In today’s post, we’re going to go over the three price-setting methodologies: cost-based pricing, competitor-based pricing, and value-based pricing.
We’ll see what each one of them is, what are their advantages and disadvantages, and lastly, what criteria you should follow to decide which one is the best for your business.
Pricing method #1: Cost-based pricing method, or cost plus pricing method
What is cost based pricing? (or cost plus pricing)
Cost based pricing, or cost-plus pricing, consists of calculating how much each unit of your product costs to produce, and set a price by adding a margin on top that unit cost. This margin should be enough to cover all your costs, and make you a profit.
And this is how we intuitively think about prices. When we assume that a higher priced product is a higher quality one, the implicit reasoning is based on this method. We tend to believe that the more expensive product is better, because the reason for the higher price is the higher production cost (we just assume that better materials used, it was more labor intensive, etc.)
Cost based pricing advantages and disadvantages
When it comes to advantages and disadvantages, the biggest advantages of this pricing method are:
- It ensures a positive margin. And
- You have the information necessary to set the price, since you only need internal data. It may be true that depending on your cost structure and portfolio, calculating your cost per unit may be far from straightforward. However, it won’t be nearly as complex as measuring your client’s perceived value.
There is one major drawback though, and it is that this method completely disregards your clients’ willingness to pay (and your costs and your target margin are kind of your problem, you know? Your clients don’t necessarily care about that).
So, chances are that your price isn’t the best one if you use this method. Because think about it: what are the chances that your costs, plus some random margin that you decided to put on top of them is precisely the price that maximizes your profuts, without taking into account your clients’ willingness to pay?
Let’s face it, it’s almost certain that you’re either overpricing, or leaving money on the table.
But let’s now take a look now at competitor-based pricing.
Pricing method #2: Competitor-based pricing method
What is competitor based pricing? Competitor based pricing consists of looking at your competitors’ prices, and set your own price in line with theirs.
This does not necessarily mean that you copy exactly the same price. It means that you set your prices by following the way your competitors price theirs’.
Competitor based pricing advantages and disadvantages
Competition-based pricing has the great advantage of being simple to implement (at least when compared to the other methods, which can both get extremely complex).
However, it does have some important drawbacks.
The first one is a quite obvious one: if you and your competitors all behave the same way, you risk losing sight of your other product’s attributes, and end up basing your competition around price. And remember, price is just one among many other product features.
This method of setting prices is particularly dangerous when one of the competitors in the market tries to systematically undercut the others. This is the type of behavior that can lead the entire industry down into ap price war, and ruin the business for everyone.
Another potential issue with competitor-based pricing, is that the difference in price you decide to keep vs. your competitor’s price, may not reflect the difference in the product’s value.
And, a third issue with this price-setting method, and that often goes unnoticed, is that you are putting your pricing strategy in the hands of your competitor. Because if all your pricing strategy boils down to copying someone else’s prices, you better pray that they know what they’re doing. Because they are in fact defining your strategy. Not you. You just copy.
And last but not least, there is a very real danger that you get caught up in all this competition based strategies, and forget to make a profit.
Now, this one may sound like an unbelievably stupid thing to do, but it happens so often. When you copy your competitors’ prices, without taking into account your own cost structure, you risk making a very large number of sales at a loss. Because you may have the same prices, but very different cost levels.
But let’s now take a look at the third price-setting methodology, value-based pricing.
Pricing method #3: Value-based pricing method
What is value based pricing? Value based pricing consists of assessing how your clients or potential ones perceive your product’s value, and basing your prices on that value perception.
Since this pricing method is based on your customers or clients' value perception of your product, this is the only pricing method that aligns your product’s price with what your potential clients are willing to pay for it.
Value based pricing advantages and disadvantages
Given the method's nature, it is the only one that on one hand minimizes the money left on the table, and on the other, avoids setting an excessive price, that your product isn’t perceived to be worth. And this is the big advantage.
From a product price, vs product value point of view, this is by far the best methodology.
But it does have its issues.
To begin, just as in the case of competitor-based pricing, the resulting price may not be a profitable one.
