[MUSIC] Cost based pricing is historically the most common pricing procedure. Because it carries an aura of financial prudence. According to this view, financial prudence is achieved by adding a markup to the cost of a product to arrive at the sales price. In theory, this is a simple guide to profitability. Let's illustrate this using a very simple example. Imagine that your company has been developing a new printer that will streamline many processes for your small business customers. Your job is to determine the price of the printer. After doing some research, you determine that the best method for pricing the printer is the cost-based pricing method. When considering all the expenses like supplies, production costs, and marketing expenses, you determine that each printer will cost $78 to produce. If you sold the printer at $78, your company would break even. Meaning you would not lose any money, but you also would not generate any profits. However your company definitely plans to make some money from the sale of the printers. In fact, the goal is to earn a margin of 25% on each printer. Adding this 25% margin on top of your cost of the printer of $78 results in a final sales price of $97.50. This allows the company to recoup the cost of producing the printer, while earning a 25% profit margin on each unit sold. Looks straightforward, right? However, there's a fundamental issue with cost based pricing. In most industries, it is impossible to determine a product's unit cost before determining the price. Now you're going to ask yourself, why? Because unit costs typically change with the volume being produced. This cost change occurs because a significant portion of costs are typically fixed and must somehow be allocated to determine the unit cost. Unfortunately, because these allocations depend on volume, which changes with changes in price, unit cost is somehow a moving target. Let's again illustrate this using our printer example. Now with some more details regarding the cost structure. Let's assume more specifically that the supplies, or we could call them as well the raw materials of producing the weight printer are $28. The cost of production, and the cost of marketing, is a total of $5 million. Remember before we said, that the cost per printer is $78.00. In order to arrive at that number, we also assumed that we're going to sell a total of 100,000 units or 100,000 printers. How would now the cost per printer and hence the price per printer change if we were to sell only 50,000 units. The resulting price would now jump to $128 or said definitely, an increase in price by more than 30%. So we have seen, the problem with the cost-based pricing approach is that it mistakenly assumes that customers base their willingness to pay for a product on how much it costs to produce it. Costs however, have very little to do with charging $19.95 for a pet rock. Instead, customers choose the price they are willing to pay based on the value that they receive from a product. Let me finish this module with an old proverb that actually says, cost is a matter of fact, price is a matter of policy. [MUSIC]