A basic guide on cost and value-based pricing
The general tenor is that marketers should sell value and not price; whereas price is an important decision criterion, in the end, the value they get or they think they get is pivotal in their decision making process.
Nevertheless, price remains an important factor. Here a few reasons why:
- Revenue driver: Simply put, money is the only element in the marketing mix that brings money into the firm
- Flexibility: Prices can be adapted quickly. The same is not true for other marketing aspects such a product features.
- 80/20 rule: Small changes in price can have big impact on the margin. Consider a company with a three percent profit margin which rises its prices by one percent; if sales remain the same, the firm’s profit margin will rise by 33 percent.
- Positioning: Your prices tells a lot about how you position yourself in the market and serves as a measurement for customers which tend to derive quality and image from price.
- Customer relationship: The way to change your products pricing will affect how existing and potential customers treat you. If you rise prices for existing customers without giving them more in return there is a good chance that they will leave you.
As pricing is that important, lets look at ways how firms can price their products. Generally speaking, the long-term price you choose for your product will less than what will cause zero demand and more than what will cause zero profit. More concretely, there are three general strategies to accomplish that:
- Customer value-based pricing
- Cost-based pricing
- Competition-based pricing
Customer value-based pricing
The starting point of that strategy is your customers’ value perception; i.e. how much money is your product worth to them? A company tries to find out what the costumers value how much and what they need. Once it determines the price it tries to figure out how to design, produce and sell the product to match the price. This strategy is one of the reasons behind IKEA’s success (See Strategic Management: Concepts by Frank Rothaermel for details on how IKEA does it). Getting the right price is, of course, a challenging undertaking. If a firm overestimates customers’ willingess to pay, it will sell less than expected. If it sets the price below customers maximum willingness to pay demand might be higher than expected but the firm would not capture all the possible profits. Companies would, therefore, survey customers to find their maximum willingness to pay or conduct other kinds of experiments. Value-based pricing can further be split into good-value pricing and value-added pricing.
This strategy is opposed to cost-based pricing.
In cost-based pricing you start with your product’s cost: you make the product, sum up the costs for it, add a profit margin and get your price. It is then up to the marketing department to convince buyers that you product is worth the price. If the company can sell at the set price everything is fine, however, if not the firm will risk selling less than expected, might have to cut prices or redesign the product. Peter Drucker even named cost-driven (cost-based) pricing one of the five deadly sins of business.
The chart below summarizes and contrasts these strategies.
Source: Principles of Marketing 15th edition by Philip T. Kotler and Gary Armstrong.