Hi! Ready to start a business or revamp your old one? Well, let’s talk about ways to price your products or services.
When you hop on the internet and search “pricing”, Wikipedia is going to show you page that lists 29 separate “pricing tactics.” That’s just simply too much, so let’s get back to basics for a moment.
Price floor - This is the minimum pricing required to make a profit. If you spent $10 to buy a widget and you want to resell it, you need to sell it for at least $10 to make any profit.
Price ceiling - This is the maximum pricing, where the price of a good or service is so high that virtually no one will buy it!
Traditional Pricing Models
In most cases, there is a wide margin between the price floor and the price ceiling, meaning there is a lot of room to decide where to price your good or service.
Take the traditional construction trades - they typically compute the cost of the materials and labor required to do the work, add a 10% margin, and then offer that as the price. Sounds pretty good to anyone who has the capital to spend on construction! In the pricing market, this would be some version of “cost-plus pricing.”
What about Rolex watches though? Even with the very nice watches, your basic Rolex watch doesn’t cost $500 to make. Rolex probably only spent $50 for some Chinese sweatshop to pump it out, right?! Well, they may or may not be using Chinese parts and labor (China has come a long way and can compete at all levels in manufacturing), but the purpose of the $500 price tag is to convey the sense of luxury. It’s now a status symbol! Rolex has priced the average consumer out of the market by pricing their good near (but not AT) the price ceiling, resulting in what is called “image-based pricing.”
These pricing models are the two most-common pricing models in goods, and of course there are shades of gray in-between! But what if you have a service instead of a good? Yes, the basics of costs and profit, floor and ceiling, etc. still apply, but this is where we encounter another VERY important concept:
Opportunity Cost - This is the economic method of pricing “But what else could I do with that time/money?” If you spend your time watching television (earning $0/hr) when you could be working your part-time job (earning $15/hr), your opportunity cost is $15/hr. This argument extends to other aspects too! Say you could hire a painting company to paint your house at $40/hr, but your day job pays you $50/hr. If you decide to take a day of unpaid leave and paint the house yourself, then you’re forfeiting a potentially large income in order to avoid a slightly smaller bill. Economics says that you should hire the company to paint your home, since that maximizes your revenue!
When we start to talk about opportunity costs, we begin to understand a new pricing model called Value Pricing.
Value Pricing - The concept that a good or service should be priced at the perceived value of the good or service from the perspective of the customer.
Let’s say you own an accounting firm. You have two clients walk in the door who have nearly identical companies. They have the same operational model, same number of employees, same complexity on the books. Before you can start pricing, you’re smart and start asking each client about their experience with accounting.
Client 1 - “Well, we used to pay $3,000 per month, they did everything we asked and we were happy, but they fired us because we were asking for things they didn’t do. Can you do these things? *hands over a long list*
Client 2 - “Yeah, our previous accountants lost everything. They were outsourced from overseas and we’d spend about $100 per month on accounting.”
These two clients have very different concepts of what accounting should cost. If you adopted a cost-plus pricing, you might tell both clients that they could pay $500 per month. Client 1 may love the cost, but actually worry that your firm cannot deliver the quality they are looking for. Client 2 may be concerned that the price is too high! What do we do?
Answer: Ask more questions. Value-pricing depends on these factors:
The perceived pain/pleasure of the experience surrounding a good or service.
The opportunity costs of alternative paths forward.
Upon asking these questions, we find that Client 1 would gladly pay $3,000 per month if his list of requests can be met. Great! If your team can actually do that list for anything less than $3,000 per month, your firm will likely have to price between $3,000 and $4,000 to win this sale.
Client 2 however, discovers that his only other alternative to your accounting firm is to hire a bookkeeper and a controller internally. That’s $120,000+ per year ($10,000+ per month) he has to add to payroll! After asking a few more questions about how painful his experience with the overseas accountants was, we discover Client 2 will gladly pay $6,000 per month to avoid the pain of the overseas accountants as well as the pain of hiring.
Notice the unique twist that happened here: Client 1 came in sounding like the money-maker for your business, but Client 2’s experience and understanding of the market is going to help your firm earn twice as much revenue!
Pitfalls of Value Pricing
Before we finish, value-pricing isn’t the end-all-be-all in pricing. Just like any strategy, it comes with pitfalls!
Value-pricing relies on delivery. If your team can’t deliver the perceived value, the client/customer will walk. This means that your delivery team also needs to understand the value targets AND feel empowered to hit them!
Value-pricing requires effective client/customer selection. If the perceived value is below the actual cost of the good/service, you need to walk away from that sale.
Value-pricing is held in check by the market. You could employ scare-tactics to artificially inflate the perceived value, but the market will correct these pricing games quickly!
Value pricing is difficult for most consumer goods. It is much easier when you can develop a relationship and have a conversation with end consumer, which means that your product needs to be very niche!
In short, value-pricing excels best in niche markets. If it’s used properly, it ends up as a great profit stream for companies and has a natural feedback mechanism to signal when a client/customer is unhappy - because they’ll come talk to you about it! Make sure that you check in with your clients/customers regularly and see how they’re feeling.