Cost-Based Pricing, Value-Based Pricing, and Price-Based Costing

Yeah, that’s a confusing jumble of a title, but these are important terms for anybody in business. Unfortunately they’re easily-misunderstood-and-conflated important business terms. Hopefully I can help with that.

I’ll be explicit about just one thing regarding pricing. The point is to maximize profits, considering the fact that the more you charge the less people buy. With that as background, I’m going to explain what each of these pricing methods means.

Disclaimer: This is not an academic approach, so I won’t guarantee my definitions will meet that standard. You should be able to figure that out from my tone, but this is the internet. If you’d like to point out some missed distinction that is useful to the point of this post, please behave as if this weren’t the internet and do so politely and intelligently.

Cost-Based Pricing

Here’s how it works: Figure out how much it costs you to make your stuff, and charge more than that. Done. Of course, figuring out cost is a little more complicated because of fixed and variable costs, and there’s some flexibility in your margins, and you have to consider volumes to know whether you can turn a profit, but that’s the basic idea.

This is the bare minimum pricing method, a step above blind-pricing (also a popular method). It’s ultimate goal is to meet the “let’s just not die” threshold. The main advantage that cost-based pricing has over blindness is that, when done correctly, you won’t get the price so wrong you’ll lose money. But you’re not likely to maximize your profits either. As such, it’s not exactly the nirvana of the business world, but it’s probably the most commonly-used and easily-understood pricing method.

A good example of this is Sony’s PlayStation 3. It cost $600 when it was first released because it cost so damn much to build. I’m deliberately ignoring all other facts that make the PS3 a terrible example of cost-based pricing. I invite you to do the same.

Value-Based Pricing

Cost-based pricing isn’t terrible. Plenty of companies have made millions using it, but if you want the quickest path to Scrooge McDuckish piles of cash, value-based pricing is the way to go. Here’s how it works: Figure out how much people are willing to pay for your stuff, and charge that. The assumption here is that the price will end up being considerable higher than a cost-based price. Of course, you still have to know your costs so you can feel appropriately awesome for charging so much for your goods or services.

Value-based Pricing is generally superior because it allows you to break free from the confines of cost, and make more money. Yes, it’s more complicated than that so let me just put it this way. If you knew you could increase your prices without a significant hit to volumes, wouldn’t you? If the answer isn’t yes, you’re a communist.

Gasoline, is a pretty terrible example of this, but I’ll use it anyway. Because of competition, gas prices are primarily determined by cost, but when prices go up, people don’t really buy much less. This means that oil producers could collude to raise prices without losing money on decreased volume. Really though, it’s not like some Organization of Petroleum Exporting Countries could ever colluded to raise oil prices in the 1970s, right? So yeah, terrible example.

Price-Based Costing

This is actually not a pricing method at all, but because it’s just the word-reversal of cost-based pricing, people often think it means pricing based on what people will pay rather than how much it cost to make. Here is what price-based costing really means: do market research and figure out the pricing sweet-spot, then design and build your product around a cost that lets you make money at that price.

In price-based costing, you determine the product to make based on what people will pay, not what people are willing to pay for the product you made. These terms are easy to distinguish. Just ask yourself whether you already have something to sell. If you do, you’re already past price-based costing and you want to go for value-based pricing if possible. If you don’t have something to sell but you know there’s a market for something, (you’re just not sure exactly what yet), then you’re in a good position to do some price-based costing.

An example of this is PCs. HP and Dell determine various price points they want to meet in the market, then decide what hardware to put into their boxes in order to meet those price points. Hey! a good example finally!

Wrapping Up

If you’re doing anything businessy, don’t confuse these terms. If you think I’m wrong, you’re wrong. Unless you seriously think I’m really wrong, then feel free to tell me. Just remember that you’re wrong.

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