Cost-based pricing in SaaS: How to use it (examples included)

In SaaS, finding the right pricing strategy is crucial for success. Cost-based pricing, a method where you set your prices based on your production costs plus a markup for profit, offers a simple yet powerful approach.

This method provides a clear path to profitability, especially for startups and businesses operating in stable markets.

Interestingly, recent data from Vendr's Q2 2024 SaaS Trends Report reveals that while overall purchase volume decreased, the number of new sellers on the SaaS Leaderboard doubled compared to the previous quarter.

This data suggests that despite market fluctuations, new SaaS companies are finding success, and cost-based pricing can be a valuable tool in their arsenal.

In this article, you'll learn:

• Types of cost-based pricing methods
• How to calculate the selling price for your SaaS product using each method
• The advantages and disadvantages of cost-based pricing
• Whether cost-based pricing is the right strategy for your SaaS company
• How Orb helps you implement and manage cost-based pricing effectively

Let’s start by explaining cost-based pricing and its different types.

What's included in a cost-based pricing definition?

Cost-based pricing is a method where you set the price of a product based on its cost. To do this, you must first calculate the total cost of production, manufacturing, and distribution. Then, you add a markup percentage to this cost to determine the selling price.

This method is different from value-based pricing, which focuses on the perceived value of the product or service to the customer. With value-based pricing, businesses may charge a higher price for a product or service that is seen as being more valuable to customers.

There are several different types of cost-based pricing, including:

• Markup pricing
• Cost-plus pricing
• Target return pricing
• Break-even pricing
• Activity-based pricing

Each of these methods uses a slightly different approach to calculating the selling price. However, they all have one thing in common: they are based on the cost of production.

Understanding the key terms

To properly understand what cost-based pricing is, it's important to define some key terms. Here are a few of the most important ones:

• Cost of goods sold (COGS): This is the direct cost of producing a product or service. It includes the cost of raw materials, labor, and overhead.
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• Markup: This is the percentage of profit that you add to the cost of goods sold to determine the selling price.
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• Fixed costs: These are costs that do not vary with the level of production. They might include things like rent, insurance, and salaries.
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• Variable costs: These are costs that vary with the level of production. They might include things like raw materials and labor.
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• Total cost: This is the sum of fixed costs and variable costs.

How cost-based pricing works

The basic formula for cost-based pricing is:

Selling price = Cost of goods sold + Markup

For example, if the cost of goods sold for a product is $100 and the markup is 20%, then the selling price would be $120.

Cost-based pricing can be a simple and effective way to set prices. However, it is important to note that it does not take into account all of the factors that can affect the price of a product or service.

For example, it does not consider the demand for the product, service, or the prices charged by competitors.

Remember: Cost-based pricing is not always the best pricing strategy for every business. In some cases, it may be more appropriate to use a value-based pricing strategy.

Cost-based pricing examples for SaaS companies

Cost-based pricing can be a valuable tool for SaaS companies. However, it is important to understand the different types of cost-based pricing and how they work before you use them to set your prices. Here are a few cost-based pricing examples for SaaS companies:

1. Markup pricing

Markup pricing is one of the simplest cost-based pricing methods. It involves adding a fixed percentage to the cost of goods sold (COGS) to arrive at the selling price.

The markup percentage is typically based on the desired profit margin. This method is straightforward and easy to understand. That’s why it’s a popular choice for businesses that are new to cost-based pricing.

Formula:

Selling Price = COGS + (COGS x Markup Percentage)

Example scenario:

Imagine a SaaS company, "CloudBoost," developing a project management solution. CloudBoost has meticulously calculated its COGS for a single-user license to be $50 per month.

This $50 figure includes all the direct costs associated with providing the software to one user for a month. Think server costs, development costs, and customer support costs directly related to product functionality. CloudBoost aims to achieve a 25% profit margin on each license sold.

To determine the selling price using markup pricing, they apply the formula:

Selling Price = $50 + ($50 x 0.25) = $62.50

Based on this calculation, CloudBoost would set the price of their project management software at $62.50 per user per month. This pricing strategy confirms they cover their direct costs and achieve their desired profit margin.

Advantages of markup pricing:

• Simplicity: Markup pricing is very easy to understand and implement, even for businesses with limited financial expertise.
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• Quick calculation: Determining the selling price is a direct calculation, requiring only the COGS and the desired markup percentage.
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• Profitability: By incorporating a markup, this method ensures a profit margin on each unit sold, contributing to the company's overall profitability.

Limitations of markup pricing:

• Ignores market dynamics: Markup pricing doesn't consider external factors like competitor pricing or customer demand. Neglecting these factors could lead to prices being set too high or too low.
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• May not be suitable for all products: For products with highly fluctuating costs or those in very competitive markets, markup pricing might not be the most effective strategy.

