What is cost based pricing? Example and strategy

What is cost based pricing?

Cost-based pricing is a pricing method where the selling price of a product or service is determined by adding a markup to the unit cost or, in the case of hotels, the cost of keeping a room available and maintained for use. 

For hoteliers, understanding cost-based pricing as a method for hotel pricing is crucial for setting room rates that not only cover the costs of operations but also provide a healthy profit margin.

Why do hotels use a cost-based pricing strategy?

Cost-based pricing offers a straightforward approach to balancing a pricing strategy, allowing hotels to:

• Cover operational costs: Ensuring all costs are covered is crucial for ongoing growth. This includes fixed costs like rent or mortgage, salaries, and utilities, as well as variable costs like supplies, maintenance, and marketing.
• Achieve desired profit margin: By adding a markup to the cost, hoteliers can set room rates that provide the desired profit margin, enabling reinvestment and financial growth.
• Simplify pricing decisions: The cost-based method provides a simple, straightforward way to price rooms for both direct bookings and via distribution channels, cutting out the complexity and providing an instantly actionable number.

Cost based pricing formula

The basic formula for cost-based pricing is quite simple:

Selling Price = Cost of Service + (Cost of Service × Markup Percentage)

Cost based pricing example

Let’s say the total cost to clean, maintain, and service a room is $50. If the hotel wants a profit margin of 20%, the selling price would be calculated as follows:

Selling Price = $50 + ($50×0.20) = $60

This is a very simple example that considers only the maintenance cost of the room itself. 

More complex calculations would also include things like costs of insurance, costs of running supplementary services, wages for support staff, and so on.

Key factors to consider when implementing the cost-based pricing method

Implementing cost-based pricing requires a thorough understanding of various factors that could impact the effectiveness of this pricing strategy, as well as a mastery of yield management. In a hotel setting, these factors become crucial for ensuring not just cost recovery but also achieving a competitive edge. 

Let’s delve into some of the pivotal considerations:

Market trends

Understanding market trends is crucial for setting prices that are both competitive and profitable.

• Demand fluctuations – Analyse room demand throughout the year, taking note of peak seasons, local events, and other factors that could drive demand up or down. Adjusting prices accordingly can ensure maximised revenue during high-demand periods while maintaining occupancy during slower times.
• Seasonal variations – Seasonal variations might affect your operational costs; for instance, utility costs may rise in winter due to heating needs. Adapting your pricing to reflect these cost variations is essential to maintain profitability.
• Economic indicators – Stay abreast of economic conditions which might affect consumer spending and travel trends, adapting your pricing strategy to meet changing market dynamics.

Competitor actions

Keeping a close eye on competitors’ pricing strategies can provide insights and help maintain a competitive edge.

• Competitor pricing – Continuously monitor the pricing strategies of competitors. Are they offering lower rates, packages, or value-added services that could sway potential guests? Adjusting your pricing or offerings in response can help maintain a competitive edge.
• Market positioning – Understand your hotel’s positioning in the market in comparison to competitors. Ensure your pricing reflects the value and experience you offer, and is aligned with guest expectations based on your market positioning.

Cost analysis

A thorough cost analysis forms the backbone of an effective cost-based pricing strategy.

• Fixed and variable costs – Regularly review both fixed and variable costs, including staffing, utilities, maintenance, marketing, and distribution costs. Accurate cost analysis is crucial for setting prices that cover costs and deliver the desired profit margin.
• Unexpected costs – Have a contingency plan for unexpected costs such as emergency repairs or unscheduled maintenance. Ensuring a buffer in your pricing for unforeseen expenses can prevent eroding your profit margins.

Price sensitivity

Understanding price sensitivity within your target market can inform your cost based pricing strategy, helping to find the sweet spot that maximises revenue without deterring bookings.

• Customer perception – Gauge how price changes are perceived by your target market. Is there a price point at which guests might choose a competitor? Understanding price sensitivity can help set prices that balance profitability with competitive appeal.
• Value proposition – Ensure your pricing reflects the value you provide. Are guests receiving the expected value for the price they pay? Clearly communicating the value proposition of staying at your hotel can help justify your prices and keep guests satisfied.

Benefits and advantages of cost based pricing for hotels

Cost-based pricing not only ensures profitability but also provides several other benefits:

Transparency

Cost-based pricing offers a clear insight into the financial health of your hotel by aligning prices with the actual costs incurred. This transparency is not only beneficial for internal management but also facilitates clear communication with stakeholders regarding how pricing decisions are made.

It demystifies the pricing strategy, making it easier to explain and justify the rates to stakeholders and even guests, should the need arise.

Planning finances 

With a transparent view of costs through cost-based pricing, budgeting and financial planning become more straightforward and accurate. It allows for a solid foundation upon which future financial decisions can be made, including investments and expansions.

Knowing the cost structure also aids in setting realistic financial goals and expectations, ensuring that the hotel remains financially viable and on a path of steady growth.

Risk management

The predictability that comes with cost-based pricing reduces financial risks associated with pricing decisions. By ensuring that the set prices cover the costs and contribute to the profitability, there’s a level of financial security provided.

Furthermore, being well-versed with the cost structure aids in better contingency planning for unforeseen circumstances, thus enhancing the hotel’s resilience to external financial shocks.

Competitive pricing

Cost-based pricing helps in establishing a competitive pricing strategy that reflects the value proposition of your hotel in comparison to competitors.

By understanding the cost structure, hoteliers can adjust their markup to stay competitive while ensuring cost recovery. This form of pricing provides a grounded approach to pricing decisions, keeping them realistic yet competitive in the prevailing market conditions.

Revenue management

Cost-based pricing provides a solid foundation for revenue forecasting and optimisation, allowing for better management and allocation of resources. By understanding and controlling your costs, you can set prices to achieve desired profit margins, which is crucial for the financial health and sustainability of the hotel.

It also aids in evaluating the effectiveness of current pricing strategies, making adjustments as necessary to meet revenue targets.