How do you pick value based pricing vs cost based pricing?

pricing
Recent activity on Aug 12, 2018
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Anonymous A asked on Aug 12, 2018

how do you differentiate between what strategy to use for pricing?

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Sidi
Expert
replied on Aug 12, 2018
McKinsey Senior EM & BCG Consultant | Interviewer at McK & BCG for 7 years | Coached 300+ candidates secure MBB offers

Hi Anonymous,

cost based pricing relies on having a reference regarding the margin that you add to the production cost of your good or service. Such a reference margin does only exist if you are dealing with an established product, or if a very close substitute exists. The same is by the way true for pure benchmark pricing.

If, however, you are dealing with a product innovation, where no closely comparable competitor product or substitute exists, then you have to take the more difficult path of identifying customers' willingness to pay (WTP). The WTP essentially is the value which your new product generates at their side. This then leads you to value based pricing.

So rule of thumb: whenever you deal with a product innovation, value based pricing is most probably the way to go.

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Vlad
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Content Creator
replied on Aug 12, 2018
McKinsey / Accenture Alum / Got all BIG3 offers / Harvard Business School

Hi,

It depends on the case. Sometimes you need to take into account all the 3 types of pricing.

1. Cost-based pricing - you actually check what are the costs and apply the industry / target markup. You need to take into account R&D and capital costs if the case (interviewer) specifically states that. Also, the availability of patent is important, since the whole point of it is to protect your price and achieve ROI on the whole R&D pipeline (think of a pipeline of drugs where 8/10 were not launched / approved)

2. Competitors - basically it's simply benchmarking against competitors with a similar product. Make sure you take into account the segment (i.e. in premium higher price may be the proxy for quality). Since the value proposition of the competitors may be different, competitor pricing is just one of the metrics that you should take into account

3. Value-based pricing can be done in 2 ways:

  • For existing products, you identify what it the economic value and perceived value for the customer. Also, you compare the value proposition and features of your product vs. the VP of your competitors. If you have a significant difference in value prop - you have to define how much value you propose to the customer in $ terms. (e.g. your product may have additional customer support, better packaging, additional features and thus should be priced hire. Or it should be priced the same and you will win the market share due to these differences)
  • For the new products, you can calculate the closest alternatives and think how much additional value we provide by replacing them. Think of the discount airlines compared to trains or buses

4. Pricing strategy - here you define how you will price the product taking into account 1,2,3 and your company strategy. Maybe you decide to have a zero margin if you can cross-sell other services. Or maybe you would like to subsidize to win the competition. Also, think of price differentiation and having different pricing tiers (e.g. basic, premium or even freemium) and how it helps to drive price perception and fulfill strategic goals

Good luck!

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Sidi gave the best answer

Sidi

McKinsey Senior EM & BCG Consultant | Interviewer at McK & BCG for 7 years | Coached 300+ candidates secure MBB offers
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