Setting the right prices for goods and services can make or break a business, which is why it’s important that company owners understand the differences between pricing based on value and pricing based on cost. Value-based pricing is determined by estimating the value that prospective customers assign to a product or service, whereas cost-based pricing is determined by how much it costs a business to design, manufacture and distribute a product or service and the margin of profit that the market will bear above that cost.

Elements of Value-Based Pricing

Businesses that choose value-based pricing must determine how much a customer is willing to pay for a product or service based on the value it provides. Since this isn’t an exact science, business owners must understand their target audience’s needs to estimate the value they would place on a product or service. That value is typically determined by the benefits that a product or service offers. For example, a Rolls Royce is a luxury vehicle that only wealthy people can afford. BMW, the owner of the Rolls Royce brand, knows that buyers value the prestige, status and exclusivity of this vehicle and are willing to pay a high amount for that value.

Elements of Cost-Based Pricing

Businesses that choose cost-based pricing must determine how much it costs to make and sell a product or service and what price would generate a profit. In cost-based pricing, there is a “floor price,” which is the minimum price that the product or service can sell for and still be profitable. There is also a “ceiling price,” which is the maximum price that the market will bear for that product or service. Business owners position their selling price between the floor and ceiling prices to ensure profitability and to avoid overpricing that drives customers to competitors.

Differences Between Value-Based and Cost-Based Pricing

The primary difference between value-based and cost-based pricing is that value-based pricing is almost exclusively focused on the benefits a product or service offers a customer, whereas cost-based pricing is focused on the features and characteristics of a product or service. Value-based pricing has a larger range of prices than cost-based pricing because value is an estimate of what people will pay to obtain desirable benefits, whereas cost is based on quantifiable numbers.

Cost-based pricing is typically less expensive than value-based pricing because cost-based businesses offer competitive prices to lure customers away from competitors. Value-based businesses are more expensive because they are based on the willingness of buyers to pay higher prices for benefits that are difficult to quantify. There is usually a higher profit margin with value-based pricing, but fewer of these products and services are sold than the more affordable products and services that use the cost-based pricing model.