Excerpt from Chapter 2: Your Pricing Belief System
Cost Based Pricing
The most common pricing model used in technology services is cost based pricing, so let’s start there. When cost based pricing is used, firms develop a service offering, calculate the costs of delivery and then think about what price to charge to achieve a margin target. The pricing mantra is make your margin.
The first thing you notice looking at the Value-Price Surfboard is that you only have half of a Surfboard. Indeed, the primary reasons firms employ cost based pricing is that it is easy to use and it is the lowest cost pricing system. You can go into any surf shop in Monterey and purchase half a surfboard for cheap. In my shopping, one surfer said “You gotta go with the flow man, but that one might be a bummer.” Let’s see what he means.
Cost based pricing makes intuitive sense. If you understand your costs, and you price higher, you are basically doing the right thing. Of course, during roughly 7,500 years of human civilization the idea that the world was flat, and behaving as if it was, was considered the right thing. But then a guy named Chris challenged the accepted norm and literally changed the world.
You will recall from Marketing 101 in business school that price is one of the four Ps of the marketing mix along with Product, Place and Promotion. Diving a little deeper into marketing, any marketing strategist worth their salt will tell you that the three key elements of marketing strategy are segment targeting, offering design and price. Hence, the primary problem with cost based pricing is obvious: there is no connection whatsoever to what customers are willing to pay. The needs of the market are ignored. Where your marketing strategy should be on three legs, you have it teetering on two with cost based pricing.
For this reason, the terms “pricing strategy” and “cost based pricing” cannot be used in the same sentence. Cost based pricing is not strategic. Strategy, by definition, occurs when firms compete for a customer. Here the customer is excluded. Instead, cost based pricing is an expedient response when you must choose a price and no other means is available. If simplicity and low cost are your primary considerations, then cost based pricing can’t be beat.
There are some tradeoffs, however, you should be aware of if you rely on cost based pricing. As I said, there is no connection between your costs and what the customer is willing to pay. Anyone reading this who has paid full price for a cell phone, or is willing to pay full price for a cell phone, raise your hand. I don’t know the statistics, but I would be willing to bet that fewer than 1% of all cell phones sold to consumers in the US are sold at full price. Here’s another one. Any consultant out there who has used cost based pricing, only to have a customer throw it back in your face, raise your hand. I bet 99% of us in professional services have learned that lesson the hard way. Cost based pricing has the potential for seriously getting in the way of sales and marketing.
From these examples, it may sound like the disconnect with the market is an occasional occurrence, more of an annoyance than a day to day issue for technology services. So we need to think about it from a sales perspective to understand how cost based pricing gets in the way of sales day in and day out. When sales is presented with a cost based pricing, it has no connection to the world they live in. They are given a price with no justification for the customer other than this is what it costs us to deliver. Sales in turn hears from customers that prices are too high, and have no defense. Since nature abhors a vacuum, and being a creative bunch, they develop their own pricing system: “customer based pricing” where the mantra is make the sale. If customers say our prices are too high, they must be too high, and getting in the way of making sales. It rarely occurs to them that customers may be less than truthful. So sales takes the next logical step. If our pricing is justified based on our costs, then our costs are too high, getting in the way of sales. So sales pushes back on price. You would do the same thing if you were walking in their shoes.
The owner of pricing, often a Director of Finance, in an effort to make his margin, puts controls in place to hold against the pressure. Being the creative bunch they are, sales proactively searches for ways around the controls. Again, not malicious intent, just enlightened self interest. If finance won’t give on price, they go to service product managers with dire warnings that the sale will be lost without a price concession. If product managers don’t give in, they pressure their sales managers for concessions. In some cases, sales will refuse to take the service offer to the customer without discounting. Sales will give away products and services to close the sale. I have seen discretionary discounting over 40% because sales cannot justify the service price to the customer and controls don’t work. Ultimately the Director of Finance becomes labeled as the “VP of No” for standing in the way of sales for no good reason. Raise your hand if you employ cost based pricing and this doesn’t sound all too familiar.
It’s not that costs should play no role in pricing. Understanding costs and cost behavior is essential to achieving good margins through good pricing. It’s just that cost based pricing is fraught with problems.
Truth is sales may have a point. Let’s say you’ve had a bad year, attach rates are low and service revenues are down. Since costs are now spread over a smaller number of service agreements, costs per agreement go up. Cost based pricing says you should raise your prices to hit your margin targets. So you announce a price rise for sales. Does this make any sense? And the perversion can become worse. Let’s say you have a low cost service and a high cost service that each would solve a customer problem equally well. You would rather sell the high cost service because it means higher margin. Sales would rather sell the higher cost services at a discount because it means a larger commission. What does this do to your competitiveness?
And what are costs anyway? Anybody who has had the privilege of diving deeply into understanding costs knows it is no picnic. What is the cost of a technical architect at 25% utilization? At 90% utilization? If we use the service team in Pakistan to take customer service calls and the cost is $1.50 cents per call, the cost is $9.00 for the European call center, and $6.50 for the US call center. What cost should we use for pricing? We could take the average? If we do, how do we account for variances in language and skills and customer requirements? How should we handle overhead costs?
Or what about investments to improve productivity? One PS executive confided that within the next 12 months he will be able to increase the speed and productivity of his implementation team by 50%. With cost based pricing, he has no opportunity to capture a share of the value of that improvement. His costs go down so his prices go down. He creates greater value for customers but can’t capture it.