Pricing Should Be Based on Customer Value, Not Cost

The typical approach to cost-plus pricing starts with the product cost and then adds a markup, often somewhat arbitrarily. You usually end up with a price that’s either too low or too high. Price too low and you leave money on the table. Price too high and you miss out on closing the deal.

It’s very important to understand that customers don’t care about what it cost you to manufacture the product. They do care, however, about what they are paying and if they’re getting a good deal.

A better pricing strategy is based on understanding how customers perceive the value of your product or service. You can’t get this insight from behind a desk. You have to go out and talk to your customers. Start the conversation by asking questions such as:

By looking at the Total Cost of Ownership (TCO) you’ll get even more insight into how the customer might value your products.

Let’s say your product improves productivity, is more reliable, requires less setup time, is more energy-efficient, and requires less maintenance. It does not take too much effort to put these benefits in terms of dollars and cents.

Knowing the benefits your product offers, you may be able to demand a higher price over a cheaper competitive product that lacks some of these benefits. The Total Cost of Ownership advantage provides an opportunity to set a higher price, and still be seen as a “good deal” because of the benefits.

Also, with insight into customer value and the TCO analysis, you can present a compelling story to the customer about the benefits of your product and how it’s different. This beats having to compete on price.

No doubt, this pricing strategy is more complex than using cost-plus pricing. It takes effort to find out the perceived customer value and doing a Total Cost of Ownership analysis. But, if you do the work, you’ll be able to improve your margins.

With market-based prices, products are priced close to or the same as competitors’ products. No differentiation, nothing strategic about this approach. As far as the customers are concerned, all products in that particular category are pretty much the same.

You can escape this commodity trap by creating a Unique Value Proposition that sets your product apart. This will allow you to command price levels above the market average.

Good market segmentation is a key element of a smart pricing strategy. Market segments are different in their needs for your products, how and where they use them, and why and how customers in each segment go about buying the products. Also, you can expect each segment to behave differently as far as price sensitivity. As a result, each market segment has its own customer-perceived value.

Your approach to price setting should reflect your insight into the market segments. Instead of using the same pricing across all market segments, you can set a different price for each segment.

In addition, you could also decide to pursue only the most profitable market segment, ignoring those segments where it’s more difficult to make a profit.

Total Cost of Ownership analysis can also be helpful in segmenting the market by getting a better understanding of how your product is used in each segment as well as the perceived benefits and value.

Often, a detailed analysis of your sales figures will show that a firm has a considerable percentage of customers who are only marginally profitable or even unprofitable. This is especially true if the costs of customer acquisition, warranty, shipping and handling, customer support, etc., are taken into account.

Identifying your (most) profitable customers enables you to concentrate your sales efforts and resources on that particular segment.

On the flip side, knowing who your unprofitable customers are allows you to take steps to improve their profitability, e.g., by raising prices, cutting out ‘freebies’, charging more for S&H or customer support, and so on. You may even decide to stop serving these unprofitable customers altogether.

Firing unprofitable customers or exiting an entire market segment that’s unprofitable is an important strategic decision that can dramatically improve the bottom line.

Too often, pricing decisions are made based on anecdotal information provided by the sales force. Unfortunately, often this information is not reliable or based on a single case, making it difficult to generalize and develop a robust pricing strategy.

A rigorous approach to price optimization uses hard data and analysis of detailed market intelligence about customers, competitors, and other marketplace metrics.

Price optimization requires, and deserves, the same level of attention and effort as cost reduction.

The way you incentivize the sales force can have a negative impact on profits. If salespeople are rewarded for pushing volume, at any price. they will do just that. This can be especially costly when salespeople have the authority to offer discounts. The result could be that sales are only marginally profitable, or perhaps even unprofitable, due to aggressive discounting.

A different approach is to have the sales force focus on profits, not revenue. To support that goal the firm needs to put the proper incentives in place. In order for these to get accepted, the sales force has to become educated about profit margins, perceived customer value, TCO, and product cost.

Even within a particular market segment, your customers will likely have a different value perception of each of your products. Not each product line is valued the same way. This means that each product has its own optimal price point, and consequently profit margin, for that specific market segment.

Simply applying the same profit margin across your entire product portfolio for a particular market ignores the importance of the value-based approach. Once again, you’ll end up with products priced too high or too low.

You need to accept a different profit margin for each product or line of products, rather than applying the same gross margin across the board for the entire product portfolio.

Raising prices is something managers try to avoid as long as possible for fear of customer backlash. However, companies with a strategic approach actively manage prices and accustom their market to price changes. Proactively informing customers of price changes can be part of good customer service and communication.

The marketplace is very dynamic. A lot can change in a short period of time. How customers perceive the value of your products is not static but moves up and down with events in the marketplace such as a competitor’s price change, a new product launch, or emerging new technology. Product prices must be adjusted to reflect these changes in the marketplace. Failing to do this impacts your competitiveness and your bottom line.

You have to recognize that a price change will likely be met with a competitive response. You need to know enough about your competitors to anticipate how they will react to your pricing. Anticipating competitor reactions can avoid costly price wars that can destroy an entire industry in the race to the bottom.

Companies put a lot of effort into cost tracking and cost reduction. Yet, at the same time, managers often overlook the importance of a formal pricing strategy that supports the goals of the business.

Determining price levels needs to be a multi-disciplinary approach. It’s no longer the purview of accounting or finance alone but requires the active involvement of the marketing department.

Don’t forget that pricing is one of the elements of the 4 P’s of the marketing mix, a classic concept in strategic marketing.

Pricing is a complex topic. Many books and articles have been written on the subject. Hopefully, this post got you thinking. I’m looking forward to your feedback.