There are a lot of opinions on the best small business pricing strategy. But to ensure you’re setting your prices right, for both you and your customers, it’s important to get clear on it. In this post, I’ll examine the two most popular approaches for small businesses: cost-plus pricing and value-based pricing.
Knowing the pros and cons of each strategy can take the overwhelm out of pricing and make sure you’re generating the profit you need to sustain and grow your small business.
What is a pricing strategy?
Simply put, your pricing strategy is the method you choose to work out how much to charge for your products/services. It’s the system used to find the sweet spot between:
- Rates your ideal clients are willing to pay
- A healthy profit margin
- Your competitors’ prices
And there are different ways to approach it.
For example, depending on the business model, some companies will be able to implement a captive product pricing strategy. In this case, the business will sell a core product (for example, a games console), and a number of accessories to go along with it (games, controllers, a headset, etc). The customer may only buy the base product once (or once every few years, when a new edition is released). However, they will frequently come back to you for the necessary accessories or add ons.
Another option is penetration pricing. With this approach, the business will price their products or services lower than the competition in order to win over customers. They will gradually increase pricing as time goes on. This allows the business to gain market share early.
And in the opposite approach, some businesses will go with a skimming approach when it comes to their pricing. This means going in with a high price at launch, and gradually lowering that over time as demand decreases. This ensures a high rate of return at the time the product is popular and then creates opportunities for sales when that popularity lessens.
These are just three approaches to setting your prices (here’s a nice pro and con list of the most common pricing strategies). But in this post, I want to focus on two commonly discussed strategies for small businesses that I’m sure you’ve heard being compared online: Cost-plus pricing and value-based pricing.
Cost-Plus Pricing
What is it?
Cost-plus pricing is probably the most straightforward pricing strategy out there. It’s a clear-cut formula. You start with the total cost of producing the product or delivering your service and add a markup to generate the selling price. The markup covers all of your overheads (and tax!) and your profit margin to ensure you see a return on your investment. This can then be divided down to price an individual service or unit if you’re creating products in bulk.
For example, if it costs you £10 to produce the item, and you decide to add 30%, the selling price will be £13. This means the business owner recoups the £10 spent and makes £3 profit per item sold.
Pros
Especially when you’re just starting out, cost-plus pricing is the option which will cause the least overwhelm. It’s an easy formula you can apply to all of your products, and it guarantees that you’ll cover your costs and make consistent money on each item or service.
Another benefit of this pricing strategy is that it is a clear way to explain your prices to your customers. It also means that you can easily justify any increases in prices you have to make. If you’re basing your prices solely on the cost of producing the items, any external price increases will impact on what you ultimately sell your products for.
Finally, cost-plus pricing can be great for testing the water, especially with a new business or product range. If you don’t have a whole lot of information on the market, using this formula can allow you to get your product out there and see what customers are willing to pay. Once you have a feel for the popularity of the product or service, you can adjust.
Cons
Like any other super straightforward system, a cost-plus pricing strategy has its limitations. While it is easy to calculate your prices, this system doesn’t consider any external factors and lacks the flexibility of other pricing strategies.
Working on this basis means ignoring the pricing of competitors, who may be selling the same item for a lower price. Unless your USP is strong and you have a loyal group of returning customers in your community, the fact that a competitor is offering a cheaper price could lose you business.
On the other hand, this pricing strategy also doesn’t take into account the value that you are providing your customers. Using a fixed formula to generate your prices may mean undervaluing some of your items. It also doesn’t give you the opportunity to explore what your customers are actually willing to pay.
Value-Based Pricing
What is it?
Depending on who you listen to, value-based pricing can either sound like the best or the worst idea ever. Unfortunately, this often comes down to some speakers treating it as a revolutionary concept. Usually without really exploring the pros and cons – or giving advice on how to actually implement it.
Value-based pricing means approaching your prices with the perceived or estimated value of the product in mind. So, it’s about generating a cost based on what benefit or value your customer gains from your product or service, rather than via a set formula including production costs!
And sure – that sounds great! But how do you really pinpoint what that number is? And can it really work for any industry? Let’s dive into some of the main pros and cons.
Pros
I know I sound sceptical, but there are advantages to this pricing strategy. First of all, value-based pricing is a very customer-focused approach which is always a good thing. It can work particularly well in creative industries if you’re selling items like art or fashion. And it’s a no-brainer for luxury and premium brands.
This is because what you’re selling is more than just the item itself. It’s a lifestyle and an association with a desirable brand. Because of this, you can likely achieve much higher markups than you would with cost-plus pricing. A luxury handbag, for example, costs a lot more than the sum of its parts, because customers perceive it as adding significant value to their lives.
The beauty of this strategy is that it is flexible and relies on interest in and perception of your brand. So if you’re clever with your branding and marketing, that markup can go up further with time. It also doesn’t hurt that this pricing strategy can create large profit margins and needs fewer sales to cover costs.
Cons
I’m sure it’s no surprise that the major con of this strategy is that it is far less stable than others. It’s because you are basing it on what your customers are willing to pay and how your value is being perceived at any given time. And this, quite like the economy, can fluctuate quite a lot, requiring regular research and price adjustments.
Additionally, if you’ve based your prices on the perceived value of your products, but the cost of your supplies skyrockets, it’s not easy to explain to your customers why you suddenly believe your product is worth more. Whereas, as we explored before, it’s a very clear-cut and understandable explanation with cost-plus pricing.
The other major issue is that it is much more difficult to settle on a price in the first place. While research into your industry and competitors may lead you to a rough figure, it’s impossible to tell what your perceived value is until you start selling. This can feel like a very vulnerable position to be in when you have all of your costs to cover.
Another challenge is the fact that quantitative market research might not deliver any actionable results when targeting a fairly small niche – like most small businesses do. Instead, you need to determine the perceived value based on in-depth interviews with existing and potential customers.
Which is right for you?
Settling on which pricing strategy is right for your business is a decision for you and you alone! Hopefully, though, this post has helped to demystify a couple of the more popular options. Each has its pros and cons, and there’s no right answer – it’s all down to what works for you!
KEEP READING
To read more about this topic, have a look at these:
Should You Keep Your Rates a Secret?
Stop Discounting: How to Compete on Value rather than Price
How to Deal with Price Shoppers as a Small Business
How to Raise your Rates as a Small Business
