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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.
COST-PLUS PRICINGBecause 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.
PROS AND CONS OF COST-PLUS PRICINGThe 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)
WILLINGNESS TO PAY (WTP) TRUMPS COST-PLUSLet's review a couple of scenarios that illustrate why it's important to price based on WTP rather than the cost-plus approach.
SCENARIO 1Our 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.
SCENARIO 2Our 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%.