Thursday, November 22, 2012

Pricing: Cost-Plus vs. Willingness to Pay

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Pricing decisions are critical - get them right and you can maximize profitability.  Get them wrong and you can destroy your revenue or leave loads of money on the table.

In this post we'll review why pricing based on your customer's willingness to pay (WTP) is superior to simpler, cost-plus pricing.  I'll include a few examples that illustrate why this is true.


Because this is a simple method for pricing it is, unfortunately, more common than it should be.  The approach involves 1) figure out the cost of producing your product, 2) add your desired mark-up, and 3) calculate the final selling price.


The primary benefit of cost-plus pricing is that it THEORETICALLY ensures you will earn a sufficient profit on your sales.  You can set the hurdle rate or minimum return you need to earn on your investments into the business and adjust your mark-up accordingly.

However, the downfall of cost-plus pricing is that it does NOT take into account the price your customers will actually pay for your product ("willingness to pay" or WTP)


Let's review a couple of scenarios that illustrate why it's important to price based on WTP rather than the cost-plus approach.



Our cost-plus approach has us selling our product for $120 ($100 cost + 20% mark-up).  Unfortunately, customers are only willing to pay $110 for it.  As a result, we would sell no units.  Not only do we not make any money, we would lose money on whatever units we'd made and put in inventory.

If we'd used a WTP approach, we could have sold our product for $110.  Our mark-up only would have been 10%, but we would have sold units.  Whether or not the 10% mark-up would be sufficient to make it worth our while would still have to be considered.


Our cost-plus approach still has us selling our product for $120.  In this case, plenty of customers will buy from us because they were willing to pay as much as $150 for it.  That means we're leaving $30 on the table for every unit we sell.

If we'd used a WTP approach, we would've priced at $150 and our mark-up could have been 50% instead of 20%.


As mentioned previously, cost-plus is still used because it's easy.  Determining your customers' WTP can be difficult.  I'll cover some options for determining WTP in a future post.

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