Did you know that pricing could be the most powerful profit lever you have in your business? It probably won’t be, however, because most executives still don’t know the difference between these 4 common pricing strategies.

  1. Cost-plus pricing
  2. Competitive based pricing
  3. Value-based pricing
  4. Dynamic pricing

As I am sure you’re already aware (because I know many consultants use this chart) pricing is the number one driver of profitability above volume, cost, and mix:

a pricing strategy is

Impressive right? Pricing is just as powerful as the consultants say. Both theoretically and empirically. But I’d like to put a caveat here in the usual consultancy spiel which is: …when you know what you are doing.

A chart like this is quite dangerous.  To people who don’t know about pricing, this chart suggests pricing for profit is just so simple and easy.

All you need to do is increase your prices by 1-3%, and away you go; you’ve just made up to a 10 – 30% increase in earnings – just like that.

Simple, right?

Well no. The truth is, most of us aren’t world class pricing managers and may not know enough about pricing, including the differences between 4 common pricing strategies or implementing a price rise to safely drive earnings growth.

In a way, the 4 common pricing strategies pricing teams use are still a mystery to most people (or perhaps a well-kept secret hidden behind overly simplistic bar charts).

Your finance director may well tell you that ‘they know pricing’ because they’ve very impressively put together complicated financial models, which identify an immediate revenue opportunity to raise product prices by 1 or 2% this quarter.

But inside, when you hear this, you’re probably thinking is this right? Can the market bare this kind of broad-brush pricing action right now?

Well, you’re right to be cautious about taking pricing advice like this because a broad brush price action seldom works out well.

In fact, in our experience, whenever a commercial director or CEO signs off on this type of brash price rise decision, they lose thousands of dollars. Plus the trust of thousands of customers in one fail swoop. (A harsh and memorable blow we don’t want to risk happening again simply because we didn’t have the depth of knowledge about 4 common pricing strategies.)

Most finance managers at this point squirm or cross their arms defensively. It’s not their fault. The price model said it was a good decision. However, their financial model is most probably based on cost plus logic. An assumption that has been proved to be full of flaws time and time again.

In many ways, behind all the financial jargon and financial modelling, pricing is still a bit of black art.

Most managers end up using their gut and intuition. A lot of bubble charts, graphs, and fancy models may well be produced before a price rise is taken to justify a price rise or strategy. But really, all this modelling is overcompensating for the fact they don’t know what the right price is and are guessing.

“The model says this price; it feels about right to me, let’s see how it goes…” the finance manager says.

Some managers may even talk themselves into adding extra on top of their original cost plus financial guessimates for safe measure.

Couldn’t hurt right?

“We need to make sure we are covering our costs, overheads, expenses and time & materials,” says a very prudent finance manager as he’s spreading costs across thousands of products and services to produce a supposedly fairer?? average cost position upon which to set an arbitrary margin on top.

Unfortunately, the wrong price or a poorly managed price rise has a direct and negative impact on your bottom line.

When you pull prices out of thin air, lots can go wrong….

You’re betting that your customers will happily accept your prices; and that they know less about pricing than you do.

But what if your customers are more informed about pricing in your industry than you are? What if they have done their pricing homework on you and your competitors’ prices?

That’s right; they’ll be very angry. Annoyed. Frustrated. They’ll feel ripped off. You’ll lose even your most loyal customers to your competitors simply because you didn’t know they were offering similar products and services to you but at lower prices.

So in this article, I am going to demystify ‘the dark art of pricing’ and share with you the 4 most common pricing strategies that successful businesses like GE, BP, Caterpillar, John Deere, Woolworths, Coles, Rockwell Automation, CSR all use so that you can get a head start on pricing for profit just like the big end of town.

So let’s get to the 4 common pricing strategies. First, up: Cost-plus pricing.

Cost-plus pricing strategy examples

Cost-plus pricing is a pretty simple method. It’s probably the simplest of all the 4 common pricing strategies out there.

A good cost-plus pricing example is when you add up all of your costs, then add a fixed percentage amount on top of a product or services cost.

The cost-plus pricing formula is: Price = Cost + added amount.

Cost-plus pricing meaning is: Work out the cost of an item or service in detail. Then put an arbitrary, made up percentage amount on top of the services costs to get the margin you want.

A cost-plus pricing strategy is a top-down costing approach to improving profitability. It is very accountancy driven because cost-plus pricing looks at determining a product’s unit cost first to then determine price. To do this, you got to include direct as well as indirect costs associated with the product or service.

If you’re not sure what fully allocating costs means, cost allocation is the process of identifying, aggregating, and assigning costs to cost items before you set a percentage amount on top to get your margin. A cost item is any activity or item for which you want to separately measure costs.

