Pricing Strategies: Cost-Plus Pricing vs Market Value
Pricing Strategies: Cost-Plus Pricing vs. Market Value (The Strategic Choice)
Pricing Strategies: A practical guide on how to compare Cost-Plus Pricing with Market-Based pricing, set effective pricing policies, and manage discounts to achieve sustainable profitability—Digital Salla.
- Fundamental methodology of Cost-Plus Pricing.
- In-depth view of Target Costing (The Market-Driven approach).
- Value-Based Pricing: How to price based on customer perception.
- Pricing Policies: Skimming vs. Penetration strategies.
- Discount Management: Protecting your margins from excessive erosion.
1) Cost-Plus Pricing Strategy
This is the “Inside-Out” approach. You calculate the Total Cost of the product and add a Markup to reach the final price.
- Formula: Unit Cost + (Unit Cost × Markup %) = Selling Price.
- Pros: Simple to calculate and ensures all costs are covered if sales volume is hit.
- Cons: Ignores what competitors are doing and what customers are willing to pay.
2) Target Costing (The Market-Driven Strategy)
In highly competitive markets, you don’t “Set” the price; the market does. You must then work backward to find the allowable cost.
3) Value-Based Pricing Strategy
This is the most profitable but difficult strategy. You set the price based on the Value Delivered to the customer rather than the cost of production.
- Example: A software that saves a company $1,000,000 in labor costs could be priced at $100,000, even if it only costs $1,000 to maintain.
- Requirement: You must have a strong Unique Selling Proposition (USP) and deep customer insights.
4) Strategic Pricing Policies (Skimming & Penetration)
When launching a new product, management usually chooses between two extremes:
Gross Margin Bridge - Excel Template
4.1 Price Skimming
Setting a High Price initially to “Skim” the early adopters who are less price-sensitive.
Common in high-end tech (e.g., new smartphones).
4.2 Penetration Pricing
Setting a Low Price initially to gain market share quickly and discourage competitors.
Common in consumer goods and digital subscriptions.
5) Summary Comparison Table
| Strategy | Drivers | Best Used For | Profit Margin |
|---|---|---|---|
| Cost-Plus | Internal Books | Govt Contracts / Specialized Services | Predictable |
| Target Costing | Competition | Consumer Goods / Retail | Tight Control |
| Value-Based | Customer Perception | Luxury / Software / Consultancy | Highest Potential |
6) Managing Discounts & Price Erosion
A 10% discount doesn’t just reduce revenue by 10%; it hits Net Profit much harder.
- Trade Discounts: Used for bulk buyers to reduce administrative costs.
- Cash Discounts: Used to speed up the cash cycle (e.g., 2/10, n/30).
7) Operational Controls & Readiness Checklist
To ensure your Pricing Policy is effective:
Pricing Quality Gate Checklist
- Are prices reviewed at least quarterly against current material inflation?
- Is the Contribution Margin monitored per product line?
- Do sales teams have a “Maximum Discount” threshold before requiring approval?
- Is the Sales Mix analyzed to ensure you’re not just selling low-margin items?
- Have competitors’ prices been benchmarked in the last 30 days?
8) Common Errors and How to Prevent Them
- Death Spiral: Continually raising prices to cover fixed costs as volume drops (leads to faster volume loss).
- Static Costing: Pricing based on a budget made 12 months ago without considering supply chain shocks.
- Ignoring Overhead: Using only “Material + Labor” as the base for cost-plus pricing and failing to cover rent/salaries.
- Discounting for Cash: Giving a 5% cash discount when your short-term borrowing cost is only 1% (Giving away 4% unnecessarily).
9) Frequently Asked Questions
What is Markup vs. Margin?
Markup is the percentage added to the cost (Profit/Cost). Margin is the percentage of the selling price that is profit (Profit/Price).
When should I use Price Skimming?
Use it when you have a unique product with no immediate competition and a strong brand that can attract “Early Adopters.”
Why is Target Costing considered superior for electronics?
Because consumer electronics prices drop rapidly due to competition. A company must design the product to be profitable at the future market price.
10) Conclusion
Strategic Pricing is the bridge between your cost structure and your market position. By understanding the discipline of Cost-Plus Pricing, the market focus of Target Costing, and the profit potential of Value-Based Pricing, you gain the power to steer your entity’s profitability with precision. Remember, price is not just a number—it is a signal to your customers and the primary engine of your sustainable growth.
Action Step Now (30 minutes)
- Take your top 3 products and calculate their Markup % over total variable cost.
- Compare this with a competitor’s price for a similar product.
- Ask: Are we pricing based on our In-house Costs or the Market Reality?