Nothing is more useful than water: but it will purchase scarce anything… A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.
—Adam Smith [1723-1790]
Traditional pricing methods have generally calculated price as “cost + profit.” My experience has taught me that pricing is an art, not a science. Customers do not care about your internal cost or whether you make a profit. They want to receive more in value than the price they are paying or they won’t purchase the product.
I believe that the whole theory of pricing is undergoing a paradigm shift. As we move from a labor intensive society to an intellectual, capital society, Cost-Plus Pricing no longer works. Every business owner needs to understand what value their customers place on the services they provide or the products they produce. Values are determined by how much money customers are willing to pay for those products and services. It is the customer’s point of view that now drives value.
Your customers’ access to information on prices has increased dramatically with the advent of the Internet. In addition, social media sites such as Facebook, LinkedIn, Twitter etc. spread information (good or bad) about your company’s products or services. Pricing power has moved into the customers’ hands. We are moving from Cost-Plus Pricing to Market-Based Pricing.
Under the Cost-Plus Pricing model, a product’s cost is determined by the labor, materials and capital requirements of that product. The business owner’s required return on his investment is added to the product cost to determine the value (price) delivered (charged) to the customer. This pricing theory is internally focused and may or may not be what a customer is willing to pay given their access to your competition’s pricing information.
Under the Market-Based Pricing model, the customer is asked what value they would place on the features and benefits of your product or service, which results in the product’s price. The product’s price is reduced by the required rate of return of the business owner to arrive at the target cost of the product. If the target cost can be met during the product design process, then it will produce the desired profitability and will meet both the customers’ and the company’s needs. If the target costs cannot be achieved it should not be introduced as a product.
Here at B2B CFO® we are experts in helping business owners increase the value of their companies. We believe in working under the Market-Based Pricing model whereby we establish a value for our services together with you upfront. We work on a hand-shake, no surprises basis and look forward to being your long-term trusted advisor.