More times than not, pricing decisions for new products are based more on internal production costs and less on the value of the actual benefits that these products provide for your customers. Probably the biggest reason for this is that it is far easier to calculate internal costs than to go out in the marketplace and do the heavy-lifting to ascertain the value of the benefits provided.
But even if you go through the heavy-lifting of determining the economic value of these benefits, many times that information is compromised by the additional knowledge of your internal production costs. This is because is is much easier to rationalize a price based on known data (internal costs) than to rely on data that is much more abstract (economic value to customer) and far less defensible during the pricing debate. And so while we don’t like to admit that our pricing decisions are cost-based, the fact of the matter is that most of them are – perhaps not directly, but certainly indirectly.
For anyone having to go through the process of pricing a new product, here’s a great exercise…and it comes from William Davidow – author of Marketing High Technology – An insider’s view. Here’s what the author had to say about this subject:
“When a marketing department [or the department with ultimate pricing responsibility] is given cost information about a product, it will tend to rely heavily on that information in determining the value of the product to a customer. I’ve long believed that the first pass at pricing a product should be made without the foreknowledge of what the product will cost to manufacture. When a marketing department knows the cost and the margin acceptable to a company, it will use that data to determine a price acceptable to the company rather than to the market.
That is a lazy and naive approach. If you are interested in finding out if your company is guilty of pricing by computation, try this experiment. Deprive your marketing department of cost information during a pricing exercise and see how much agony it produces in the group. The experiment will quickly bring the problem to the surface.”
This is an excellent exercise to go through – and one that should be the norm when you begin most pricing discussions. When pricing decisions are tainted by the knowledge of internal cost information, that same information acts as a psychological anchor to prices. And it is this “cost anchor” that results in money being left on the table because of an inability to separate value from cost.
Here’s the takeaway: Value-based pricing is easier said than done. And when you do go through the exercise of attempting to set prices based on the economic value of benefits provided to your customers, having prior knowledge of production costs will taint this process and result in poor pricing decisions. Separate the information – price first and then compare those prices to your costs.
Patrick Lefler is the founder of The Spruance Group – a management consultancy that helps growing companies grow faster. He is a former Marine Corps officer; a graduate of both Annapolis and The Wharton School, and has over twenty years of industry expertise.