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Things I hate: Cost-Plus Pricing

If you’ve been here the last few days, you know I decided to start off the new year with something other than a “how to have an amazing 2015” series. So instead, I’m doing a four-part “things I hate” series.

And today I want to tackle pricing.

Pricing is hard

I don’t need to tell you what you already know, right? But you can pick up a good book on pricing and start learning. That’s for sure. And you’ll be busy for a while because there’s a lot to learn.

I could have just as easily called this “people who think there’s only one way to price things” but I don’t want to pick on people per se. I want to pick on the notion that there’s only one “right way.”

So to be clear, I don’t think value-based pricing is the “only” or “right” way, but I think it’s a good way and an approach that is worth learning.

Unfortunately, most people consider it hogwash because it’s not easy. And so everyone reverts to one of two ways to price things:

  1. What is everyone else doing-pricing

  2. Cost-plus pricing

The problem with Sideways Glance Pricing

Ok, “sidesways glancing” is my term. But it’s an easy way to think about how people determine pricing. They say, well Jim is pricing it this way, so I’ll match him. Or Suzy is pricing it like that, so I’ll do it too.

We all do this. Naturally. It’s the desire to be in a crowd and never get called out in a negative way. The problem is that you’re always in a crowd. And that makes differentiation a lot harder. It also makes you unremarkable. And that means you have to work even harder on other fronts. Fronts that may not get noticed.

But everyone asks about price.

So why not differentiate there? (Even if it means you cost more.)

The Problem with Cost Plus pricing

Let’s be honest, everyone likes this model. It’s easy to calculate (though amazingly, most people use a function of value in calculating even this).

They say something like, “Well, it’s going to take 10 hours, at $150/hour, so that’s going to cost us $1500. And assuming we can get away with a 20% margin, that means we’ll charge $1800.”

Did you see where value got introduced? At the “$150/hour” and at the “20% margin.” Because surely someone else could sell it at $100/hour and be willing to live with 10% margins. So you were already making value determinations.

Nevertheless, that’s not the real issue with cost-plu pricing (at least for me).

The real issue is that people forget about all the hidden costs. All. The. Time.

And guess what happens then? That margin shrinks in a bad way.

That’s why I appreciate Value-Based Pricing

Value-based pricing is harder than either of the other two approaches because it takes more work. But it’s work I feel like you should be doing anyway. The more you know about your market segments (how they work, how they make decisions, what they value most, what it costs for them to do things, what they struggle with), the better you can serve them.

So you should be doing this work anyway – just to be a better partner to them. But it also translates into being able to better determine the right value for the work you do, and that translates, often, to higher prices and margins for the work you do.

Here’s another way to think about it.

If you truly understand your client, you’ll be better able to determine all the different ways you can help them. And that includes all the different ways you can add value. And that means you can do a better version of cost-plus pricing – one that looks remarkably like value-based pricing.

So if you hate the idea or concept of Value Based Pricing, think of it as better cost-plus pricing.

An Example

In case you think this is all just a “nice” idea (which translates to you thinking I have no idea what I’m talking about or that it’s all theoretical), let me walk you through an example from my old job.

To understand things, at Emphasys (where I used to work), we regularly were the highest priced solution when we bid on projects (a combination of product sales and a lot of customization services).

Nevertheless, we regularly won the business of new clients that had the opportunity to get similar products and services for 30-40% less than our prices.

On one particular deal, this is what our competitor bid:

  1. 3 Software Modules – X

  2. 6 months of Services – Y

  3. Maintenance – .25X

We understood this customer’s particular wants and needs, along with their challenges much better than our competitor did.

So as a result, we knew they needed more than what our competitor was going to offer. We had already created additional products that would lower their operating costs (because we knew their business well). We also knew that they would need to rush their implementation in order to meet political goals (again, something we knew because we knew their business well).

So our bid was different.

  1. 5 Software Modules – 1.55X

  2. 4 months of Services – 1.3Y

  3. Maintenance – .2X

When you compare our costs, you’ll see that we were .5X+.3Y more expensive. But if you compared us over time, and included their own costs, we added more value and saved them costs downstream (because of our additional modules). And we gave them a stronger political win (which had value) by being done earlier.

We were able to do this because we knew their business well.

And in reality, those extra software modules were already written, so we weren’t increasing costs by adding them to our bid. And while it’s true we layered in more services more quickly than our competitor, we covered the cost with our overall margins and long term maintenance.

When you know your clients well, and when you serve their entire set of needs (not always just what they initially request a quote for), the result can be a more expensive offering that delivers better value.

The result is that your pricing can go up because its tied not to your internal thinking about costs, but to their interests and values.

And that’s why I hate cost-plus pricing.

Because it’s a bit selfish. Thinking only about your own needs instead of the needs of your customer.

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