Retail and B2B businesses have used cost-plus pricing strategy examples for many years now to make sure they were ‘fairly’ covering their costs and hitting their margin target.

The cost-plus pricing method is still very popular today because it’s relatively simple to add a percentage amount to a product’s or service’s cost to set a price.

Cost plus is widely used in both B2B and B2C markets because ‘pricing’ is still to this day managed largely by finance managers (as opposed to pricing managers) who believe cost-plus pricing strategy is the most financially prudent way to yield a fair and safer return overall fully allocated costs.

by product pricing strategy

But here’s the problem with cost-plus pricing…

Cost-plus pricing assumes you can set prices without impacting volume. But this is not realistic at all.

It’s almost impossible to determine how much a product costs per unit when you don’t factor changing in costs with changes with volume.

It’s also pretty difficult to work out a product’s or services unit costs because a product’s unit cost is not a static thing – it’s a moving target because it’s impacted by volume.

Many finance managers try to get around this problem by simply avoiding the impact of volume on cost when they set prices. Which yes, is a pretty absurd assumption to make because no matter how hard finance managers try to avoid it, unit costs change with volume changes; and volume changes with price changes – fact.

Cost pricing strategy explained

The failure to account for the effects of price and volume and volume on price leads finance team to make risky pricing decisions – like poorly structured price rises.

If you increase prices to cover increasing fixed costs, you’ll quickly reduce sales and annoy customers because your prices will go up way too high beyond what the market can bear.

Likewise, if you decided to lower prices because sales are higher than expected, and you’ve spread costs over more units, you’ll lose margin. This is because your average unit cost would have declined to the point that the percentage amount you added to the product’s cost base may not even be enough to cover your actual costs – let alone hit your margin target.

In other words, a cost pricing strategy leads you to overprice in weak markets and under-price in strong markets. It’s probably the least effective strategies of all of the 4 common pricing strategies out there.

Thinking that you can make up for a bad pricing decision or action by simply lowering your prices is a big mistake too (and a mistake that does not correct a bad cost-plus strategy example). This is because you are wrongly assuming people only buy on price, when in fact, price is only part of the story.

Not thinking about the effect of price on volume and volume on costs may appear to be maximising margins (from the cost side of the profit equation), but it’s seriously undermining profitability (from the revenue side of the profit equation).

Not considering your customers and the market when you set prices is a fundamentally broken and flawed pricing model – no matter how common an approach cost plus still is across industries.

Your customers don’t care about your explanations of your costs when they buy from you. What they care about when you discuss your price with them is how you are going to:

  1. Solve their problems,
  2. lower their costs;
  3. or make them more money from the commercial exchange.

What is a pricing strategy…

When you set prices, managers shouldn’t even be dealing with the problem of pricing to cover costs. A cost-focused approach to pricing reflects an old-fashioned perception of the role of pricing; a perception based on the belief that a finance manager can first determine sales levels, and then calculate unit cost and profit objectives, and then set a price. Not realistic at all.

Overall, cost-plus pricing is the most inward-looking approach to pricing for profit of all of the 4 common pricing strategies. Cost-plus pricing strategy examples don’t grow with the market – they destroy value.

Cost-plus pricing was a medico approach at best when markets were simpler, and price environments were more stable. Markets, nowadays are by no means simple. Many industries have been disrupted. Pricing for profit has moved along way in the last twenty years.

It’s probably best to stop using cost-plus pricing now and get a high calibre pricing manager with a different view on pricing. One who asks questions about how a change in price will result in a change in revenue. And, whether this change is enough to offset the change in total fixed, variable costs.

A good pricing manager asks different questions to accountants. They are focused on calculating the change in volume necessary for any proposed price rise or adjustment. Many accountants don’t know how to do this. Or, simply just can’t get their heads around price profit elasticities, customer value, customer psychology, and marketing. Not their fault, their passion and skillset are accountancy and spreadsheet modelling – not making money using advanced pricing strategies and practices.

Next up competitive based pricing.

What is competition based pricing?

Competition based pricing is when you set your product or services prices by lining up all your competitors’ prices for the same or similar items or services and then benchmark or compare where your prices sit versus your competitors’ prices.

Competitive pricing strategy advantages and disadvantages

Again, like cost-plus, there are benefits to competitive pricing. Its a relatively simple pricing strategy to implement against a monopolistic price taker or maker. Especially if you can get the data on your competitor’s prices. Their prices tend to be publicly available.

Competitive pricing is also a pretty good approach to take if you want to factor pricing under imperfect competition because you’ll find out quickly whether your prices are somewhere in the right zone or not.

