Top three pricing mistakes: Use cost to price.
(Article 2 of 3)
Over the years, I have seen so many companies make mistakes with pricing. These are mistakes that can easily be avoided just by knowing they are actual mistakes. These pricing mistakes lead to sub-optimal performance: lower sales volume or lower profit margins compared with the right way to price. Sometimes both.
This three-part article series will cover the most common mistakes; price to competition, using cost to price and using guesses to price.
2. Using cost to price
The cost of a product or service is important, as companies want to make sure they do not sell below their cost (unless there is product or service designed to be a loss leader). Using cost as the basis for pricing is flawed thinking. This is because the cost of the product or service is irrelevant to the buyers. They really don’t care if the company makes a profit margin of 10%, if the company sells at a loss, or makes a 300% profit. Buyers are just interested in the benefit and the value the product or service provides them.
Yet there are so many companies using cost as their basis for their pricing. Different industries typically have different rules of thumb for what the gross margin uplift from cost. In some industries, the rule of thumb says the margin uplift should be as low as 20%, while others say that it should be at 100%, and yet others say that is should be at 500%.
The problems with cost base pricing are the following:
- Since the cost of a product or service is uncorrelated to their customers’ willingness to pay, it is unlikely that a cost-based pricing strategy yields is the “right” price — which is the price that matches customers’ value perceptions and willingness to pay. When implementing cost-based pricing, it is highly unlikely that the sales volume or the resulting profits are where they should be. Or in many cases, neither profits nor sales volume is where they could be. Now, making profits is of course important because it is these profits that fuel additional product or service definition development and what funds additional marketing and sales development. Cost based pricing will inevitably mean the company is not performing as well as it could if prices were set differently.
- In most industries, the cost of developing and manufacturing products, or the cost of defining and delivering services are very similar. Since most companies that use cost-based pricing also use industry- specific rules of thumb to price their product, as most products or services in certain industries end up with very similar prices. In the end, this leads to commoditization, with most companies in a commoditized market generate similar profit margins. A commoditized market is characterized by tough competition, small profits and where it is almost impossible for one company to rise to market leadership.
- With cost-based pricing, if a company manages to reduce its cost, then its prices will fall along with its margin in dollars. Companies typically spend a lot of resources controlling and minimizing cost, and if they also use cost-based pricing it means that the lower the cost is, the lower the price is and the less money and other resources will be available for other activities. This is probably not the result expected from better cost control! The company will have less to spend on product development and on sales and marketing. The company has just shot itself in the foot.
- Almost every company has some products or services that are complete commodities, some products or services that are substantially unique and some products or services that are somewhere in between. But using an industry rule of thumb for what markup should be, and like most companies do, the same margin uplift for all products, the commodity products will end up being priced too high and will therefore not sell as much as they should. The unique products will be priced too low, and the company will fail to capture the value that their uniqueness delivers to customers. Those products in between may fall into either one or both of those scenarios.
- Above I talked about “cost,” as this is something easy to define. It is not. It is easy to define the hard costs. For example, a product uses components that cost X, the manufacturing takes Y time and use Z personnel resources to do so. That is easy but is not all. To get an accurate account of the cost of a product one must consider the soft costs, such as the overhead costs. And this is where the problem comes in. How do you accurately allocate sales and marketing expenses to a particular product? How do other expenses, such asmanagement overhead, rent, cost of capital, and other soft costs be allocated to a particular product? Or delivering services for that matter. Well, it becomes a judgment call. Which is a euphemism for an informed guess!
- As cost-based pricing leads to so many negatives, why do so many companies use it? It is because it is, from a corporate management point of view, easy to understand. Controllers, CFOs and other managers can easily look at data on cost (as good as it may be), price, and margin and make both tactical and strategic decisions. Cost-based pricing also requires relatively few resources and is easy to explain for the rest of the company.
- Cost plus is such an imprecise way of setting price, and it leads to subpar business performance and companies switching to pricing based on customers willingness to pay always see substantial improvements; higher sales and higher profits.
Don’t forget to look out for the third installment in this series: Using guesses or gut feel as the base for pricing.
The Price Whisperer™
Sjöfors & Partners Inc
Pricing has always been an interest area for Per. As a serial entrepreneur, running companies in Europe and the US, he did pricing experiences. Some of these worked spectacularly well, some did not work at all. As a result, Per founded Atenga (now Sjöfors & Partners) out of his frustration that what business schools teach about pricing is too abstract, too academic for a business executive to act on. Likewise with books about pricing. Consequently, he set out to make pricing practical and actionable. Pricing for business people. Since then, he has been at the forefront as thought leader in everything pricing and he is a sought-after speaker for a variety of conferences and business circuits.
Per appear regularly on business radio shows and gets quoted regularly in the financial press, including Forbes, Fortune Magazine, Inc., IndustryWeek, Business Insider and the Financial Times.
About Us: Sjöfors & Partners has developed a unique method for data-driven pricing based on price-specific market research, that generate precise measurements of customers’ willingness to pay or buy for a product or service. Armed with this knowledge, companies can focus their sales, marketing and product development efforts towards the market segment with the highest willingness to buy at the highest prices. The measurement also allows Sjöfors & Partners’ clients to accurately predict the results of different prices, taking the uncertainty out of pricing decisions.