3 Approaches to pricing & how to pick the best model for your startup

Let’s face it. As an entrepreneur, creating a pricing strategy can feel quite daunting, and it’s easy to get caught up when choosing what kind of approach is best for your startup–there are so many ways to go about it!

 

Nevertheless, having a strong pricing foundation is a critical part of building a long-term growth strategy, because your foundation will involve understanding what kinds of pricing approaches there are and knowing which approach will best deliver value for you and your company’s goals.

 

Let’s get started with the basics. 

 

The 3 Main Approaches to Pricing

There are three core approaches companies use to price: 

 

1. Cost-plus Pricing
2. Competition Based Pricing
3. Value Based Pricing

As you consider which pricing approach to adopt, think about the impact of choosing one over another. 

 

Each approach requires specific types of input and information to design and execute as a part of your overall strategy. Gathering input will require data collection, field research, analysis, and testing. The more you know that’s backed by data, the higher quality pricing decisions you can make. 

 

Each approach also presents different kinds of growth opportunities. Those growth opportunities start with revenue and profit growth, but include market and customer expansion, as well as product diversification. 

 

Cost-Plus Pricing

Cost-plus pricing is the simplest of the three approaches, because it takes your costs then adds a largely arbitrary margin to come up with a final price point. It can be summed up using this equation:

 

Price = Unit Cost + (Unit Cost x Markup %) 

 

For example, let’s assume you are pricing a chair. If it costs $10 to make or source the chair and you want to ensure a 100% margin from each chair sale, then the price you would charge customers would be $20.

 

$20 = $10 + ($10 x 1) 

 

The primary inputs considered in cost-plus pricing are your costs and your margin expectation. 

 

Why is cost-plus pricing popular? 

Cost-plus pricing is the most common form of pricing used by companies. There are a few reasons for this: 

 

1. It’s simple. Your inputs, cost and margin expectation, are data points that are relatively easy to gather and calculate. 
2. It’s designed to prevent unprofitable sales. Prices designed with cost-plus pricing ensure that your costs are covered by your price. 
3. It’s straightforward. Most companies don’t have to think about their pricing again after using cost-plus pricing. 

 

Beware of cost-plus pricing pitfalls 

In theory, this pricing approach sounds great! Your costs are covered and you can set your own margin expectations to easily reach a final price point. For some companies, this is and should act as a starting point to understanding their pricing. 

 

However, sticking with cost-plus pricing ultimately underserves companies because it cannot account for other factors that influence price. 

 

1. Cost-plus pricing requires quality data

While costs are generally straightforward, many startups do not understand the intricacies of how those costs are calculated. This results in pricing that is constructed with incomplete–and in worst cases incorrect–data, thus less profit is generated than was originally assumed. 

 

2. Cost-plus pricing undervalues your product

When designing prices with cost-plus pricing, you are potentially undervaluing and under-pricing your product, because cost-plus pricing does not account for your customer, their perception, or their willingness-to-pay. Without fully understanding what your customer thinks of your product (including how much it’s worth), you could be leaving revenue on the table. 

 

3. Cost-plus pricing doesn’t account for competition

Finally, cost-plus pricing does not explicitly account for market and competition dynamics. While this is sometimes assumed when setting your margins, adjusting your pricing to reflect these factors becomes more difficult when inevitable competitive shifts occur. 

 

Cost-plus pricing can help you start to design your pricing strategy, but it clearly can’t be your long-term structure. Let’s look at a competition-based pricing approach that can help your pricing respond to market dynamics. 

 

Competition Based Pricing

Competition based pricing designs prices using available information on your competitors–but it goes beyond just knowing their prices.

 

This approach is more complex than cost-plus, because it requires companies to define their competitors, assess their products against what their competitors offer, and conduct market research to collect relevant data–which includes data on their prices–to analyze and assess.  

 

A core component to competition based pricing is positioning. Ideally, a competitive price positioning decision is based on a data-driven strategy that can inform more accurate decisions. 

 

Depending on how your startup is positioned relative to your competition, the desired outcomes can vary when you price.

 

Pricing below your competitors

This one way to differentiate and to draw customers driven by price when making a purchasing decision. You are creating an affordable option that customers can opt for instead. 

