Value based Pricing, Cost based Pricing
Value-based pricing is a strategy of setting prices primarily based on a consumer’s perceived value of a product or service. Value pricing is customer-focused pricing, meaning companies base their pricing on how much the customer believes a product is worth.
Value-based pricing is used when the perceived value of the product is high. The strategy tends to involve products that possess a certain level of prestige in ownership or are completely unique.
Designer apparel companies are well-known for using value-based pricing. While a designer shirt may cost nominally more than a non-designer shirt to produce, the status carried by the designer brand increases the perceived value of the shirt. Many companies capitalize on such perception, increasing their margins greatly, while minimally reducing sales volume.
A similar strategy may also be used when the purchasing decision is emotionally driven. For example, while a famous painting may sell for millions of dollars at an auction, the cost of creating that painting is meaningless relative to the sale price. The value and price are being derived from the prestige of the artist, as well as other emotional aspects that the buyer may connect with.
Value-based pricing is different than “cost-plus” pricing, which factors the costs of production into the pricing calculation. Companies that offer unique or highly valuable features or services are better positioned to take advantage of the value pricing model than companies which chiefly sell commoditized items.
The value-based pricing principle mainly applies to markets where possessing an item enhances a customer’s self-image or facilitates unparalleled life experiences. To that end, this perceived value reflects the worth of an item that consumers are willing to assign to it, and consequently directly affects the price the consumer ultimately pays.
Although pricing value is an inexact science, the price can be determined with marketing techniques. For example, luxury automakers solicit customer feedback, that effectively quantifies customers’ perceived value of their experiences driving a particular car model. As a result, sellers can use the value-based pricing approach to establish a vehicle’s price, going forward.
Characteristics Needed for Value-based Pricing
Any company engaged in value pricing must have a product or service that differentiates itself from the competition. The product must be customer-focused, meaning any improvements and added features should be based on the customer’s wants and needs. Of course, the product or service must be of high quality if the company’s executives are looking to have a value-added pricing strategy.
The company must also have open communication channels and strong relationships with its customers. In doing so, companies can obtain feedback from its customers regarding the features they’re looking for as well as how much they’re willing to pay.
Cost based Pricing
Cost based pricing is a process of setting the price as a result of adding a profit margin to the cost of the product/service. This pricing method guarantees that certain profit is obtained above total cost.
When determining prices for products and services, companies commonly apply cost based pricing. This means to fix prices by calculating total cost and then adding a pre-defined percentage as profit margin. For example, if the manufacturing cost of a computer is US$1,000 and the price is defined like cost plus 10%, when the manufacturer sells a computer to the distributor charges US$1100. This is US$1,000 plus a $100 of profit.
This method considers the company’s internal situation but it does not provide information about the external environment. Setting a price based only in costs incurred could be inefficient when the product is well positioned in the market. In that scenario, the company might increase the price to take advantage of a favorable, but surely temporary market condition. If the price based in costs seems too high, the company should implement a cost reduction strategy or maybe it should study the possibility to reduce its profit margin.
Price = Unit Cost + Expected percentage of Return on Cost
Unit Cost = Variable cost + Fixed Cost
Selling Cost = Total cost of Product + Profit Margin
It is the simplest method of determining the price of the product. In cost-plus pricing method, affixed percentage, also called as markup percentage, of the total cost (as a profit) is added to the total cost to set the price. Say, for example, ABC organization bears the total cost of $100 per unit for producing a product. It adds $50 per unit to the product as’ profit. In such a case, the final price of the product of the organization would be $150. This pricing method is also referred to as the average cost pricing and used most commonly in the manufacturing organizations.
The formula to calculate the cost-based pricing in different types is as follows:
Price = Unit Cost + Expected Percentage of Return on Cost
It refers to a pricing method in which the fixed amount or percentage of the cost of the product is added to the product’s price to get the selling price of the product. Markup pricing is more common in retailing in which a retailer sells the product to earn a profit. For example, if a retailer has taken a product from the wholesaler for $100, then he might add up a markup of $50 to gain a profit.
Price = Unit Cost + Markup Price
Markup Price = Unit Cost / (1-Desired Return on Sales)
Break-Even Cost Pricing
In the case of Break-even Pricing, the company aims at maximizing contribution towards the fixed cost. This is relevant, particularly in the industries that involve high fixed costs like the transport industry. Here, the level of sales which will be required to cover relevant variable and fixed cost will be determined.
Price = Variable cost + Fixed Costs / Unit Sales + Desired Profit