Thursday, March 10, 2011

Moving from cost- to value-based pricing

Throughout my travels, I have heard business describe their grandiose plans for moving towards "value-based pricing".  Great... this sounds wonderful... value is a good thing, you base your price off of this value... recipe for success!  Right? ... right?

Not exactly.  There are many questions you have to answer when talking about the "value" in "value-based pricing".  First and foremost, this is not your perceived value; it is your customers' perceived value.  But I will get to that in a second.  First, I want to address what is specifically NOT "value-based pricing": when determining if a price offered to us by your customers meets some pre-determined margin minimum, this is decidedly NOT "value-based pricing".  In fact, this is (everyone say it with me now): cost-based pricing (the clue are the words "margin" and "minimum").

Anytime you take a price based on margin (revenue less cost), you are taking a priced based on the one aspect you control... cost.  Cost-based pricing is good for two things: determining a floor price (which has its place in pricing strategies) and relying entirely upon your procurement department to drive your profitability.  After all, if they do their job better, profits increase!  Wait... you mean that is not the message you are sending to the Street?  Then you need to stop cost-based pricing methods from impacting the price delivered to customers.  Cost-based pricing is a disaster waiting to happen, just ask anyone who tried to compete with Walmart on price (oh, forgot, those places are not in business anymore).

When you price based on cost, you are not taking advantage of what the market has to offer.  You are looking at your own internal metrics and hoping for the best.  This will never move the needle of profitability.  In order to transform your profits, you must transform the ONLY element of the marketing mix that brings in revenue and profit - price!

So, back to my comment about how your customers perceive your products' value…  You have to get over your own egos and start thinking like your customers.  And this is not easy, because last time I checked, you are not your own customers.  So how do you get in their heads and start to think like your customers?  Unless sci-fi becomes a reality, this simply will not happen (and besides, all the sci-fi movies about miniaturization and being implanted in someone’s head never ends up pretty).  But you can forecast how customers might behave, given certain market characteristics.

To better forecast, you need to better segment your customers and products.  I'm not asking for a revolution for any current practices, I'm simply suggesting to break out of your current segments and start treating profitable customers like profitable customers and non-profitable customers like non-profitable customers, regardless if they are in the same country or not.  I cannot tell you how many times I have heard, "well, customer A and customer B are both in France; therefore, they should purchase the same".  OK, you are right, I have not heard that explicitly, but I see it all the time because many companies I have worked with price the same to all customers in France!  You have the data necessary to identify these segments, but you need to take the time to build these segments properly.  And this is a topic for another day.

Once you have those segments, you can begin to appreciate how those segments behave.  For example, a scatter plot of revenue and volume should look similar for all those customer/product combinations in one segment.  But there will still be variation.  Now, you can take this smaller amount of variation and quantify the gains made by forcing higher prices to the lower performers.  Will you achieve 100% of this improvement?  No, but 50% is reasonable.  One company I worked with simply stopped selling below market average for a week for specific product lines in specific areas.  The results?  15% improvement in profits against the baseline forecast for that week.  Imagine what you could achieve by implementing pricing strategies at this level?  The possibilities are almost endless.

I'll leave you today with the reiteration of one of my statements above and encourage you to comment: price is the ONLY element of the marketing mix that brings in revenue, hence profits.  All others only bring costs to the table.  Why then is SO much time devoted to the other elements, with so little attention being paid to price?


  1. I've received several great comments on LinkedIn threads that I'm paraphrasing here in hopes of capturing the information for future reference...

    Many commented that the commoditization of products typically leads to organizations falling back to cost-based pricing, because it guaratees some return.

    Steven Forth pointed out, "... with cost-based pricing you will stay in business, at least in the short-term. In the long-term you can easily be commoditized and then driven out of the market by the low-cost vendor."

    Excellent point. I've seen it time and time again, the sales force believing that the products they sell are already commodity and that the only way to win is on price. This type of thinking, in a black and white world, has to be driven out of an organization. If anyone truly believes all they offer are commodities, then they no longer believe the name they work for, the people they work with, bring any extra value to the enterprise. This type of thinking is infectious, and self-destructive. Some companies I have worked with actively sought out this thinking to re-educate (or cut); others have ignored it, hoping it would go away, and yet they were still amazed that pricing strategies were met with resistance and skepticism!

  2. Well put Michael(and Steven). It goes back to one of the points I make in my article re the daily challenges of pricing practitioners i.e
    pricing EDUCATION is a key component,across all functions including executive management, in order to make the transition to value-based pricing.

    But, as we know it's a challenge to change behavior and mindsets away from..."that's how we've always done it..". It's one of many
    missions of the pricing community!

    Peter Maniscalco