Living Economics

Value-based Pricing
Innovative products offering high customer value should command value-based prices rather than cost-plus prices.

If you want something badly enough, you don't care how little it costs to produce the item. You are willing to pay a price matching its use value to you. A vendor who practices cost-plus pricing for a unique product would leave a lot of money on the table. Instead, the vendor should practice value-based pricing to convert as much consumer surplus as possible into profit.

In fact, the ability to charge value-based prices motivates the introduction of innovative products that satisfy some deeply-felt customer wants or needs. Value-based pricing means higher profit. For mature products with many substitutes, there is no choice but to charge cost-plus prices. And cost-plus pricing means basement profit.

But cost-based pricing for unique items could still be found in some companies due to organizational inertia. When a new CEO took over Parker Hannifin Corp., an industrial parts company, he found that 1/3 of Parker's parts offering unique customer value were priced on a cost-plus basis as if they were mature commodities. Some of these parts were custom-engineered for their customers which should have commanded premium prices.

Cost-plus pricing not only reduces profit, it also has the unintended effect of discouraging innovation. Any cost saving in production must be entirely passed onto customers and not to the bottom line. And there is little point in introducing innovative products if they do not command premium prices. But cost-plus pricing is straightforward and gives managers broad authority to negotiate deals. Managers understandably resist any deviation from straight cost-plus pricing.

After overcoming resistance, the introduction of value-based pricing resulted in raising Parker's returns to invested capital from 7% in 2002 to 21% in 2006 and its per share value by 88% compared with a 25% gain in the S&P 500.

Value-based pricing certainly means that prices of items with unique features should go up to match customer value, but it also may mean that prices of less competitive items should go down to maintain or expand market shares.

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