3 Approaches to Pricing

Approaches to pricing can be categorized into three groups that are based on either costs, competition or customer value (Ingenbleek et al. 2003, p. 291).

Cost-plus pricing

Cost-plus pricing implies the determination of prices based on fixed and variable costs. While the implementation of cost-plus pricing is straightforward (Simon & Fassnacht 2009, p. 190) – e.g., by adding a profit margin to average costs (Avlonitis & Indounas 2005, p. 48) – this approach is unlikely to yield optimal prices (Simon & Fassnacht 2009, p. 191), as concentrating on costs offers no insights into whether or not the resulting prices are acceptable for buyers. Moreover, for an online service provider with high fixed costs and close-to-zero marginal costs, the correct determination of price would, to a major extent, hinge upon an accurate estimation of future sales in order to accurately spread fixed costs.

Evidently, cost-plus pricing can be considered a very weak approach (Hinterhuber 2008, p. 42), particularly so in the case of an online service provider (Simon & Fassnacht 2009, p. 517). Nevertheless, even ambiguous sales estimates can help to determine a lower limit of the acceptable price range (Ingenbleek et al. 2003, p. 300) [1].

Competition-based pricing

Competition-based pricing takes offers and prices by competitors or market leaders into consideration in order to set prices (Meffert 2000, pp. 530-531, Ingenbleek et al. 2003, p. 292). While this approach is an improvement, it is still a one-sided approach insofar as it does not take the consumers’ perspective into account (Hinterhuber 2008, p. 42). Furthermore, the absence of competitors with comparable offers, such as is the case for many revolutionary online services, makes this approach unfeasible.

Customer-value based pricing

Pricing driven by customer value, or market demand, finally, emphasizes the customers and their perceived value of a product (Meffert 2000, p. 542). Specifically, it aims at determining the amount a customer is willing to pay (Hinterhuber 2008, p. 42) – thus allowing to price a product according to the worth of a product to the buyer (Dean 1969, p. 166). In contrast to the aforementioned methods, value driven pricing takes explicitly into account the consumers’ perspective. It is therefore widely considered superior to the other methods (e.g., Hinterhuber 2008, p. 41).

Due to difficulties with respect to measuring the consumers’ willingness to pay, however, the implementation is significantly more challenging than the other methods (Jedidi & Zhang 2002, p. 1351).

In an empirical study Ingenbleek and his colleagues (2003) prove the common assumption that value-based pricing generally contributes to the performance [2] of new products (pp. 298-299). Most importantly for the present case, they show that the relative advantage of value-based pricing is higher in a situation of low competitive intensity and a high relative product advantage [3] (p. 300) – such as is the case for new internet businesses.

Bottom Line

If you want to get your pricing right, forget about cost-plus and competition-based pricing and go for value based pricing.

Check in later to find out what exactly this means for your business.

[1] Note that this applies to the long term. The short-term lower limit for zero marginal costs is zero (Simon & Fassnacht 2009, p. 517).
[2] Performance was defined as “the degree to which the product had been successful in meeting its objectives since its launch” (Ingenbleek et al. 2003, p. 296).
[3] Defined as “the relative superiority of the new product over competition” (Ingenbleek et al. 2003, p. 292).