How do you set the right price?

There are basically only two methods for determining the selling price of a product or service? You can either use what’s called a cost-plus model where a (usually) fixed mark-up percentage or amount is added to what the business’ pricing manager considers to be the underlying cost. (It works even better when your cost is accurately known!)

Or the selling price can be set by using what’s referred to as value pricing, which I learned to call perceived value. This is a nice way of saying, charging what the traffic will bear.

While my mentors always advocated using value pricing, as Hamlet would have said, this is more honored in the breach than the observance.  It can be complicated to do value pricing. Whose opinion of the value? The customer is what counts, but except in auctions, the source is typically the pricing manager’s instinct or market knowledge. And things get really complicated when the costs change, because the perceived value often doesn’t. At least not immediately.

Cost-plus pricing is simpler for many businesses to administer because a formula can be used to determine and later update the selling price. Of course, the trick is to know the proper profit factor to use. And it might not be a consistent margin across the range of products or services. Higher margins might be employed as the constant when perceived value dictates. So there obviously is room for hybrid methods.

This article from Harvard Business Review makes good arguments for why cost-plus is often the best approach.

No matter what system your business uses, you should ensure that there is some underlying logic in your approach that considers both the impact of complexity in administration, your ability to understand your costs accurately and how you stand against your competition and your customers’ expectations.

— Frederick Welk
CEDF Business Advisor


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