It’s that time of year again. The media is filled with year-end lists, projections, resolutions and wishes. Compared to all that drama, my wish for 2015 is simple: let’s have this be the year that puts an end to cost-based pricing.
For more than ten years, we have been preaching the evils of pricing based on costs. We truly believe its only place is in government contracts that require cost transparency and a margin or ‘fee’ on top of those acceptable costs.
Cost vs. Value
The arguments against cost-based pricing are well-known. First and foremost, if you are pricing based on cost, you are not thinking about value. This is critical because value is the lens through which your customers look at your offerings – “what is this worth to me relative to my next best alternative?” Your costs do not factor into their ‘value equation. If you do not understand value, you have no way of knowing if your prices are too high or too low, and importantly, you also have no idea what you can do to make your offerings more valuable (what is the alternative – become less efficient so your costs go up so you can justify a price increase?).
In our consulting work with enterprise clients in the industrial manufacturing and technology industries, we have come across situations where cost-based pricing led to prices that ‘seemed fair,’ but were capturing only a fraction of the value created. In some cases, the prices were too low by more than a factor of ten!
In reality, this type of pricing is even worse than just not knowing value. If you price based on costs, then when your costs go down, you may be tempted to lower your prices, or at least not argue as hard for price increases. And try getting those prices back up when your costs increase! Further, even if you want to price to cost, very few companies know the actual cost to serve a given customer. So, you end up pricing based on your average cost, letting customers self-select (we get more than our share of the customers that we priced too low!) rather than targeting those where we create the most value and leaving yourself vulnerable to competitors who better segment the market.
Why It's Still Around
So if this type of pricing is so obviously wrong, why does it persist?
I think there are a few reasons.
1. It is simple.
By contrast, understanding customer value takes work and is an ongoing, time-consuming process – costs and target margins are based on history or dictated by the finance people.
2. It is precise.
Value is always an estimate and always changing – cost is given by the accountants to three or four decimal places (even though it is usually last year’s average cost, not the right cost for any specific customer this year).
3. It seems fair.
Value is usually derived from product features or service benefits that took many years to build and strengthen; the cost for all this investment is often invisible to customers. Tacking a margin onto current costs seems easier to defend, especially when your customers may be facing a profitability challenge themselves.
So, how about it? Can this be the year we stamp out cost-based pricing? Let’s start spending our time with customers to understand what they value and worry a little bit less about those detailed cost spreadsheets. Are you with me?
Thought questions:
- Does your company still practice some kind of cost-based pricing?
- Why do you think this type of pricing is still so common?
- What can you do to shift your company’s thinking to customer value?
