Your costs: Nobody cares and what to do about it!
Let’s talk about prices. How do you set yours? To what degree do you consider your costs when you do so? These are questions I find myself asking more and more often, as I come across situations in which costs have driven the approach to pricing.
This typically looks like, “It costs us X to make our product. We want to make Y profit. Therefore, the price is X+Y”. In pricing theory, this is called ‘cost plus’. If so many people do it, you might be wondering why this is problem. Well, let me give you three reasons why I find it problematic and what you can do about it.
1. Nobody cares
The first and biggest problem, in my opinion, is that nobody really cares what it cost to make your product. Sorry. Worse yet, if they think about it at all, it’s probably because they think you are ripping them off.
Think about the last time you bought a sandwich. Did you worry about how much it cost them to make it? You probably didn’t give it a thought. I’d argue that most often that’s because you don’t care. If you do, it’s because you were comparing *what you think it cost* to the price. The comparison is unfavourable…“£4 for a sandwich that cost them 50p? How dare they!?”
Cost plus can work where the markup (profit) is somehow agreed up front as being fair. Most of you are not in that world, though.
2. Profits are the first thing to go
If the product does not sell as well as you’d like, the most common response is to drop the price. But ‘in flight’ it is often difficult to do very much about your cost of production. If the price goes down but costs remain unchanged, your profits are going to get squeezed. Not good.
When the product does not sell as well as you expect, it’s usually because customers are not perceiving or experiencing the value you anticipated. The cost plus model, because it is disconnected from value, does not help you avoid the low-value trap.
3. Costs are more of a given and less of a constraint
The cost plus model presumes a cost to which you add a markup. It doesn’t have much to say about what that cost should be. If you are smart, you will constrain your costs, however, in the world of software that can be especially difficult. Why? Because you don’t really know how that works; you work in terms of features and sprints rather than a budget.
This is a kind of a side-effect of the cost plus model. It treats your costs as a given and says, “What is the right price?” rather than forcing you to think about what profit you want to make and ask, “Is this the right cost?”
In identifying these problems with the cost plus pricing model I do not mean to suggest that your costs should have no impact on your pricing. Clearly a viable business must charge more for its products than they cost. But what I do mean to suggest is that where this kind of thinking goes wrong, it is your problem and neither prospects nor customers will care.
So, if the ‘cost plus’ approach is a bad choice, what is a better choice? This is a tricky question to answer in general, but for companies who are principally building software platforms or applications you might think about it this way:
Understand that your product is going to have a value in the marketplace. our job is to understand this and then extract a fair share of that value in terms of profit. How might you go about this? Here is one approach:
1. Undertake a comprehensive value proposition design process. This helps identify the key problems you are solving, for whom, and what their actual value is (in the mind of the customer)!
2. Use market analysis and sales forecasts to determine the expected value of the product over time. This is necessarily likely to be probabilistic so you are going to end up with a “pricing region” rather than a specific figure.
3. Determine the minimum amount of profit you would like to take due to this product. That is, you set the profit in advance.
4. With these data points, you can project a minimum and maximum that your product can cost to make.
5. Now use a technique like Impact Mapping to focus your development on high-value features and constrain your development & maintenance costs to budget.
It’s fair to say that this is a more complex model of pricing and comes with its own risks attached. It requires you to have a clear handle on your value proposition, to do effective market analysis, and to manage development to a budget.
None of these are easy things to do but all are worthwhile in themselves. And the bonus is that you can access pricing models that will generate more profit and protect your profit better when things go wrong. Time to take a look at your prices?