There are three common ways to price a product or service.
- Cost Plus Pricing
- Competitor Minus Pricing
- Value Based Pricing
Cost Plus Pricing
Cost plus pricing is so named for the equation used to arrive at a final price. The person setting the price calculates how much it costs to create and sell the product, then sets the price above that number to afford an acceptable margin. For example, if it costs $10 to produce each good, and $5 in marketing costs to sell it, and you need a 10% margin to be profitable, then you will set your price at (10 + 5) x 1.1 = $16.50.
Competitor Minus Pricing
Competitor minus pricing gets its name the same way. In this model, all we care about is what the nearest competitor’s price is. We want to match it or beat it, so that we can use price as a way to attract new customers. If they are selling their product for $16.50, we want to sell ours for $15.99.
Value Based Pricing
Setting a price using value based pricing is more difficult than the two models above. But the principle is simple. Price your product based on the amount of value it provides the end user. Take into account the consumer’s alternatives, and their cost. Then figure out how your product is better or worse than those alternatives. For example, if a competitor offers a similar product for $15.99, but our product lasts twice as long as theirs, an appropriate price might be something closer to $29.99.
Which Works Best?
Pricing is not a one-size-fits-all decision. And no model is perfect. But of the three basic practices detailed above, value based pricing is best.
Why? Cost plus pricing and competitor minus pricing both have inherent flaws that value based pricing does not.
Cost plus pricing does not take into account the consumer’s alternatives. You are pricing based on your costs. But what if a competitor’s costs are lower. They will always be able to underprice you. In addition, cost plus pricing does nothing to maximize profitability. Perhaps you could sell it for more, but your formula prevents keeps you locked into a lower price.
Competitor minus pricing forces you into a low-price mentality that can be very difficult to succeed at. It forces you to cut corners and save money in ways that new entrants in a field can’t always do effectively. It keeps you from creating more value for your customers because price is what defines your offering.
When you use value based pricing you can take all factors into account and set a price that makes the most sense based on your specific offering, and the market you hope to win.