Imagine standing in the hardware store looking at the screwdrivers. You need a good screwdriver to use in the shop every day because you ruined yours yesterday trying to remove a rusty shield. There are three screwdrivers on display. Their price tags show $.99, $6.99, and $8.99. Which one will you buy? Remember, you will use it hard every day in the shop. Certainly, you are not even considering the $.99 screwdriver. It might break in your pocket while you are going out the door. The $6.99 one might be okay, but you really do not want to return in six weeks to replace it. Why not go for the best right away and pay the $8.99? That sounds logical. I would make the same choice, and so would almost anyone else in your situation.
But wait! The only information that I have told you about the screwdrivers is their prices. How do you know that the $8.99 screwdriver is the best? You know nothing about the quality, color, size, or warranty. Yet you feel very comfortable making that decision knowing only the price! Isn’t that amazing! We have a strong tendency to believe that the product is worth the same amount as the published price. Price is the single largest indicator of value.
Two Methods of Pricing
Let’s look at two common methods of establishing prices: cost-plus and value-based.
A simple cost-plus pricing formula would look like this:
Material Cost + Labor Cost + Overhead Allowance + Profit Allowance = Price
The cost-plus method of pricing is a good way to ensure that the price you charge will cover your expenses and generate a profit.
Value-based pricing sets the price by comparing the product/service package to similar product/service packages on the market. To establish pricing, list your significant points of value. A few examples include quality, ease of use, comfort, aesthetics, size, capacity, options, availability, service (before and after the sale), and warranty. Each point of value is assigned a score. The chart belows shows a sample value-based pricing model for a company considering a niche in the screwdriver market.
Where does opportunity exist in this screwdriver market? It exists in the mid-range of pricing. There is already the low-priced $.99 screwdriver, attractive to a six-year-old boy with mechanical aspirations. The $6.99 screwdriver would be attractive to a do-it-yourselfer. The $8.99 model meets the needs of the serious screwdriver professional. But what about a screwdriver for the housewife’s kitchen drawer? Wouldn’t a $4.99 price appeal, especially if it included feminine styling and colors?
Notice that the relationship between the total value and the price is somewhat loose. Value-based pricing is not a strict formula. Rather it provides a guideline for what the market would expect to pay for the value provided.
Which method should you use to establish pricing — cost-plus or value-based? You should consider both. First calculate the cost-plus price. This is the minimum price that you can afford to charge. Then determine the value-based price. If the value-based price is higher, the decision is easy. Use the value-based price. If the cost-plus price is higher, you have a problem. The market will not bear what you need to charge. You can address this one of two ways.
- Find a way to lower costs and/or increase the value of the product/service package.
- Discard the product/service package and look for a better opportunity.
If the value-based pricing model yields a price that is higher than the cost-plus calculation, you may have thoughts like this, “I’ll provide more value than the competition and charge a lower price. That will really be attractive to customers and generate a lot more sales.” That is a good theory, but in practice it does not work that way. The screwdriver pricing scenario in the hardware store demonstrates our tendency to believe in the value that the price indicates. When you set a price that is out of line with the actual value, you are giving the customer misinformation; it is a disservice to them and to you. People are willing to pay for the things they want, and they usually believe the common statement, “You get what you pay for.”
The best practice is to be realistic with the value of your offering and charge accordingly. Sell more by setting your pricing correctly. Price is the single largest indicator of value.
Does this work in the real world?
When John and David Martin moved to a new settlement, they left behind a successful furniture-manufacturing and retail business. Their business experience and knowledge of woodworking had come along with them, and they decided to use it to build another business after the same model in their new community. Judging by the general surroundings, there seemed to be plenty of money around for high-quality wood furniture. John and David got their business off to a fair start and reached a moderate level of profitability, but it seemed to them that they were missing too many potential sales.
Many folks came into the showroom. They toured the showroom with interest — rubbing their palms across the furniture tops; gazing admiringly at the styling; and asking questions about the quality of the materials, building techniques, and production time. Then, after looking again at the price, they would slowly walk out — still looking around the showroom with pondering interest.
John and David wondered, “What is going on in these people’s minds?” They began asking questions. Soon they learned that many of their prospects were comparing their product with a high-priced national brand which had a longstanding reputation for high-quality furniture. Their prices were not anywhere close to the prices of the national brand. John and David understood something about the way pricing communicates value. They took a brave step. They raised their prices 30-40%. What do you think happened? Did higher prices send more people out the door without buying? No! They sold more pieces of furniture! Now customers could believe that they would get the quality of furniture they were looking for. At the lower pricing level, many people walked away because they “knew” that they could not buy the quality they wanted for such a low price.
Remember, price is the single largest indicator of value. So get out your calendar and schedule a time to evaluate your pricing with a value-based pricing model.