But, here’s the problem with competitive pricing…

Using this approach, you’re assuming your business model, operations and products are pretty much the same as your competitors. You’re assuming that you are selling to the same customer base as your competitors. And, you’re assuming that your competitors have done their pricing homework and know more about the market than you.

Not the case.

  • What if your competitors are going after a completely different market segment to you?
  • What if your competitors’ products are not exactly like yours?
  • If your major competitor is de-linking from costly operations to reduce their CAPEX and using freed-up cash flow to invest in a penetration pricing strategy to gain market share, what then?
  • What if your competitors are following your price movements (kind of like the blind leading the blind scenario)?

Like cost plus, competitive based pricing is a bundle of unfounded assumptions and guesswork.

It has a few good elements to it (as discussed), but overall its one of the 4 common pricing strategies which lack depth.

Remember: don’t rush to use competitive based pricing too quickly. Most companies are not ready to compete with you like you think they are.

Your competitors are not like you, so your pricing really should be like theirs.

It’s probably best to build out your pricing strategy if you want more earnings growth (using the other 4 common pricing strategies) if this is current strategy to date.

Next up: value-based pricing.

Value-based pricing definition

Out of the 4 common pricing strategies out there, value-based pricing is one of the best pricing strategies available.

A value-based pricing strategy should be designed and developed completely around what your customers think is valuable about your products and services (not what you think is valuable).

The difference between cost-based pricing and value-based pricing is that value-based pricing sets the price of a product according to the value it provides to the customer and not, for example, based on its manufacturing costs (like cost-plus pricing) – sometimes referred to as customer value-based pricing.

Companies that use value-based pricing include Hilti, John Deere, Caterpillar, 3M, Parker Hannifin.

A value-based approach as you can see is not just about the price. It’s about the product, positioning of that product, branding, marketing. There is no one size fits all to customer value-based pricing.

Value-based pricing requires you know your customers inside out. You need to know what your customers want to fulfil their needs and create or articulate value for them. This means finding out how your products or services make your customers’ lives easier before you put a price on a product or service. By no means the easiest of the 4 common pricing strategies.

Remember price is a summation of value; not an arbitrary number generated by overly complicated cost allocations and made up mark up percentages (like cost-plus pricing strategy) or margins (margin-based pricing).

You’re probably wondering, then, if value-based pricing is so good, then why do so many companies resist customer value-based pricing strategies?

The only real drawback of value-based pricing is that no one can do it properly. It is a great concept, but there are only a few pricing experts out there who have mastered how to design and implement value-based pricing strategies, algorithms, and needs-based segmentation.

The truth is; most consultants, let alone finance managers and pricing managers, haven’t yet figured out how to translate customer value into price points which sum up the total economic value of commercial exchange.

Many managers, even software pricing developers, have still not created a value based algorithm to set and manage prices. The majority of software algorithms rely on complicated regression models, which, yes, are mathematically sound, but not really value based.

Even the best price software vendors are still modelling pretty standard price volume data rather than psycho-graphic variables (nothing radically different from what good pricing managers have been doing but just more powerful systems to crunch more data).

But let’s not be mistaken. Price optimisation is not value-based pricing; it’s a process of customising prices, not a strategy.

Of all the four common pricing strategies, value-based pricing requires that the manager truly understands his or her customer base, including changing preferences and complicated decision-making processes – which seems to enter the realm of psychologists, not mathematicians or financial analysts…

You see, computers are still not capable of interpreting emotion like humans; and 99% of decisions made by people, including most pricing decisions are emotional. So why do companies insist on hiring accountants for value-based pricing management roles? This makes absolutely no sense.

Many consultants think they have solved design and implementations issues using customer or needs-based segmentation. But they haven’t really because most customer segmentations are not psychographic segmentation. Rather they are standard segmentation; sorting customers only by descriptive criteria like size or application field.

Only a small number of companies do a needs-based or value-based segmentation to identify customer groups with distinct needs. This includes specific willingness to pay profiles, risk driver analysis, and psychological/persona profiling.

Needs-based segmentation is important when you implement a value-based pricing strategy. It helps a pricing manager to develop different offers for different groups of customers based on their needs. (i.e., offers which balance what customers want with the amount of money they are ready to spend to fix their problem).

The problem with needs-based segmentation, however, is that they are generally designed and implemented by managers who are great at numbers, but not great at understanding people (including their own teams). Fair enough, they are not born leaders or even trained psychologists.

Value-based pricing (algorithms and segmentation) requires a lot of research and pricing expertise to be implemented properly. It’s not a simple slap a fixed margin, and away we go.

