Cost-Based or Value-Based Pricing
Which should you choose?
The Question
A pricing colleague recently asked me if I thought cost-based pricing was outdated because of the current unstable economic climate. Her question gave me pause.
Like most other pricing consultants, I spend little time thinking about cost-based or cost-plus pricing. Our mission is to advance the client’s pricing strategy to a higher level, ideally grounded on customer value. Cost-plus pricing is usually the starting point of our engagements, never the final destination.
This is a bit ironic given that cost-plus is a standard practice for professional services firms. Their day rates are designed to cover salary and overhead costs plus a healthy margin for partner bonuses. Don’t get me wrong, I have nothing against cost-plus pricing. I put it into the category of “nice work if you can get it.” Meaning if your company has enough market power to earn its desired profit margin, go for it!
The rub is that most companies can’t make cost-plus work because they lack the market power to unilaterally set their profit margins. Other market forces block that, such as competitors (especially low cost producers), serving diverse customer segments, and disruptive technology. Layer on other macroeconomic challenges like inflation and now tariffs and it does makes you wonder whether cost-based pricing is no longer up to the task.
My response:
Cost-plus is NOT outdated! Rather, it is foundational for every pricing strategy. Prices should cover costs and make a profit. Otherwise a business cannot survive very long.
Unless your company is the dominant, lowest cost producer in its industry, you will need to find an alternative strategy for competing and winning in the market. According to strategy guru Michael Porter, that means choosing where you will focus and how you differentiate your product. This is usually the moment when consultants enter the scene.
Good product packaging design and pricing policies can mitigate the cost shocks caused by macroeconomic forces. Higher ACV (annual contract value) contracts can include multiple price components, some of which can be indexed to costs or proxies.
Delivering superior customer value is the best insurance policy for protecting your profit margin. For example, raising subscription prices to fund new R&D is acceptable as long as customers expect to gain additional future benefits.
Final point: If your product is sold to businesses (B2B), offers differentiated value, and seeks to win ACVs of five digits or more, then it's not a choice, but a no- brainer. You need to do BOTH cost-based AND value-based pricing.