The Tug-of-War Between Different Pricing Models

Marketers are familiar with cost-plus and value-based as two most frequently used pricing models for products and services.  Under cost-plus pricing, all input costs are totalled up and a markup is applied on top to arrive at the selling price. On the other hand, value-based pricing sets the selling price based on brand, competitor prices, perceived value of pain solved or gain created, and many other factors that are not linked to input costs.

Any given item in the market will have a price that is either based on cost-plus or value-based pricing models. This makes a direct comparison of the two prices impossible. However, most people intuitively know that value-based prices are often much higher than costs. The following price of a full English breakfast in a typical London five star hotel confirms this intuition beyond any doubt.

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This example has been taken from Hotel Babylon, a book written by Imogen Edwards-Jones and Anonymous about the luxury hotel industry in London.

At the same time, most people – including us – tend to believe that cost-plus and value-based prices for a given brand will be directionally identical. In other words, for two products A and B from the same manufacturer, if it costs more to produce B, we’d be inclined to believe that B should have a higher selling price than A, no matter whether the manufacturer used the cost-plus or value-based pricing model.

We recently came across an example which went counter to this notion.

Panasonic recently launched a new model of desk phone called KX-TSC62SX. Readers would be aware that feature-rich handsets generally need batteries and a charger to charge the batteries, as a result of which they need to be plugged in to the mains at all times. Unlike its older brethren, the KX-TSC62SX doesn’t use any batteries.

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No batteries means no charger, therefore KX-TSC62SX has a lighter bill of material and a lower cost as compared to previous models of Panasonic phones that require batteries. At the same time, lack of batteries means no need to plug a KX-TSC62SX to the mains. As a result, KX-TSC62SX alleviates the pains inherent with conventional phones of having to cart around one more wire and be tethered to a power socket.

Therefore, cost-plus pricing dictates a lower selling price, whereas value-based pricing justifies a higher selling price, for the same product. There’s the tug-of-wars between different pricing models.

8 Responses to “The Tug-of-War Between Different Pricing Models”

  1. Interesting post. What you didn’t point out is that customers (B2B or B2C) don’t care about what it costs to produce a product or service, but they do care about the value they receive. Yet 70% – 80% of companies still use cost-plus pricing.

    At PricingProphets.com, the worlds only crowdsourcing platform devoted to pricing, our experts only provide recommendations based on value-based pricing.

  2. sketharaman says:

    @Pricing Prophets: 

    Thank you for comment. We don’t subscribe to the view that buyers don’t care about costs. 

    Maybe it’s a cultural thing and varies from country to country, but we know lots of people in both B2B and B2C who keep doing back-of-the-envelope calculations of what something should cost and then assess whether the quoted price is fair or tantamount to scalping. It’s another matter as to how qualified such people are in making such calculations, and who determines what’s fair and what’s not, and so forth, but point is, these are potential buyers and they follow such practices.      

    We believe that companies like iSuppli that provide detailed bill-of-material and manufacturing costs of various products (e.g. iPad2) will reinforce this practice. Furthermore, not all buyers believe themselves to be capable of assessing the value of what they’re about to buy before buying and using it for a certain period. 

  3. softwarepricing says:

    While I agree with PricingProphets that people don’t generally care about your costs, I think they do if a). your prices are so low relative to costs (known or perceived) that you may go out of business or b). perceptions of the offering (not just the product) haven’t been managed so people see/understand the value.

    The GBP25 breakfast is a good example. To the hotel guest, a person on an expense account, or someone who is meeting a client, the price may be just fine — in line with the price of a 5 star hotel.

    People who are price sensitive would probably look at the bill of materials and decide the price was too high. They might look at the surrounding, the qualifications of the chef, the service, etc. and value all of these elements as nil. 

    These same people might view the same breakfast for GBP1 or 2.50 as fair since they didn’t have to cook the meal or clean up. (If they were really price sensitive and didn’t place a value on their time, they would likely only buy the ingredients — at a high price shop.)

    What this boils down to is the need to manage a customer’s perception of both the value and the costs — a task that can be very difficult.

  4. sketharaman says:

    @9618a94cb29aeaa2c058208c4cc01ce8:disqus:
    Thank you for your comments. We fully agree that it can be very challenging to simultaneously manage a customer’s perception around cost and value. 

  5. David says:

    I agree with Pricing Prophets.  As an example, may I quote a story about my own business.

    I don’t have an hourly or daily rate because I set my prices purely based on the value the customers tell me – before work ever starts – that they will derive from the results I produce.

    Once I went back and calculated my hourly rate, mainly because it would create a good story.  The best hourly rate I have ever worked for is £6,000 per hour, yes per hour!

    The customer and I agreed the value of the result and the price – £500 – for producing it.  The customer happily paid me the price and I delivered a totally acceptable result well within the desired timescale.  The delighted customer neither knew nor cared how little time – 5 minutes – it had taken me.

  6. David says:

    Managing perception of value is not difficult at all because it just never needs to be done.

    Value can only ever be in the eye of the beholder, so the customer has to tell you how much value they will derive.

    Often they will need help to understand value.  This is not difficult either.  It is a skill that is rarely innate but it can easily be learned by most people.

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