But here, if you are charging what your customers perceive your product or service to be worth, and you’re still not making a profit, you don’t have a pricing problem, it’s much deeper than that.
Finally, a value-based pricing approach is very complex to implement. It’s complex to set up, and it’s complex to maintain.
The required market research, analysis, and strategy development, can go seriously wrong at every step of the way. So, due to the higher implementation complexity, the chances of getting it wrong are much higher.
So, when would it make sense to use each of the pricing methodologies?
Let’s start with cost-based pricing.
When would it make sense to use cost-based pricing?
Unfortunately, as we’ve seen, the chances you end up with an optimized price are pretty minimal.
So, in theory, it would never make sense to use this methodology.
However, due to its simplicity, I do think it’s worth taking a look at. Not to build your entire pricing strategy around it, but as a starting point from which to further optimize.
Because let’s face it, if you’re running a small business, you may just not have the time, energy, or capabilities to throw yourself into a full-fledged value-based price optimisation process.
Or, the room for improvement doesn’t compensate the effort (which can happen).
And what about competitor-based pricing?
When would it make sense to use competitor-based pricing?
Well, using a mathematical algorithm to blindly copy your competitors’ prices probably isn’t a good idea either. What is a good idea, is to take your competitors’ prices into account, when building your value-based pricing strategy.
However, sometimes it may make sense to keep your prices aligned with your competitors. Especially if the products you’re selling are very similar, and the price comparison is unavoidable.
If you know that your customers will be comparing your product vs. your competitor’s with a heavy focus on price, then the competitor’s price will necessarily be a strong pricing reference for yours.
However, don’t just assume that customers will be doing this. Because that’s a big issue with this method. Sellers often assume that customers will be comparing only based on price and selecting the cheapest option.
When the reality is that price is just one of many product features, and sometimes people don’t even buy the cheapest options just because it is the cheapest. And if you'd like to know why charging premium prices may actually be a good idea, check out this post about 3 reasons why you should be charging a premium price.
Anyway, back to our competitor pricing strategy, before you start basing your prices on your competitors’, you must conduct the market research that shows that this is the smart thing to do.
Also, you need to understand whether your product should be prices at a premium, at parity, or at a discount vs. your competitor.
And to finish, never assume that you know what your customers value without asking. I have done many pricing projects, and believe me, it’s often very surprising.
And lastly, value-based pricing.
When would it make sense to use value-based pricing?
In an ideal world, always.
Value-based pricing is especially important when you are selling an innovative product for which a price reference doesn’t exist, or your product is so different from your competitors’, that it’s difficult to compare their value.
So, if you’re selling and innovative product, a differentiated product, or a product that doesn’t have a manufacturing cost, value-based pricing is the obvious way to go.
And, even if it turns out that your competitors’ prices are in fact strong price references for your product, you still shouldn’t be copying their price before conducting the price research.
Because unless you’re selling obviously the same thing, to the same people, you just won’t know whether the competitor is a strong price reference before you ask.
At the end of the day, your choice of methodology needs to rest both on your capabilities and resources that you have available to implement the one that you select, but also on the room for improvement in terms of profit that comes from the potential price optimization.
Ideally, everyone should be doing value-based pricing. However, given the high complexity involved, that just isn’t realistic, or even worthwhile for a lot of small businesses.
One thing is certain though: you need to know your costs, and you should know your competitors, and how your product's value compares to theirs.
But while I’m a big proponent of value-based pricing for large corporations, if you have a small business, you don't want to implement a price setting methodology that is so complex to keep up, that it eats away the increase in profit that it generates.
So, initially setting your prices based on your costs, or even on your competitors’ prices, and gradually adjusting them in time as you get a better perception of your product’s value vs your competitors’ and move towards that value-based pricing can be actually a good idea.
So, I’m afraid that I cannot truly tell you which price-setting methodology is the best for you. At the end of the day, it depends a lot on your product, your market, and your resources and capabilities.
That said, you do not want to miss out on your profit potential, because you didn’t implement the bare minimum price optimization strategies. You do need to find the right balance for you, and your business.