2. Cost-plus pricing

Cost-plus pricing considers all costs linked with producing and selling the product, not just the COGS. Think fixed costs such as rent, salaries, and marketing expenses. This method provides a more complete view of the costs involved and can lead to more accurate pricing.

Formula:

Selling Price = Total Cost + (Total Cost x Markup Percentage)

Example scenario:

Consider a SaaS company, "ClientConnect," that offers a CRM tool. Their total cost per user per month, including COGS and fixed costs, is $80. This $80 figure includes the direct costs of providing the CRM software. It also includes a portion of the company's overhead expenses, such as rent for their office space, salaries of administrative staff, and marketing campaigns to promote the CRM tool. ClientConnect has set a target profit margin of 20%.

To calculate the selling price using cost-plus pricing, they use the formula:

Selling Price = $80 + ($80 x 0.20) = $96

Based on this calculation, ClientConnect would price their CRM tool at $96 per user per month. This approach helps them ensure they are covering all their costs and hitting their profit goals.

Advantages of cost-plus pricing:

• Total cost consideration: Cost-plus pricing considers all costs associated with the product or service. It provides a more accurate picture of the company's expenses.
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• Profitability: By including a markup on total costs, this method helps ensure profitability and financial stability.
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• Easy to justify: It's easier to explain and justify price increases to customers when they are tied to increases in the company's overall costs.

Limitations of cost-plus pricing:

• May lead to overpricing: In some cases, cost-plus pricing could result in prices that are higher than what customers are willing to pay. In this case, you’d be looking at potentially lost sales.
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• Doesn't consider competition: This method doesn't factor in competitor pricing. Ignoring this factor could put the company at a disadvantage in the market.

3. Target return pricing

Target return pricing means setting a price that will yield a specific return on investment (ROI). This method is often used by companies that are looking to achieve a certain level of profitability. It's a more strategic method of pricing that aligns with the company's financial goals.

Formula:

Selling Price = (Total Cost + (Desired ROI x Investment)) / Number of Units Sold

Example scenario:

Let's say a SaaS company, "Data Insights," has developed a new data analytics platform. They have invested $1,000,000 in the development and marketing of this platform.

Their total cost per user per month is $100, which includes all costs related to providing the platform and supporting its users. Data Insights has set a target ROI of 15% on their investment. They forecast that they will sell 10,000 user licenses.

To calculate the selling price that will achieve their desired ROI, they use the formula:

Selling Price = ($100 + (0.15 x $1,000,000)) / 10,000 = $115

To meet their ROI goal, Data Insights should set the price of their data analytics platform at $115 per user per month. This pricing strategy guarantees that they not only cover their costs but also achieve their desired ROI.

Advantages of target return pricing:

• Goal-oriented: Target return pricing directly aligns with the company's financial goals and desired ROI.
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• Strategic decision-making: It encourages businesses to think strategically about their pricing in relation to their investment and profitability targets.
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• Long-term focus: This method promotes a long-term perspective on pricing, considering the ROI over time.

Limitations of target return pricing:

• Relies on accurate forecasts: Achieving the target ROI depends heavily on accurate sales forecasts. The main issue is these forecasts can be challenging to predict.
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• May not be flexible: If market conditions change or sales fall short of expectations, adjustments to the pricing strategy might be necessary.

4. Break-even pricing

Break-even pricing is a method that lets companies know the minimum price they need to charge to cover their costs. This method is often used by startups and small businesses that are just starting out.

It provides a crucial foundation for pricing strategies, confirming that the company is not operating at a loss.

Formula:

Selling Price = (Total Fixed Costs / Number of Units Sold) + Variable Cost Per Unit

Example scenario:

Imagine a SaaS startup, "Mail Maestro," that offers an email marketing tool. Their fixed costs, such as rent for their office, salaries of their developers, and marketing expenses, are $5,000 per month.

Their variable cost per user per month is $5, which covers the direct costs associated with providing the email marketing service to each user. Mail Maestro projects that they will have 1,000 users.

To calculate their break-even selling price, they use the formula:

Selling Price = ($5,000 / 1,000) + $5 = $10

This calculation shows that Mail Maestro needs to charge at least $10 per user per month to cover their costs and break even. To generate a profit, they would need to set their price above this break-even point.

Advantages of break-even pricing:

• Vital for startups: Break-even pricing is crucial for new businesses to understand the minimum price they need to charge to avoid losses.
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• Cost control: This method encourages businesses to carefully manage their costs. It highlights the direct impact of costs on pricing.
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• Foundation for pricing: It provides a solid foundation for developing further pricing strategies. The company knows the minimum price they must charge.

