One of the biggest decisions a business can make is whether to value pricing or cost based pricing for their product or service.
Cost based pricing, also known as commodity pricing, is based on what the competitive market will bear.
Value based pricing centers around the perceived or actual value added to the customer.
Let’s look at some of the pros and cons of each.
Cost Based Pricing
Cost based pricing identifies the cost of selling a product, and leaves enough margin to make a profit. There is a base price, determined by fixed costs to the business, that the product cannot go under to be profitable, called the floor price. The ceiling price is the most that the market will bear, and the price of the product is somewhere in between the two. Commodity pricing is good for products or services that can be bought and sold in bulk. Hourly services would also be considered cost based pricing in most cases.
The major competitive advantage in cost based pricing is price. If the business can make the product for less than their competitors, they can price it lower, and do more in bulk sales. A business can also set a higher margin on their product than their competitors, but risk customers finding a similar quality product at a better price.
Cost based pricing works well for larger companies, as they can better withstand the race to the bottom. Smaller companies have to be competitive, but they cannot beat larger companies on price long-term without sacrificing quality.
The disadvantage in cost based pricing for services is that it punishes efficiency. If a service technician has an hourly rate, the faster they are able to solve a problem, the less they earn.
Value Based Pricing
Value based pricing focuses on how much value the product or service will add to the customer. This requires deeper analysis of the customer, what their needs are, and how they will benefit from the service.
While cost based pricing emphasizes features, value based pricing emphasizes benefits. Value pricing says “ here’s how these tools will help you”; cost based pricing says “here’s a bunch of tools—maybe they can help you”.
Luxury items and brands are also value priced. Products like Coach purses, Rolls Royce automobiles, Dom Pérignon champagne, Kobe beef, or Rolex watches are purchased in part because they add status, distinction, and a feeling of pride to their customers.
Value pricing is not simply a matter of artificially marking up a product. It requires an understanding of what those customers want and need, and the ability to provide that for them.
The disadvantage to value based pricing is that it alienates the customer base motivated by affordability.
Not all product companies have to use cost based pricing, and not all service companies use value based pricing. A good example of a product company that uses value based pricing is Apple, who sell their products based on increased efficiency, ease of use and quality of life.
For me, in the battle of Value Pricing vs Cost Based Pricing, value pricing wins hands down. Not every business model or industry is the same. You must decide for yourself which pricing system is the best for you long-term.