial prices lower than your competitors to gain a larger market share.
Use cases
Companies with minimal fixed costs can use the variable-cost pricing method to evaluate and compare the production costs of different product lines. However, businesses can use the full-cost pricing method to identify the right price that covers the complete expenses of making a product or service with an added markup on top for healthy profit margins.
What is full-cost pricing FAQ
How do you calculate the full-cost price?
You can calculate full-cost price with this simple formula: Direct costs (such as raw materials) + indirect costs (such as rent) = X. Then divide X by the number of units produced to get the price per unit.
Lastly, determine a percentage markup (how much you want to earn per product) and add that number to the price per unit.
Is full-cost pricing or variable pricing a better strategy for ecommerce?
It depends. Full-cost pricing is a more comprehensive pricing strategy than variable pricing, and it can be a useful figure for financial reporting—especially if you have a significant amount of fixed costs, such as rent or insurance. On the other hand, variable pricing is a useful tool for comparing the specific production costs between different product lines.
What is the goal of full-cost pricing?
The goal of full-cost pricing is to provide an accurate picture of the direct and indirect costs associated with producing a product or service to ensure that prices are set high enough to cover expenses and earn a profit.