 

But be careful. 

 

Pricing below your competitors can be a short-term solution to initially bring in customers before re-positioning in the future. However, it is much more difficult to raise your prices from a low initial price. Think tactically when employing this pricing model, and be sure to manage your unit economics well when positioned here. 

 

Pricing at or similarly to your competitors

This brings the focus to your product itself, and relies on its features to differentiate from the competition, not the price. In this case, the ability to market your product in order to stand out is most critical.  

 

Pricing above your competitors

Pricing at a premium means using your pricing to send a statement to customers that there is more value and benefit delivered when purchasing your product–thus justifying a higher price point than what your product typically goes for. For example, if your product has extra features your competition can’t offer, or is of higher-quality than your competition’s product, you have a great opportunity to introduce premium pricing. Essentially, instead of competing on price, you’re competing on quality so that you can charge a higher price. 

 

Competition based pricing works best when you have a clear business model that can inform your market positioning. This approach also begins to explain how companies set premium prices that can help them secure more of the potential revenue that their products are capable of bringing in. However, even competition based pricing has some limitations. 

 

Difficulties when setting competitor based prices

The primary input of competition based pricing is competitor information, which makes this approach difficult to repeat and sustain, especially if you offer a wide range of products or if you are looking for long-term growth. Additionally, your growth opportunities are limited, because this approach makes the assumption that your product is a replacement, rather than an additive and expansive product in the market. 

 

Competitor-based pricing can work well for some, but for startups looking for more ways to differentiate and seek long-term growth opportunities, there is one more pricing approach to consider. 

 

Value Based Pricing

Value based pricing sets prices based on research and data on your customers and the unique value your product or service offers. This is the most complex of the three approaches, because not only does value-based pricing ingest cost and competition data, but also requires insights about your customers to drive more targeted pricing decisions.  

 

Similar to competition based pricing, which 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.

 

This approach creates the opportunity for more variation in pricing, not less. Why? Because every customer has their own perception of value and associated price of that value. Value based pricing identifies and designs pricing around knowledge of perceived value. This then creates new growth opportunities, because  the addressable market is expanded both through prices and the offers/packages created around those prices. 

 

Challenges of Value Based Pricing

The main challenge of implementing 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–and may be a lot for one person (for startups, likely the CEO), to handle on their own. Consider getting your team involved when designing your pricing. Check out this article for more on why pricing has a huge impact across your business and tips on how to set up stronger pricing infrastructure.  

 

Considered to be the gold standard of pricing models, the growth opportunities and differentiation created by value based pricing can have a greater impact on your company, because they are driven by your product’s value and your customers’ willingness to pay. In addition to pricing applications, the insights collected and analyzed to form your pricing can also be used in marketing and in the sales and customer success funnels. 

 

Quality research can really pay off.

 

Final Thoughts

Each pricing approach has its own merits, and which approach you will ultimately use should be driven by your company’s objectives and needs. 

 

When evaluating which pricing approach to go with, consider repeatability and scalability for the long-term. Ask yourself these questions: 

 

• Does the pricing approach help you accomplish your startup goals? 
  • Beyond a price point, your pricing can achieve so much more for your startup (revenue, positioning, etc.). Think beyond the number. 
• Which pricing approaches can your business support with its current resources? 
  • Like any other part of your business, better information and input lead to higher quality decisions and outcomes. When it comes to pricing, this remains 100% true. 
• As your company and product evolves, will your pricing approach be flexible enough to keep up with market, customer, and growth changes? 
  • Change is inevitable, and your pricing needs to be ready to adapt. Each model is capable of adjusting to new dynamics that will affect your pricing, so choose wisely which model will best serve your company. 
• How will your chosen approach enable you to leverage your pricing to grow and push your company further?
  • Your pricing is a critical part of your company’s growth journey, because it’s a statement of value you make to your customer. Being able to express value at all stages of growth is how the best companies differentiate and stay on top. 

 

Pricing exists at every company, but smart pricing sets industry leaders apart. The sooner you fine-tune your strategy, the more prepared you’ll be to take on the market at every stage of growth. No matter which approach you choose, make sure your business isn’t just competing—but winning with pricing.