Cost Plus Pricing = No Good
You must balance value versus (multiple) costs to determine price. (By Hans Splinter, Attribution-NoDerivs 2.0 Generic (CC BY-ND 2.0))
People sometimes ask me “how should I price my product?” so I Googled it. I found a LOT of blog posts about pricing. A surprising number recommend “cost plus” pricing. How much does it cost to make your product? How much do you have to sell it for to make money? They say “Sell it for more than that.”
It’s well known that “cost plus” pricing doesn’t work for enterprise software. In fact, it doesn’t work for most high value products of any type.
The alternative to “cost plus” pricing is “value-based” pricing. A few people recommend this. And then they don’t say much about what that means.
Let’s explore this idea a bit more, and see what we can learn.
The customer’s perspective
Of course, the customer cares zero, not one iota, NOTHING, about your problems with making money. OK, they might care a tiny little bit if they want you to be around to support them. But they don’t care very much. It is not their problem if you make money or not based on choosing the wrong pricing.
But customers do care about something. In so many words, the customer has a problem. The problem is costing the customer some amount of money or time or business friction. They are looking for a solution to that problem. Your product may provide a solution to that problem. That’s what the customer cares about – solving a problem.
The first rule of pricing is:
Your product must cost less than the problem costs the customer. No customer will pay more to solve a problem than the problem is costing them.
Corollary: If your product doesn’t solve a problem the customer needs to solve, it cannot be successful.
But the customer has other concerns, not just about the price of your product:
- Your product represents a big risk to them. Does your solution solve their problem? It looks like it does, but until they put it into production, they won’t know for sure. That risk makes your product worth less, until they are confident it solves their problem.
- Your product represents a big change management cost. Their current solution or lack of solution to the business problem is costly. Your product may completely solve that business problem. But the cost of moving from their legacy solution to your solution will be significant. In some cases the cost of putting a new solution in place can outweigh the benefits of the new solution, irrespective of its price.
- Your product represents an opportunity cost. The business problem you solve is not their only business problem. By buying your solution they won’t be able to buy a solution to some other business problem.
The Value Inequality
If you put all these customer concerns together into kind of some math, you get the following inequality:
V > P + R + M + C
The customer will only buy your solution if:
The value (V) the customer gets from your solution is greater than the price (P) of the solution plus the risk factor (R) that the solution will or will not work plus the cost of migrating (M) to your solution plus the opportunity cost (C) of not using that money to solve some other problem.
I call this the “Value Inequality.”
To buy your solution, the value the customer gets (solving the business problem) must be greater than all these costs combined.
And to make your sales easier, strive to ensure the value the customer gets from your solution is MUCH greater than the price of the solution. (In math terms:
V >> P + R + M + C
As product managers we have some control over all the terms in that inequality. In the next installment I’ll give you concrete ways to get this inequality working in your favor.
Three Things You Can Do Today
In the meantime, here are three things you can do today to start using these ideas.
- Put yourself in your customer’s shoes. What are the risks, change management costs, and opportunity costs they perceive with your product? Be specific. You should be able to come up with ten or more items.
- Start from the risks you found in step one. Find three ideas for reducing the customer’s risk of implementing your product. For example, do you have successful customers already? Can you use the story of their success to reduce the fear of a new customer?
- Find three ideas for increasing the customer’s perception of your product’s value. Again, you might be able to use the experience of existing customers. Get a good story from an existing customer about the value they experienced when they implemented your product. Or maybe your product has features whose value is not described well in your sales and marketing.
I’d love to hear your feedback on this idea. Have you used a model like this for pricing?
Ah, reminiscing about this blog post I wrote in 2005 on what I call “negative pricing”: http://blog.cauvin.org/2005/07/negative-pricing.html.
You’ve added some important observations about risk and migration costs.
Thanks for your comment Roger! Not only do you have to consider the “negative price” as you discuss, you also have to consider the additional costs I mention. And then you have to include a factor (that I didn’t include, but implied) of “getting a deal.” If the price of your product (with all components) simply equals the cost the customer is experiencing, why would they change from the current situation?
This framing reminds me of the “consumer surplus” Economics concept. That is, the difference between what we pay and what we’d be willing to pay for some product or service.
Loved this episode from the Freakonomics podcast, where they cover it: http://freakonomics.com/podcast/uber-economists-dream/
Here’s further reading on consumer surplus: http://www.economictheories.org/2008/08/jules-dupuit-marginal-utility-and.html
Thanks for the comment! I think there’s a lot of commonality in these concepts. But for my example, I tend to think of it more like activation energy. Decisions are hard (they take “energy” in a metaphorical sense). The easier the decision is to make, the more likely it is to be made. One way to do this is to make sure the customer’s value from a product is a lot bigger then their potential costs. And from that you get the Value Inequality concept. You can actually interpret consumer surplus in a similar way. I think it’s a more intuitive explanation than the theoretical explanation for consumer surplus.
Completely agree. I really like how you framed it. The fact that there are commonalities between the two approaches I think further validates your concept 🙂
Nils, thanks for outlining a process for objection handling and product value.
In my industry (enterprise B2B), I see a lot of instances of (1) change management cost and (2) reputation risk being our buyers’ big objections. One of the tricky things about those 2 common objections is that they’re valid to some degree…you can’t say anything that totally dispels them.
I like what you say in your 3-pronged approach about *reducing* their concern by proactively addressing every value objection you can think of.
Matt – what methods do you use to reduce your prospects’ concerns about risk?
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