Product Pricing – An Operations Tool
The product pricing methodology used by most businesses uses this formula:
Price = Cost plus a Mark-up.
All causal costs for the product are summed; a profit margin is then added to produce the price. Simple eh.
What’s wrong with this picture? A few things:
– The cost-plus-margin method may not yield a price the market is willing to pay. There is no guarantee that customers will belly-up to your price and accept your cost structure and margin expectations.
– Your costs are not likely to come in on target. My experience says they rarely do; they typically are higher than expected. The result is that margins are squeezed if the price isn’t changed to reflect higher costs. Even if price IS increased, customers may not accept it – elastic demand, right?
– This approach provides little incentive for a firm to be more efficient; price is simply the consequence of current operating procedures which may not be in the market zone.
The BE DiFFERENT pricing approach, on the other hand, places the emphasis on using price as an operations tool for generating profit. The formula is:
Cost = Price minus a Margin. Here’s the process:
1. Determine the price the market is likely willing to pay FIRST.
2. Decide the margin you want.
3. Calculate the cost that you can afford given the above two inputs. For example, if the market price were $10 and you expected to achieve a 30% gross margin, the cost target would be $7.
4. Determine whether or not you can hit the cost target.
5. If yes – proceed.
6. If no, change operating processes to reduce costs or STOP ( if you can’t introduce the product profitably so you shouldn’t).
This is more than an arithmetic manipulation of the equation variables. It represents a fundamental change to the strategic intent of pricing. Pricing shifts from a focus on hitting the right point on the demand curve to a tool that determines affordable costs.
BE DiFFERENT. Consider price as an input to cost, NOT cost as an input to price.
So, pump up the volume on this Price-driven-costing methodology:
– Track product costs religiously; review performance regulary.
– Pay Product Managers on meeting costs in addition to revenue.
– Hold Operations folks accountable to meet the cost targets of their components in the delivery chain.