Cost based pricing is relatively simple; you figure out your cost of goods, set a desired margin for each unit, add that margin onto your costs and you have your price. Cost based pricing doesn’t require the detailed level of analysis and value measurement necessary to employ a value-based pricing strategy. Because it’s simple, many companies fall into a trap of cost-based pricing. But as far as strategic pricing goes, cost-based pricing strategies are anything but. Despite its simplicity cost-based pricing is rarely recommended by consultants and/or academics? Here are three reasons why:
1. Cost based pricing limits your ability to price to different segments of the market
Think about these two examples; the last sporting event you went to and your SEO strategy.
In the case of the sporting event, ticket prices vary based on the view you get of the game. The cost to install a seat, serve a customer and the game itself don’t change whether you are at game level or up in the nosebleeds, but you certainly pay more to sit up close because it is perceived to be a better, more valuable seat.
In the case of SEO, it doesn’t cost Google more to place your key words near the top of the list, but you pay more for a higher position if you value higher visibility of your key words. Both of these examples have something in common; pricing is about capturing as much of the demand curve as possible. In each example the customer base can be segmented by its willingness to pay. There are multiple offers, each at different prices based on what people are willing to pay, not based on the cost of the offer. By setting a variety of prices based on how different customer segments value your offer you capture a greater portion of the market, maximizing revenue at each point on the demand curve.
2. Customers don’t care about your costs, they care about the product attributes they value
In the Smartphone market, do customers really think about what it costs the manufacturer to produce a phone? Do customers consider what the wireless carrier is paying to carry Blackberry, iPhone or various Android phones? The answer is typically no. Customers focus on the product attributes that they value; data capabilities, network coverage, apps, screen size, touch screen vs. keyboard, etc. Customers will be willing to pay more for a phone that has the features that best meet their needs regardless of the manufacturing costs. If a customer’s willingness to pay is not based on the cost of goods, your price shouldn’t be either.
3. Unrealized revenue and profit can be substantial
A tire manufacturer developed a more durable, longer lasting tire. If a cost-based pricing strategy had been implemented the manufacturer would have set prices about 10% higher than competitive products reflecting the higher cost of materials required for added durability. This would have resulted in the manufacturer missing out on millions in profit, because the price would have been 10% higher but durability was 100% better than competitive tires. The manufacturer would have missed out on capturing the true value of the tire. To capture that premium the tire manufacturer developed an innovative pricing strategy. Historically, customers expected tires to be priced based on size; tires that are the same size should be about the same price. A 10% price premium would not have been received well by customers without realizing the benefits of the added durability. To avoid losing out on sales and profit, the manufacturer avoided a cost-based strategy and used a pay-per-landing model. This created a situation where the new tire could not simply be compared to competitive products based on size and price and customers felt they were getting better value paying per landing. The customers realized the benefit of the additional landings they could get out of each set of tires. The manufacturer achieved close to a 100% premium over competitive tires resulting in significantly higher profits than a cost-based strategy would have generated.
The impact of a smart pricing strategy will show up on your bottom line. Spend the time to price based on value and avoid the easy trap of cost-based pricing. It will pay off in the long run.
Paul Hunt is the president of Pricing Solutions, an international pricing strategy consultancy dedicated to helping clients achieve World Class Pricing competency. Written in partnership with Madeline Stein, Senior Consultant of Pricing Solutions.