Value-Based Pricing vs. Cost-Based Pricing
People have different motivations for why they get into the business. While a business can exist because of a variety of reasons, they all have one thing in common: businesses need to make money!
In its simplest form, businesses earn revenue by exchanging the goods or services they offer.
The amount of money they ask for is, of course, the price.
But there are a variety of ways that businesses can use to set prices.
Here we are looking at cost based pricing methods and value based pricing.
What is Cost Based Pricing?
A business can use different methods in calculating how much to sell its goods or services.
One of the most common methods is the cost-based pricing strategy. In this technique, the costs of production act as the foundation of the price of the product.
Cost-based pricing means that the total cost of the product is determined and then a certain percentage is added as a profit margin.
For example, if a pie costs £10 to make and the desired profit margin is 50%, then the price of the pie when it enters the market is £15. The £15 comes from the £10 production cost plus £5, which is 50% of the £10.
Using cost-based pricing means that pricing is an internal issue. The business is the one determining the price for the goods and services it provides.
What is Value Based Pricing?
Another strategy that businesses can use is value-based pricing. In this method, the price is primarily determined by the perceived value of the customer.
Value-based pricing is based on the “Beer on the Beach” experiment by Richard Thaler, an economist considered to be the godfather of behavioural economics.
In his studies, he determined that people are willing to pay more for beer from a hotel than beer from the supermarket. Even though the products are identical, their values were seen differently because of the context of the situation.
Examples of value-based pricing are luxury goods such as cars and branded clothes.
Differences between Pricing Strategies
Value-based pricing and cost-based pricing have their advantages and disadvantages.
In cost-based pricing, the main advantage is that the costs of production covered by the selling price. Also, the profit margin is pre-determined so the business can have expected returns.
This method is simple to calculate as long as the business knows its costs. The only external factor in determining the company’s bottom line is the number of sales made. As long as these sales targets are made, profits for the business is assured.
On the other hand, cost-based pricing can be too rigid. For example, providing graphic design services is not always suited for this strategy. If production costs are used to calculate for the price, they might not consider accurately intangible assets such as creativity or experience.
Another issue with cost-based pricing is that your client ultimately doesn't care about what your costs are, they care about what they receive. Therefore they are making buying decisions based on what they receive and if they believe that price is right for them.
Value-based pricing has more flexibility because it is based on brand perception. Businesses can charge higher prices from the beginning. They can capitalise on things like the company’s reputation and interest of the market in the product or service.
There is also greater interaction with customers, which tends to build loyalty to the company.
However, the disadvantage of value-based pricing is that it is an approximation. Since it is based on market research, it may not be sensitive to the actual costs used in production and may not always be exact.
It is important to note that there is no one pricing strategy that is better than the other. Choosing the right pricing strategy depends on the product or service the company offers and what their goals are.