What Is The Right Price
Oct 15, 2009
What is the Right Price?
Nothing is more useful than water: but it will purchase scarce anything… A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.
---Adam Smith [1723-1790]
Over the last 25 years I have spent a significant amount of my time determining the value of things. I have had the authority to set prices on the purchase of student loans, rates to be charged on automobile loans, commercial loans and residential mortgages, rates to be paid on money market, demand deposit and certificate of deposit accounts. I have negotiated the prices to be paid for agency backed, mortgage backed and municipal securities as well as hedging instruments such as derivatives. I have established the value of whole companies to be purchased or sold and whether goodwill impairment has been incurred. My experience has taught me that pricing is an art not a science.
I believe that the whole theory of pricing is undergoing a paradigm shift. As we move from a labor intensive society to an intellectual capital society, Cost-Plus Pricing no longer works. Every business owner needs to understand what value their customers place on the services they provide or the products they produce. Values are determined by how much money customers are willing to pay for those products and services. It is the customer’s point of view that now drives value.
Your customer’s access to information on prices has increased dramatically with the advent of the internet. In addition, social media sites such as Facebook, Linkedin, Twitter etc spread information (good or bad) about your company’s products or services. Pricing power has moved into the customer’s hands. We are moving from Cost-Plus Pricing to Market-Based Pricing.
Under the Cost-Plus Pricing model, a product’s cost is determined by the labor, materials and capital requirements of that product. The business owner’s required return on his investment is added to the product cost to determine the value (price) delivered (charged) to the customer. This pricing theory is internally focused and may or may not be what a customer is willing to pay given their access to your competition’s pricing information.
Under the Market-Based Pricing model, the customer is asked what value they would place on the features and benefits of your product or service which would result in the product’s price. The product’s price is reduced by the required rate of return of the business owner to arrive at the target cost of the product. If the target cost can be met during the product design process, then it will produce the desired profitability and will meet both the customer’s and the company’s needs. If the target costs cannot be achieved it should not be introduced as a product.
A perfect example of this paradigm shift was illustrated in an August 24, 2009 article in the Wall Street Journal ('Billable Hour' Under Attack - WSJ.com). The article describes how Pfizer, Cisco, and American Express, among others, were fighting back against the traditional law firm practice of billing them by the hour. These customers determined what value they were willing to pay and not a penny more. And by the way, the law firms found a way to make their services more effective (i.e. target costs in line with new market price.)
Here at B2B CFO® we are experts in helping business owner’s increase the value of their companies. We believe in working under the Market-Based Pricing model whereby we establish a value for our services together with you upfront. We work on a hand-shake, no surprises basis and look forward to being your long-term trusted advisor.