There are many principles, concepts and “laws” that apply to product and service pricing. The following are three that I’ve found organizations regularly violating, or at least ignoring, during my five decades in industry. In most cases, they’ve not consciously ignored these laws, rather they’ve violated them because they’ve never given them any thought. They blindly follow the practices they’ve inherited from their predecessors.
Law #1 – An organization will win a lot of business when it gives away the things it does, but it will not win much business when it charges customers for things it doesn’t do for them. You would think this law is pretty obvious. A price that doesn’t include the cost of performing all of the work required to produce a product or provide a service is likely to be much more competitive than a price that contains the cost of work that is not performed. Yet organizations behave as if this law doesn’t exist when they use over-generalized, financial accounting-focused cost models to establish acceptable sales prices. They win jobs they under cost – jobs that are destined to lose money or underperform – and lose out on jobs they over costs – jobs that could have been profitable. This law emphasizes the importance of valid, causality-based cost models in making quality pricing decisions.
Law #2 – Cost does not determine price; the market determines price. Cost determines whether or not a company wants to sell at the market price. When an organization quotes business by rolling up its estimated cost and adding a profit margin, it develops a subconscious, but non-existent, link between cost and price. Such organizations regularly lie to themselves by artificially manipulating costs so that they can reduce a price to meet the market and still show a targeted profit on a product or service they’re trying to sell. They’re then surprised when they win the job and it doesn’t earn them the targeted profit. In cases where the organization is especially efficient in producing its product or providing its service, it often ends up winning the business at price below market and losing out on potential profits. This law highlights the importance of both a solid understand of “what price the market will bear” and a valid, causality-based cost model to an organization that wants to maintain a profitable portfolio of business.
Law #3 – Any costs that are not assigned to products or services actually are assigned to them as a percentage of those costs that have been assigned. The standard thought process posits that the gross margin percentage added to a product or service’s cost covers both those business’ costs that were not assigned and the product or service’s profit. Let’s think about that premise for a moment. Suppose a company has a company-wide net profit target of 10% of sales and to attain that profit adds a 30% gross margin to each product or service it sells. Doesn’t that mean it adds 17% to cover the “unassigned costs” and then 11.1% to the new total to arrive at a 10% profit as a percentage of sales? Aren’t those unassigned costs being added as a percentage of the costs that are assigned? But what if those unassigned costs include customer or market support cost, product or service line support costs, order fulfillment costs or any of the other types of costs that vary based on the customer or market being served or the product or service being sold? Does a flat “percentage of total cost” really provide an understanding of the cost and profitability of each of the organization’s products, services or customers? This law highlights the fact that the causality principle also applies to many of those “below the gross margin line” expenses and should be incorporated into the costing and pricing of an organization’s products and services.
Being aware of these laws, developing a solid understand of the market and creating a valid, causality-based cost model are fundamental to making quality pricing decisions.