Most of us accept that if we go to a convenience store late at night, the items we purchase will be priced higher than a major grocery chain during regular hours. Yet when it comes to operating our businesses, many of us are convinced that cost has no bearing on price.
When we buy something and pay more than we want, we may complain that the cost couldn’t have been that much. In truth, we’re really indicating that we’re offended by our assessment of the seller’s greed. We’re using cost as a baseline indicator of what we think a more equitable price should be, and simply don’t like to admit we’re willing to pay for the incremental value this specific product or service brings us. In this case, we’re conflicted by an assessment of fairness based on cost, and a reality that we’re paying for the benefit of convenience.
So it’s easy to understand why the practice of cost-plus pricing is today’s most common approach to price setting. It seems fair, and it’s relatively easy to determine. Further, we well comprehend that cost has everything to do with profitability – and profit is why most of us are in business – so we spend a fair amount of time and energy managing and tracking our costs.
We also want to make sure we’re not selling below cost, which would indicate that we’re not competing well, and we’re spending too much on time and materials. It can also help us consider the least amount we’re willing to accept for our products or services. It’s clear that as good business people we must evaluate our costs and margins. This evaluation can be a determination of our willingness to be in a specific customer segment, to produce a particular product, or to serve a certain customer. But, we must not confuse this activity as a price-setting exercise.
Consultants often discuss setting a floor price, which may also be referred to as determining the bottom of a “pricing envelope.” This helps determines the lower limit of a product or service price-range we’ll offer to a market. Let’s be clear though; this isn’t about setting a cost-based price.
A cost-based price is not a price we ever want to offer the market. It has nothing to do with either what the market will pay – based on perceived value – or how our offer is viewed relative to competitors. Our potential customers are thinking about themselves, wondering about the benefits they’ll get relative to what they’re going to spend; and also asking if our price is cheaper than other offers.
When we dig further into cost, the whole matter of spreading fixed overhead becomes very messy. As my graduate school cost-accounting professor said when she wrapped-up a very long and tedious semester, “No cost-accounting approach is accurate, but it is better than nothing.”
It’s easy to get sucked into the vortex of which costs are most appropriate to apply. It is also easy to spend energy determining which version of margins we’ll use: gross margins, contribution margins, net margins, etc.
At best, understanding costs and margins are introspective and don’t address our would-be customers’ “willingness to pay.” Alternatively, we should think about our bottom-price as the lowest we’ll quote in a given market.
Our bottom price can be based on the lowest price for which our product or service has sold thus far. Ideally, this lowest price was given to our largest customer or for our largest transaction – the one that bought the largest quantity of units or spent the most money at any one time.
The lowest price could also be based on a contract that guarantees our “best customer” the best price – a “most-favored customer” clause. But, we should determine the lowest price before it’s introduced into a contract.
In summary, a cost-based price isn’t an indication of what we should charge for our products or services. It provides an understanding of when it’s no longer viable to sell our products to certain customers or market segments. As such, it’s an important activity that every organization must undertake. But, if we want to improve our margins and drive sales revenue, we must focus on creating an understanding of what our prospects will pay for our offerings. And we must understand this with a solid understanding of the price our customer can pay to get that need fulfilled elsewhere.
Yes, cost-based pricing is almost a natural instinct due to our sense of fairness and the ease with which we can generate numbers. But, if we study our own behavior when it comes to our willingness to pay for items beyond the cost of the goods, e.g., convenience, then we know we should also be able to add value to our products and services, and our costs are irrelevant to our customers.