Pricing Strategies for Small Businesses: Value Based vs Cost-Based
Choosing your pricing strategy is one of the most critical decisions you have to make when launching a new product. It decides how profitable your business will be and how customers perceive your brand. Two common options that you can explore include value-based vs cost-based pricing. Let’s discuss the key differences between them, from their approach to benefits, so you can choose the right one!
What is a Cost-Based Pricing Strategy?
A cost-based pricing strategy is one in which businesses set the selling price based on a product’s production and distribution costs. It also includes a fixed markup for profit, so the business doesn’t end up with a negative EBITDA. Here’s the formula for that:
- Price = Cost of Goods Sold + Profit Markup
For instance, if the complete manufacturing of the product costs around $50 and you want to keep a 30% profit markup, you’ll set the price at $65.
Why Do Businesses Use Cost Based Pricing?
Businesses often go for cost-based strategy in value-based and cost-based pricing due to some undeniable benefits, including clear and simple calculations and stabilized prices. Let’s discuss them in detail:
- Simple to Calculate: Cost-based pricing is quite simple to calculate and implement. You don’t have to conduct massive customer or market research; you simply need elementary mathematics.
- Predictable and Transparent: In value-based vs cost-based pricing, the latter is highly predictable. When production costs, such as raw materials, fluctuate, you can adjust your retail price to reflect these changes while maintaining the same profit margins.
However, despite its benefits, this strategy also has some disadvantages. For instance, it overlooks the competitors entirely, which is a grave mistake, as you may get undercut by them. On top of this, it can give the impression that you are ignoring customer value and market demand.
What is Value-Based Pricing?
Value-based pricing is a strategy where businesses set the goods’ value based on their perceived value rather than the actual production cost. It includes parameters like how much customers are willing to pay and how much they believe it is worth. For instance, a software company may spend only $10 on development and maintenance, but if it saves users hours of manual work, customers may be willing to pay more for a subscription, from $60 to $100.
Why Do Businesses Use Value-Based Pricing?
In value-based vs cost-based, the former offers many advantages, such as great margins and increased brand equity. Let’s discuss them in detail:
- Easy Market Penetration: Value-based pricing paves the way for easy market penetration as you align your prices with what customers already believe the product is worth. You easily attract the right audience and justify your pricing without playing purely on low prices.
- Develop High-Quality Products: Since value-based pricing involves collecting feedback from the audience, you can know what your product lacks. This enables you to make changes in the solution to meet and exceed market needs and stand out from competitors.
- Get High Profit Margins: By pricing your products based on the value they deliver instead of their production cost, you can charge more to customers who recognize their value. This results in higher profit margins, allowing you to reinvest the money in product development, business marketing, and overall growth.
However, it also has some disadvantages: research requires ample time, and you may struggle to justify the higher pricing. In addition, you are already playing in a niche market, so when a competitor arrives, the market size becomes smaller, which can be quite challenging.
Conclusion
In value-based vs cost-based pricing, the right choice depends upon the type of business, end customers, and growth stage. A cost-based pricing strategy is good for businesses that need simplicity and predictability, while a value-based strategy is for those that have unique offerings.