Limitations of break-even pricing:

• Doesn't guarantee profit: Break-even pricing ensures cost recovery, but it doesn't guarantee a profit. Businesses need to set prices above the break-even point to reach profitability.
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• Static approach: This method doesn't consider market dynamics or changes in demand. Neglecting these elements could affect the actual sales volume and profitability.

5. Activity-based pricing

Activity-based pricing (ABP) is a more sophisticated cost-based pricing method. It takes into account the different activities involved in producing and selling a product or service.

This method is often used by companies that have a complex cost structure. It provides a more granular view of costs and can lead to more accurate and strategic pricing decisions.

Formula:

Selling Price = (Cost Pool Expenses / Cost Driver) × (1 + Desired Profit Margin)

This formula calculates the selling price by dividing the total cost pool expenses by the relevant cost driver to determine the cost per unit and then multiplying it by (1 + Desired Profit Margin), where the desired profit margin is expressed as a decimal (e.g., 0.10 for 10%).

Example Scenario:

Consider a SaaS company, "CloudStore," that provides cloud storage services. They identify customer support as a significant cost driver.

After analyzing their customer support operations, they calculate their total cost pool expenses for this function to be $10,000 per month. This figure includes staff salaries, costs of support tools, and associated overheads.

The cost driver they focus on is the number of support tickets handled per month, which is estimated at 2,000 tickets. CloudStore targets a 10% profit margin on its customer support operations.

To determine the price they need to charge per support ticket, they use the formula:

Selling Price = ($10,000 / 2,000) × (1 + 0.10)

Breaking this down: The cost per ticket is $10,000 divided by 2,000, which equals $5. To include a 10% profit margin, multiply $5 by 1.10, resulting in a final price of $5.50 per support ticket.

Selling Price = $5 × 1.10 = $5.50

CloudStore would need to charge $5.50 per support ticket to cover the cost of customer support and achieve its desired profit margin. This cost would then be integrated into their overall pricing strategy for their cloud storage services.

Advantages of activity-based pricing:

• Accurate cost allocation: ABP accurately allocates costs to specific activities. It provides a more precise understanding of cost drivers.
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• Strategic pricing: This method enables more strategic pricing decisions. Businesses can identify and price their products or services based on the activities that drive costs.
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• Better cost management: By understanding the costs of different activities, businesses can spot areas for cost reduction.

Limitations of activity-based pricing:

• Cumbersome implementation: Implementing ABP can be complex and time-consuming. It requires detailed cost analysis and tracking.
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• Data requirements: This method relies on accurate data collection and analysis. Getting this data may require investment in systems and processes.

Is a cost-based pricing strategy right for your SaaS company?

Here's a list of criteria to help you determine if a cost-based pricing strategy is the right fit for your SaaS company:

• Your costs are well-defined: Cost-based pricing relies heavily on accurately calculating your costs. If you have a clear understanding of both your fixed and variable costs, this method might be a good fit.
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• You're in a stable market: Cost-based pricing works best in stable markets where competitive pricing and customer demand are relatively predictable.
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• You're aiming for a specific profit margin: If your primary goal is to achieve a specific profit margin on your SaaS product, cost-based pricing can be a useful tool. It allows you to set prices that ensure a predetermined level of profitability.
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• You're a start-up or small business: For startups and small SaaS businesses, cost-based pricing can be a good starting point. It provides a simple way to set a minimum price that covers costs and offers a foundation for future pricing adjustments.

Tip: For more details on alternative SaaS pricing strategies, read our article on SaaS product pricing strategies.

Use Orb to get a pricing platform that grows with you

We've defined cost-based pricing in SaaS and how it can be a valuable tool for setting the right price. The challenge is that this pricing strategy requires a billing platform that can accommodate complexity and evolution.

That's where Orb comes in.

Orb is a done-for-you billing platform that lets you implement cost-based pricing models and many more. With Orb, you gain the flexibility and control you need to manage your SaaS billing with unmatched precision.

Here's how Orb can support your cost-based pricing strategy and improve your billing operations:

• Precise cost allocation: Orb's usage tracking capabilities allow you to track the resources consumed by each user, which helps you forecast revenue and modify pricing strategies.
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• Flexible pricing models: Orb supports a wide range of pricing models, giving you the flexibility to design cost-plus pricing structures that align with your profit margins.
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• Advanced reporting: Orb provides detailed financial reports and real-time data insights. We help you monitor your costs, track profitability, and make data-driven adjustments to your cost-based pricing strategies.
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• Automated billing and invoicing: Orb automates your billing and invoicing processes. We provide accurate and transparent invoices that reflect your cost-based pricing calculations.
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• Integrations: Orb integrates with popular data warehouses and accounting software. We help streamline your billing operations and confirm data consistency across your systems.

Ready to unlock the full potential of your cost-based pricing strategy and beyond? Try Orb and discover how it can take your billing to the next level. Check our flexible pricing options to find a plan that’s your ideal fit.