Market-Based Price Metric

Cost-Based Pricing

Cost-based pricing is a common practice among internally, finance-focused businesses. Price is set based on cost and a desired margin. In the example below we assumed a unit cost of $300 and a desired margin of 50 percent. As shown, a 50 percent margin requires a 100 percent markup on the product’s cost. This yields a cost-based price of $600 (the orange dot in the graphs above).

Cost-Based Price =  Cost + Margin  =  Cost + Percent Markup on Cost

=  $300  +  100% of Cost

= $600

The problem with cost-based pricing is that it has nothing to do with the reality of what customers will pay for a product. Thus, a cost-based price may be over-priced and result in limited sales volume and lower profits, or under-priced and result in high volume but low margins and lower profits. It is the responsibility of the marketing function to provide a market-based view of price and purchase behavior and to guide pricing based on customer preferences and price sensitivity.

Market-Based Pricing – Mac Users vs. PC Users

Market-based pricing starts with customers. For example, potential customers were asked what is the most they would pay for Apple’s new iPad. Of those surveyed, 41 percent of current Mac users would pay over $800, while only 16 percent of current PC users would pay over $800. At the $600 price point, 68 percent of Mac users would buy, but only 35 percent of PC users would buy.

The two price curves above were created from the survey data obtained. Mac users are less price-sensitive and would buy higher volumes at higher price points than PC users. PC users are not interested in this product until it is priced below $600. What is the best price for this product?

Mac User Market-Based Price – $700

The market-based price for Mac users is $700 (blue dot on curve). This is the point that the maximum gross profit is obtained for this combination of customer price sensitivity and a unit cost of $300.

Cost-Based Price

Sales   =  $600 x  68% x 1,000,000

=  $408  million

Gross Profit = ($600 – $300) x 68% x 1,000,000

=  $204 million

Market-Based Pricing

Sales =  $700  x  55%  x  1,000,000

=   $385 million

Gross Profit  =  ($700 – $300) x 55% x 1,000,000

=  $220 million

PC User Market-Based Price – $700

The price that yields the highest gross profit is $500 (blue dot on PC Price Curve) based on the PC user price sensitivity and the assumed unit cost of $300. Let’s examine the profit impact of the $700 Mac User price on the PC User market.

Cost-Based Price

Sales   =  $600 x  35% x 1,000,000

=  $210  million

Gross Profit = ($600 – $300) x 35% x 1,000,000

=  $105 million

Market-Based Pricing

Sales =  $700  x  28%  x  1,000,000

=   $196 million

Gross Profit  =  ($700 – $300) x 28%  x 1,000,000

=  $112 million

What is the Right Pricing Strategy?

The $700 price is the best choice to lead with. The Mac User segment offers a better opportunity for sales and profits at the $300 unit cost. As the unit cost is driven down with cumulative production experience we would be able to lower price and capture more of both segments of the market for this product.

Differences in price sensitivity and product attractiveness should also signal an opportunity to offer multiple products at various price points to adequately serve both markets’ price and product needs.  Again, this is a strategy often pursued after crossing the chasm with a very focused core segment strategy.

To learn more, visit www.marketingmetricshandbook.com, view the  Intro Video, and download a 30-day demo.

(*) This example is for educational purposes and does not represent actual Apple price and unit cost.