How should you set your prices and why?

In this first of a series of 5 articles on how to set price, Professor David Falzani MBE gives an overview of the main methods companies use to set prices, and highlights their ‘pros’ and ‘cons’

For small businesses, setting the right price for products or services can be one of the most challenging decisions. Pricing isn’t just about covering or matching competitors; it’s about finding that sweet spot where your business can attract the right customers, maximise profits, and grow sustainably. The right pricing strategy can make the difference between a thriving business and one that struggles to stay afloat.

There’s no one-size-fits-all approach to pricing. However, most businesses rely on one of three main methods, each of which we’ll review below. The first is a somewhat weaker methodology called cost-plus pricing, the next two are much stronger: competitor-based pricing and value-based pricing. Each approach has its pros and cons and understanding these can help SMEs make better decisions when setting prices.  

Cost-plus pricing is one of the most straightforward methods for setting price. Despite being generally considered a poor approach to pricing, some companies like it because all the data required to do it is readily available. Cost-plus simply takes the cost of producing or delivering a product or service and then adds a markup to ensure a profit. For example, if it costs £50 to deliver a product or service and the company wants a 50% profit margin, the selling price would be £75.

The ‘pros’ include its simplicity, it’s easy to calculate with information you probably already have: all you need to do is understand your costs (materials, labour, overheads) and then add the desired markup. It also offers predictable margins (if your costs are accurate), ensuring every sale covers your costs and brings in a set profit. It’s also well suited to contracts which specify ‘open book’ accounting between supplier and customer.  

However, a key ‘con’ is that this old-fashioned technique is entirely introspective, utterly ignoring both customers and competitors. This fact alone means that most companies today should not be using cost-plus as a primary way to set their prices. Similarly, it doesn’t take into account how much customers are willing to pay, or the perceived value of your product: if customers are willing to pay more for your offering, you could be leaving money on the table. It also doesn’t reflect market dynamics such as competitors’ pricing, market demand, and other external factors: you might price yourself out of the market, or, conversely and much more commonly, sell at far too low a price, substantially undermining profitability and growth prospects. 

Example:  
Many retail businesses use cost-plus pricing to ensure a consistent profit margin on physical products. However, sticking solely to this method can result in under-pricing, particularly if the business offers a high quality or unique product that could command a higher price. For instance, a small furniture manufacturer using cost-plus pricing may calculate the cost of materials and labour, but completely miss that their custom-made furniture has a unique appeal that could justify a much higher price in a premium market.

Competitor-based pricing sets prices based on what competitors are charging for similar products or services. Companies look at the market and decide whether to match, undercut, or exceed competitor prices depending on their strategy, relative strengths, and positioning.

In terms of ‘pros’, this method ensures that your prices are competitive in the market. If your business operates in a crowded or price-sensitive market, competitor-based pricing helps you stay in the game. It’s also simple to execute: market research can usually discover what others are charging, and you can quickly decide how your prices compare, making this method relatively straightforward to implement. 

In terms of ‘cons’, there’s a risk that it triggers a ‘race to the bottom’: focusing too much on just competitors’ prices can lead to price wars, where businesses undercut each other to attract customers. This often erodes profit margins and can make it hard to compete on anything other than price. It can therefore overlook unique value: pricing based purely on competitors’ price points doesn’t factor in the unique value that your product or service offers. If you provide something of higher quality or which is differentiated in some way, it’s important to factor this in to your competitor-based pricing.  

Example:   

SMEs in the e-commerce sector often use competitor-based pricing, especially when selling commoditised products like electronics or consumer goods. However, while it can help capture market share, it may also mean sacrificing higher margins that could be achieved by emphasising superior service, faster delivery, or enhanced product features. Focusing on what makes your product different can sometimes be a more successful strategy, even if competitors are charging less.

Value-based pricing focuses on how much value is generated by the use of your product or service. This method involves understanding the benefits that customers derive from your offering and pricing it according to that value, rather than to costs or competitor prices. For some scenarios, it’s possible to accurately calculate the ‘value pie’ of increased worth being generated by the product, and then taking a portion of this value as the price. For example, if you are selling a tech ‘widget’ and your average customer enjoys a saving of £500 directly from the use of your product, value-based pricing typically suggests a price of 15%-25% of this saving, so let’s say £100. This would mean the customer has a net benefit of £400 and you a enjoy a price of £100. 

In terms of ‘pros’, this sophisticated approach can increase profitability – value-based pricing allows you to charge a price based on the actual value you generate, which can lead to significantly higher profit margins than cost-based or competitor-based methods. It can also be well aligned with customer perception and help you explain this value to customers: by focusing on what customers value, this method ensures that your pricing reflects the true worth of your offering in the eyes of the buyer. It also is well suited to building premium brands: value-based pricing can position your business as a premium player, enhancing brand perception and customer loyalty.

The ‘cons’ are that it requires deeper market understanding: to implement value-based pricing effectively, you need detailed insights into the customer’s buying context, willingness to pay, and market dynamics. This requires more research and may involve trial and error, often best carried out via market experiments. There’s also the potential for mispricing: without accurate data or a clear understanding of what customers value, there’s a risk of setting the price too high and losing sales, or setting it too low and leaving money on the table.

In general, a value-based pricing approach, combined with appropriate reference to competitors and substitutes, can be a powerful combination. 

Example:   

Apple is a well-known example of a company that uses value-based pricing. Their products, from iPhones to MacBooks, are priced significantly higher than many competitors, but customers are willing to pay more due to the perceived value – quality, design, brand prestige, and the ecosystem Apple provides. SMEs can adopt a similar approach by emphasising what makes their product unique or premium. For example, a small boutique offering bespoke clothing or custom services could use value-based pricing to target customers willing to pay a premium for personalised experiences and craftsmanship.

Selecting the right pricing method depends on your business model, market dynamics, and how well you understand your costs, competitors, and customers. Here’s a brief guide to help you decide: 

• If your market is competitive and price-sensitive, competitor-based pricing can help you stay aligned with the market. But avoid getting trapped in a price war. Look for ways to differentiate yourself to maintain healthy margins. As well as product features, think about augmenting the benefits derived from your products, including emotional value.  

• If you offer a unique or premium product or service, value-based pricing could be the most appropriate approach. This method requires a good understanding of your customers’ needs and perceptions, and in return, it allows you to charge what your product is truly worth, and can also help create a narrative you can use to explain this value to your customers.  

• If your costs are straightforward and you need predictability in margins, you may be tempted to use cost-plus pricing, but I would recommend you resist this temptation. In general, the more companies understand their customers and markets, the more successful they become. Cost-plus does not support this, although the approach is perfectly valid as an accounting check in your management accounts.

Pricing is more than just numbers; it’s a critical element of your business strategy. Whether you choose competitor-based, value-based, or even cost-plus pricing, the key is to remain flexible and be willing to adapt. Regularly revisiting your pricing strategy, conducting market experiments, and understanding customer behaviour will all help ensure your prices reflect the value you offer and drive long-term profitability and growth for your SME. 

By experimenting with these methods and adjusting your pricing based on real-world data, you can find the right balance that allows your business to thrive in today’s competitive landscape.

Professor David Falzani MBE has trained over 2,000 growth companies, leveraging his experiences as an entrepreneur, business consultant and Professor at Nottingham University Business School. His book, “Double Your Price: The Strategy and Tactics of Smart Pricing”, is a finalist in the 2024 Business Book Awards.