Let’s face it. As an entrepreneur, creating your pricing for your company can feel quite complicated.
It’s easy to get caught up in the complexities. Building up a strong pricing foundation involves understanding different pricing approaches and choosing one that will be the best fit for you and your company’s goals.
There are three core approaches companies use to price:
- Cost-plus pricing;
- Competition-based pricing; and
- Value-based pricing.
As you consider which pricing approach works best for you and your company, think about the impact of choosing one approach over another.
Each approaches requires a different types of inputs and information to design and execute. This requires data collection, field research, analysis, and testing. The more you know – backed by data – the higher quality pricing decisions you can make.
Each approach also presents different growth opportunities. Those growth opportunities start with revenue and profit growth, but includes market and customer expansion and product diversification.
Three important areas to consider:
- The price itself is not the goal, so consider what pricing will do to help you reach your objectives. What will pricing help your business accomplish?
- Think about the process and how accessible each approach is for your business.
- As you weigh out the approaches to pricing, it is important to consider what data and information you need to decide if it will work for your business’s needs.
Pricing is a process, but it doesn’t need to be an overcomplicated one. Let’s go through each approach.
Cost-Plus Pricing
Costs set the stage for how a company prices using this approach and goes to market.
Cost-plus pricing is the simplest of the three approaches. Why? Because it takes your costs, and adds a largely arbitrary margin to come up with the price.
Let’s assume you are pricing a chair. If it costs $10 to make / source the chair, and you want to ensure a 100% margin from each chair sale, then the price you charge customers would be $20.
The primary inputs for this approach are your costs and your margin expectation.
Cost-plus pricing is the most common form of pricing used by companies of all sizes. There a few reasons for this. First, it’s simple. You take your costs which is a data point relatively easy to gather and calculate. Second, cost-plus pricing is designed to prevent unprofitable sales. Lastly, it is simple enough that most companies don’t have to think about pricing again.
What could go wrong with this pricing approach? There are three reasons why this approach under-serves companies starting with the quality of data.
While costs are generally straight-forward, many companies do not understand the intricacies of their costs – from manufacturing companies to software startups. This results in pricing that is constructed with incomplete – and worst cases incorrect – data and less profit generating than originally assumed.
The second disadvantage of this approach is potentially under-valuing – and under-pricing – the product because it does not account for the company’s customer, the customer’s perception and willingness-to-pay. Customer information is general and often-time anecdotal.
Finally, cost-plus pricing does not explicitly account for market and competition dynamics. While this is assumed in the margins set, this is difficult to account for and more difficult to replicate when inevitable competitive shifts occur.
Let’s now look at competition-based pricing that takes into account more market dynamic data.
Competition-Based Pricing
Competition-based pricing approaches builds prices using available competition information.
This approach is more complex than cost-plus because it requires companies to assess their products against competitor offers, define their competitor set, and conduct market research to collect relevant data – including competitor’s prices – to analyze and assess.
A core component to competition-based pricing is positioning. Ideally, the competitive price positioning decision is based on a data-driven strategy, but in most cases is an arbitrary decision.
Depending on how you position relative to competition, the desired outcomes can vary. When you price:
- Below competitors: This one way to differentiate and to draw customers driven based on price. This can create an affordable option against the competition. When thinking more tactically, pricing below can be a short-term solution to initially bring in customers before re-positioning in the future. Managing your unit economics is critical when positioned here.
- At or similar to competitors: The focus is on the product itself to differentiate from the competition, not the price. In this scenario, the ability to market the product in order to stand out is most important.
- Above competitors: This is a differentiation play. It is to use your pricing to send a statement to customers there is a difference in the value proposition and benefits delivered. This could mean having extra features or offering a premium product that your competition may not be offering. Instead of competing on price, you’re competing more so on quality in order to charge a higher price.
Having a clear business strategy is important to guide this decision on where to position yourself.
Much like cost-plus pricing, competition-based pricing uses other people’s prices to drive your prices. Costs are the prices for your vendors and suppliers. Competition prices assume those prices are comparable and representative of your own product and customer’s value.
While competition-based pricing is more reflective of the market and customers within that market, the value your product creates for your customers is not reflected in the prices. By definition, your product exists because it is different and offers unique value. This approach is often proactive, because the primary input is competitor prices making it difficult to repeat and sustain. Finally, the growth opportunity can be limited, because one core assumption is your product is a replacement, rather than additive and expansive in the market.
Competitor-based pricing can work well for some but for those companies looking for more ways to differentiate and seek more growth opportunities, there is one more pricing approach to consider.
Value-Based Pricing
Here’s where we focus on your customers and the unique value you’re offering.
Value-based pricing is the most complex of the three approaches because this approach requires more research and data. Not only does value-based pricing ingest cost and competition data, but now collects insights about your customers to drive more targeted pricing decisions.
While competition-based pricing focuses on the going “market rate”, value-based pricing is driven by how your customers perceive the value of your product and their willingness to pay associated with that value.
Pricing decisions are driven by customers and the customer rings where they fit.
This approach looks for more variation in pricing, not less. Why? Because every customer has their own perception of value and associated price relative to that value. Value-based pricing identifies and designs pricing around this knowledge.
This creates growth opportunities, because the addressable market is expanded both through prices and the offers/packages created around those prices.
The challenge to value-based pricing is the additional effort required to collect the necessary data and insight. This needs time and resources to do the research to understand your customers.
Considered to be the gold standard by many, value-based pricing creates growth opportunities and differentiation driven by your product and your customers. In addition to pricing applications, the insights collected and analyzed can be used in marketing communication, and in the sales and customer success funnels.
Research can really pay off.
Final Thoughts
Each pricing approach has their own merits, and which you will ultimately use should be driven by your company’s objectives and needs.
Like any other part of your business, better information and inputs lead to higher quality decisions and outputs. When it comes to pricing, this is absolutely true.
One other consideration evaluating the approaches to pricing is repeatability and scalability. As your company and product evolves, it is important to assess how your pricing approach keeps up with that change? How will your approach enable you to leverage your pricing to grow and push your company further?
Great pricing is a competitive advantage, so whatever approach you use, make sure you are setting up your company to capture this advantage.
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