The secret to world-class pricing is an equal mix of psychology, economics, mathematics, science, strategy, sales. Many managers water down the value part of pricing with hunches and rules of thumb. They even leave out the parts they don’t feel comfortable with – usually the psychology part.

While leaving value out of the price profit equation is tempting for people that do not possess the right skill set for value-based pricing, value-based pricing (minus the value part) will inevitably underwhelm and disappoint you. You won’t get the earnings to grow you want. You may even lose money by implementing a poor interpretation of value-based pricing in your market.

To develop and implement a value-based pricing strategy successfully, you need to re-think pricing and who you put in your pricing team. Don’t expect a finance manager to naturally pick up customer psychology. And, don’t expect a sales manager to naturally pick up mathematical modelling. There’s a reason value-based pricing experts get paid a lot. They have mastered a very difficult topic and get great results.

Finally, the last pricing strategy is dynamic pricing.

cost pricing strategy

Dynamic pricing advantages and disadvantages

Dynamic pricing is the last of the 4 common pricing strategies and one of the latest addition to the pricing strategy repertoire.

This strategy enables you to sell the same product at different prices to different groups of people.

Dynamic pricing can be implemented in two ways: Time and groups.

Pricing based on groups is when companies use pricing algorithms and statistics to calculate different prices for the same product to different customer groups.

Pricing based on time refers to when a price goes up or down based on time or during a price cycle. Think airline ticket prices.

Dynamic incremental pricing example

Imagine you were the revenue manager of a major Australian airline, for example, and you saw that one of the planes on the system leaving tomorrow morning was only half full.

What pricing action would you take to increase the profitability of that flight?

  1. Keep the airline seat ticket prices the same price?
  2. Slowly reduce prices?
  3. Sharply decrease the price so that last minute buyers would buy on the spot?

First, of all, if you were managing this flight, you’ve held onto these seats for too long and have interpreted the price cycle incorrectly to implement dynamic incremental pricing.

Second, you’ve left yourself with limited time and a limited amount of good options. You now have to make a bold price action to cut prices substantially to fill the jet. You’re pretty much banking on last-minute buyers buying on the spot. A stressful and risky pricing decision because low prices are still no guarantee of filling the jet. People don’t just buy airline tickets because they are cheap. This would be non-nonsensical – they still need a valid motivation and reason to buy a flight.

Third, if you hold on and leave prices high, yes, the margin per seat or unit sold will be higher, but the overall flight will be loss-making. The airline would be displeased. You’d probably be out of a job.

Disadvantages of dynamic pricing

The big problem with dynamic pricing is that it can get very tactical, very quickly when you don’t have the right strategy or expertise to implement dynamic incremental pricing.

Like value-based pricing, dynamic pricing is very difficult to implement; and it takes a huge amount of time, expertise and resources to customise prices.

Dynamic pricing can be assisted by data and algorithms, but can be a black box if you don’t know how to manage it. So you bought a high power price optimisation system to implement dynamic pricing across different micro-segments? That doesn’t mean the system is going to do your work for you or do pricing well.

It takes a pricing system a long time to learn how a market operates. Just when it has learned the ropes, the market often changes again. The system has to re-learn all over again.

Dynamic pricing should not be used blindly or in isolation. When dynamic pricing is implemented, devoid of a clear strategy a mismanaged business can lose lots of money customer trust.

If you are considering implementing dynamic pricing in your business, get a high calibre pricing and revenue management team to track dynamic prices and apply checks to ensure prices remain reasonable, in line with broader company and pricing goals.

Conclusion

So there you have it, 4 common pricing strategies. These lessons underline how important it is to know your customers, your market and the particular variables about your business:

  • Costs
  • Volume
  • Revenue
  • Price
  • Margin
  • Customers
  • Market
  • Industry
  • Product perishability
  • Supply and demand changes
  • Price elasticity and constraints

Better systems and processes have empowered more companies by opening up new and creative ways to implement these 4 common pricing strategies. However, the calibre of the team managing your pricing and revenue models should never be seen as an after-thought (or secondary issue).

Forgetting the human element in all 4 common pricing strategies is a guarantee for failure. In fact, each of these 4 common pricing strategies, while reliant on technology, also require fundamental shifts in thinking, mindset, and culture to succeed. Making human input ever more important.

Whatever strategy you choose, remember, the 4 common pricing strategies in this article, must never be led from the top. Pricing is very much a ground-up activity requiring a step-by-step change management approach.

If you would like to know more about what a world-class pricing manager does to implement pricing strategies – or want to brush up on your pricing skills and knowledge. I’ve put together an e-book to help you click here.