How it comes to play
Consider a multinational company like Pepsi or Apple. They have customers across the world and for them, delivering their products directly to each customer is virtually impossible.
So they have to work with distributors such as retailers like Walmart or your neighborhood supermarkets.
Now, a company like Pepsi would first take account of its cost price – the total amount of money it paid to make a bottle of Pepsi. It will then create a “wholesale price” – which is the price it will charge the distributors to earn a profit.
Wholesale price is what we call the cost at which distributors will pay to get the product from the manufacturers.
Once the distributors have the product, they will sell it at a retail price where they will be able to earn a profit as well.
Let’s look at this again but with numbers now.
Sam is doll manufacturer and he spends $10 on every doll that he produces. Now in his case, $10 is the cost price.
Sam wants to make sure his customers can easily buy his dolls so he will sell them in bulk to the nearest toy shop, Jane’s Toys at $12. This is the wholesale price that Jane will pay Sam for each doll that she buys from him.
Now Jane like Sam wants to earn a profit. So when she sells them, she will charge her customers $15, which is the retail price.
So in this case, Jane is getting a profit of $3:
|Retail price||Wholesale price||Profit per doll|
For Sam, the profit was $2
|Wholesale price||Cost Price||Profit per doll|
This should clear the difference between wholesale and retail price, as wholesale price is for distributors that buy products in bulk. Sam would sell Jane 100 dolls in single transaction which would be more profitable to him. He doesn’t has to sell 100 dolls to 100 girls but only to one retailer.
This economies of scale results in producers opting for selling to retailers/distributors at wholesale price which is less than what the producers themselves can get if they directly market and sell to their customers. For instance, Sam could earn $5 profit if he sells the dolls himself at $15 but he would have to product and package each doll every time he finds a customer which would increase his cost of production in the end, thereby shrinking his profits.
Cost Price determines the profit
The Sam and Jane example shows a very important aspect of cost price – how it determines the wholesale price with respect to profit margin.
If Sam’s cost price was higher, he would have increased his wholesale price to ensure he gets a profit. This would in turn cause Jane to increase the selling price to ensure she gets to earn a profit.
Manufacturers also recommend the retail price to their distributors which is the recommended selling price. This is known as manufacturer’s suggested retail price (MSRP) and between it and the wholesale price, there is plenty of room for everyone to make profit.
Manufacturers may not always aim for profit
Did you know that manufacturers sometimes forget their profit to ensure retailers buy their products and sell them out to their customers? This is done to increase sales or to make the product or service more attractive in case of unexpected circumstances.
For instance, if there was a national scandal and a company’s product was responsible, it will try to push sales by dropping prices through reduced wholesale price and so that retailers can earn more profits.
Cost price is a company secret, it is very rare that anyone would reveal what was the cost of creating a product or service as it is something that both the customers and competitor can use against the company. For instance, nobody actually knows how much does it cost to create a single iPhone but according to Fortune’s report, Apple pays $219.80 for every iPhone 7 which means that if it sells one unit at $850, its actually making $630 on every phone.
Average Cost Pricing rule
Now that you understand cost price, you must be thinking whether some companies can charge more if they enjoy monopoly over their product or services. Government regulatory bodies usually use what is called “average cost pricing rule” to stop a company from raising the prices.
In this case, the cost price is equal to or slightly less than the selling price. With little flexibility on what they can charge to their customers, companies under this rule can still earn a normal profit and will not be able to fix price.
So there you have it. That’s what cost price is all about. Share this with your peers and friends and let them know what cost price is and how it can determine profitability.
For manufacturers it is imperative that they calculate the cost price properly since it helps them to determine what price they should charge to gain profit or losses. That is why thorough accounting along with scrupulous deliberations are done to ensure the prices are set for the benefit of the company.
How to use cost price
- Cost price is an easy concept to use, but it is strategically important especially if you are a company using a cost leadership strategy.
- The best way to use cost pricing is to set up a margin framework that is based on the market prices and then calculated backwards. Design first the price, then the cost price.
- Collect competitor pricing by monitoring them for a while. Then set your target price and calculate back what you are ready to pay as a cost price. As we say: Design first the price, then the cost price.
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