Cost-Plus or Value-Based: Who Wins?

Introduction

The world of pricing is divided into two major schools of thought: Cost-plus pricing and value-based pricing. Cost-plus pricers believe in understanding the cost of making a product and then adding a profit margin on top of the cost to arrive at the price of the product. Value-based pricers on the other hand are not keen at looking at cost or a target mark-up. Instead they focus on realizing the value that the product brings to the customer and then pricing it according to the value.

Which method makes more sense? Which method is a better approach to pricing? Which method helps the customer get a better price? Which method helps a firm make more profit? I won’t use this article to deduce the answers to these questions – rather I would state my answer at the very outset and use the rest of the article to explain why I say so.

Yes the answer to all the above questions is “value-based pricing.” Cost-plus fanatics might think that I am out of my mind or I am being plain self-contradictory – How can I give the customer a better price while helping my firm make more profit?

Myth-Busting

To begin with let’s clear some misconceptions regarding value-based selling. Unfortunately these misconceptions are deep entrenched in the literature that we value today. For example, popular hearsay found in Wikipedia as of May 2015 has this to say about value-based pricing:

“Value-based pricing (also value optimized pricing) is a Pricing strategy which sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. Where it is successfully used, it will improve profitability due to the higher prices without impacting greatly on sales volumes.

The approach is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g. drinks at open air festival at a hot summer day) or for indispensable add-ons (e.g. printer cartridges, headsets for cell phones). Goods that are very intensely traded (e.g. oil and other commodities) or that are sold to highly sophisticated customers in large markets (e.g. automotive industry) usually are sold using Cost-plus pricing.”

Nothing could be more misleading about a discipline than the above paragraph! Here’s my take on why Wikipedia got it all wrong while explaining value-based pricing:

1. Value is not defined by the seller but perceived by a buyer: Real value-based selling is all about understanding total benefits and then pricing it below the dollar value of benefits to show a customer savings. The job of the seller is to identify the true benefit and value. A component that a customer doesn’t accept as a value-add should not be used during the value calculation. Isn’t that simple to understand?  Yet Wiki says “value, rather than cost or historical prices.”  Really?

When we calculate the total benefit the formula used is simple = Cost of Next Best Alternative + Additional Value.

Assume a customer is paying $2 for a product today. I launch a similar product and make a pitch to the customer. Can I ask him to pay $3 or $5 or $10? If my product is not different from the incumbent product the best I can charge is $2. In reality I might have to go lower than that.

Let’s revert to the numerical definition and find out the value that my product brings.

Total Benefits = Cost of Next Best Alternative + Value add
= $2 (in this case) + $0 (in this case)
= $2

Hence the price has to be less than $2 for the customer to perceive value in my product.

Thus historical price of competing product becomes a reference for the value of a product that is undifferentiated from the competing product. If am pricing higher,  it is due to value add beyond the historical price of the next best alternative – even then historical pricing is definitely a reference.

2. Value-based selling is applicable every-where and not just niche markets: Yet again when wiki tags value-based selling to niche markets they end up misrepresenting the topic. I will explain why with an example. Let’s consider a product that sells to a mass market – the product has a high demand and a commensurate high supply (many customers and many sellers). How can a seller sell in such a market? What should be his pricing? If his offering is undifferentiated from the competition then the price at which competition is selling becomes his price by default. If he has to sell at a higher price then of course he has to prove value add to the customer.

Going back to the benefit equation, in this case:

Total benefit = Cost of competition (which is the next best alternative), since there is no value add.

To sum up, irrespective of what wiki or other experts state – value-based selling is everywhere!

Now What?

So when can the seller sell using a cost-plus technique?

In my opinion, an OEM (original equipment manufacturer) can never sell using cost-plus technique. Most importantly because Cost-plus technique by itself includes a whole bunch of uncertainty – Let’s consider the following scenario: A product costs $10 to make. A cost-plus pricer will decide on a percent markup on top of the cost. What determines how this percentage is determined? Should it be 10%, 20% or 50%? Assuming it is 50% the price of the product would be $15. Now the question is – at $15 will the product sell? It will not if the competition is offering the same product at $11. Thus the cost-plus pricer has to revise the price to $11 (10% mark-up) to compete. Did you note what just happened? This cost-plus pricer has embraced value-based selling and is not even aware of that! The value of the product is not more than $11 (since the customer can get the same for $11 from other source) – and the seller cannot sell at a price higher than that.

Some readers may argue that I deliberately chose a very high mark-up percent to denigrate Cost-plus pricing technique. For the sake of neutrality let’s consider a peculiar scenario where a firm decides to sell all products at 0% mark-up. Even then is revenue guaranteed? Maybe not if the competition is selling the same product at $8. Can you explain to the customer to pay you $10 when they have alternative at $8 – just because your cost is at $10?   Maybe you cannot in a rational environment.

If the same firm used Value selling instead of cost-plus pricing this situation could be avoided. At the very outset the firm would know that there is an alternative available at $8 and thus before launching a same product which costs $10 to make, the following factors would be evaluated:

1. Can the cost be beaten down enough to be able to sell at $8 or below?
2. If Cost can’t be changed then is it possible to launch a product with more features than competition so that the customer sees higher benefit (let’s say $15)?
3. If none of the above is possible – should the product be launched at all?

Remember – not getting into a business is more profitable than getting into a permanently loss making business.  Hence effectively value-based selling helps a firm provide a fair price to a customer while not losing out on profit.

Some firms may argue that their pricing is competition driven or market driven. I hoped that I have established already that all these forms of pricing are but special cases of value-based pricing.

Enter the Price Disruptor

One topic however remains open – If all firms sell on value will a product price ever come down? My answer would be – yes! Every industry eventually has a market disruptor who figures out a way to manufacture a product at much cheaper costs than the competitors. The cost-advantage is then pushed forward as a price advantage. The pricing of this disruptor resets the industry in general – some players quit while some re-adjust to the new price-level. Can any player continue at the previous price level using “cost” as a justification? History says no.

The question that comes up now is whether this disruptor was a value seller (remember- I stated already that they are transferring cost advantage forward as a price advantage). In my books –Yes! Please note Value selling is not about selling at a price higher than competition. It’s about selling a product at such a price such that the customer sees value in the deal. Situations when a customer sees value –

1. More benefits than existing alternatives but at a higher price
2. Same benefits as existing alternative but at the same price
3. Less benefits than existing alternatives but at a lower price

Usually a disruptor chooses the third scenario. Sometimes of course a firm may choose to blow the customer over by offering more benefits at a lesser price – In value selling terms: They are maximizing the value for the customer.  Getting back to the point of how this disruptor firm is actually selling on value – Their business plan itself is all about finding a method to produce at a cost so low that they can undercut the existing market! The fact that they are using the existing market price level as a reference to fix their pricing and then using that target pricing to innovate out a new manufacturing process – shows that their mode of operation is outward looking. A cost-plus player is typically not focused on how the market operates rather they strive to define the price of the market based on their own costs (which might be highly inefficient).

So in What Situation is Cost-Plus Applicable?

I would say cost-plus is still applicable for firms that charge a fixed fee or fixed percentage cut for their services. I would include the traditional distribution firms, retailers, brokerage firms in this category. These firms effectively operate in a zero-risk low return policy and thus a fixed-dollar mark-up or a fixed-percentage mark-up works for them. Or should I say worked for them? The various channel partners, brokers, service companies who are upgrading to a more modern form of doing business are gradually moving out from fixed percentage model. I will talk more about that in the sequel to this article.