Everything about this question makes me think of the answer NO. But let’s break it down between the risks and opportunities of using cost based options for a startup. I will base it on the background of technology and software development. I have not seen cost based pricing for a technology startup since the costs are so difficult to ascertain.
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Understanding Costs in Technology Startups
A simple example of the types of costs in a technology startup include:
- Maintenance cost based on the number of subscribers for your product (Your suppliers costs will change based on the tiers and number of users)
- Hosting, servicing and service providers cost – you might be able to identify these numbers over a 5-year period
- Opportunity cost – this is the hardest to ascertain because you’ll need to qualify against your time, energy and that of everyone else who’s joined in the startup journey.
What is Cost-Based Pricing?
The definition of cost based pricing is very simple. It simply says that the price at which you sell is a proportion or multiplier of the cost that you incurred in creating a product or service. Normally all businesses will have a markup on the cost to define their pricing. This appears simple and easy on the outset because it is simple and easy to calculate.
Should Startups Use Cost Based Pricing?
NO! Pricing is a tricky affair. You never know how many customers would be willing to try your product. Even to define your economies of scale you’ll need these numbers. In addition, think about convincing the investors about the cost-based pricing which limits your benchmark in a market that’s about market-based pricing. (Pricing in startups)
The Main Problems with Cost Based Pricing
Problem 1: Ignoring Customer Willingness to Pay
It ignores the customer’s willingness to pay which may be significantly more or less than your cost. For instance, if you define your costs based on 100 customers and manage to get only 50 in the first year, how will you justify the loss of this business? At the same time, you might be driving away the customers whose perception of price might be something else compared to your costs. It might either to be too high or too low.
Problem 2: Market Misalignment and Loss of Trust
Customers will define pricing based on what they see in the market. Your cost-based pricing might not align with what they see in the market. They immediately lose trust and worst of all; they won’t take you seriously enough if the prices are that far off.
Problem 3: Investor Skepticism
The cost-based pricing will not work very well with investors because there are too many assumptions in it. Whereas a market-based approach can give you better data than the cost based approach.
What Type of Pricing Should a Startup Use Instead?
“Price is what you pay. Value is what you get.” — Warren Buffett
Value-Based Pricing: The Recommended Approach
Value based pricing. This is the simplest way to price in a startup, especially when you don’t have a lot of primary data. The idea of value based pricing is that – you identify a monetary value for the type of product/service that you offer.
You can find this monetary value through categories such as: time saving, convenience, ease of use, accuracy and removal of frictions. You can be creative about assigning a monetary value for the time saving and project it as the value orientation. There are some very good examples of such value-based pricing for startups.
“People don’t buy what you do; they buy why you do it.” — Simon Sinek