Balancing Cost vs. Value in Pricing Strategy Consulting

While this advice is admittedly self serving, I’ve grown very skeptical of the recent trend of B2B Pricing Consultants pairing off with B2B Pricing Software Companies as “strategic partners”.

The issue isn’t the pricing software. The mathematics behind the optimization are generally first rate. The broader challenge is ensuring that the client even needs the solution in the first pace.

Borrowing from Tolstoy’s Anna Karenina, “Companies with effective pricing are all alike; each company with pricing challenges is challenged in its own way”

It’s like seeing a doctor who’s decided to prescribe a drug before he even looks at a patient. How do you even know you’re treating the correct problem?

Sometimes your pricing problem isn’t really a pricing problem. In fact, that’s how I commonly pitch services to new clients: as a pricing consultant with a broader commercial background, capable of working across functional boundaries to address the root cause of your problem. Someone in your pricing transformation team needs to be solution agnostic.

You can’t magically sacrifice a few million dollars at the altar of pricing software and expect an improvement; you need to identify and address the real-world constraints on your margins.

Three Paths to a Pricing Decision

Your average price in a market reflects the sum total of conversations with customers about what your services are worth. Assume every customer has a default option, an alternative to buying from your firm. In theory, you create value (the sales call) and claim part of it (pricing).

From an economic perspective, a “reasonable” price sits at the intersection of three factors:

  • Customer value must be greater than the price (or they won’t buy)
  • The price must be greater than our cost (or we won’t sell)
  • Our value net of price as greater than competitors (or they won’t buy from us)

Your pricing strategy is ultimately a reflection of how the firm has positioned itself in the market. Effective B2B pricing strategy projects should seek to understand these three constraints and identify how the business can shape them going forward. Don’t neglect the power of making appropriate investments to shift these curves: either in new features or lower production costs.

All of this sits on top of your tactical processes for setting the price of a product, maintaining price lists, and pricing transactions. This is an area where software can offer huge benefits, using a pricing tool to simplify pricing decisions and ensure the sales team executes transactions at that price.

Except tactics aren’t strategy. Starting with software runs the risk of automating weak ideas, which is an expensive way to drive a marginal improvement in your results. Our B2B pricing strategy consulting practice starts with a higher level view of the business – to ensure we’re focusing on the right ideas – and uses software and automation as a tool to drive execution.

With that in mind, let’s look at the strengths and weaknesses of several common pricing methods. Some of these are more effective than you might think.

Cost Plus Pricing And When To Use It

We’ll kick off our review of B2B pricing strategy examples with the perennial favorite, cost plus pricing and its cousin, customer profitability. Most distributors use some version of the former and there’s an active consulting trade in setting up customer profitability models for companies.

Mathematically the two views of the world are closer than you might think. Cost plus pricing sets a target margin over your acquisition or production costs. Customer profitability layers some additional perspective on cost-to-serve and reduces the view to a profit margin number. Both represent an internally driven views of price, often reduced to a simple yes/no decision about whether to pursue a particular piece of business at that margin rate.

Cost plus pricing works reasonably well in markets where most of the competitors are selling similar products produced using a similar cost structure. Especially if the details of specific quote can vary substantially by job. For example, consider pricing the services of a HVAC installation company. Most of your competitors are using similar technicians selling the same basic offering. You’re not exposed to radical differences in customer value or cost structure.

This can actually work against you if there is tremendous diversity in competitor offerings and production capabilities. For example, what if Company A has a highly efficient machine and Company B has an older model that runs at a higher cost? If both companies used cost plus pricing, Company A would likely leave money on the table: they should earn higher margins than Company B, since they have a cost advantage and no competitive pressure to discount. Given that these differences can be incredibly subtle (affecting some items and not others, based on your manufacturing strategy), this lack of alignment with the market can be costly.

Value Based Pricing

So if we shouldn’t price our services based on cost, the logical next step is to look at what our services are worth to a customer. Once you understand the type of value you create, you can set a percentage of value you wish to claim.

This has a very positive side effect: it gets your sales team and marketing strategies focused on creating and communicating customer value, which helps build a competitive moat around your top accounts. While this is a challenge to manage at scale, it works very well for products or services where you can rally management attention to ensure the process is executed.

Value based pricing is most effective when you’re delivering highly customized work for a client or setting premium prices for an innovating new product. The real challenge here is competitive pressure: once another market player understand the value you create for a specific type of client, they will attempt to undercut you to gain market share.

As Jeff Bezos said, your margin is their opportunity…

Competitive Pricing Strategy

A competitive pricing strategy seeks to set product prices based on your value relative to a competitor. For example, if you believe your product is worth of a 15% premium, you would assess where competitors prices are at in the market and add 15%.

While it can be challenging to collect competitive price data, this approach is easier to scale than value priced pricing. Relative value can be determined from customer interviews and preference testing, along with some judicious analysis of historical data.

The process of measuring relative customer value also provides an opportunity to focus your strategic investments. You’re aiming to understand what premium or discount is needed to achieve competitive parity, where the customer is indifferent. This is an area you can adjust over time through R&D investments and adjusting your product features. If the customer is willing to pay for new features, that points you down an R&D path. On the other hand, if the customer is solely focused on price, that’s a signal to focus on lowering production costs and streamlining your product features.

Management of industry price increases falls into this camp. While this is ostensibly a cost based pricing approach (raise cost, raise price), you should be using competitive insights to tweak your price increases. Industry increases are rarely monolithic and this provides a great opportunity to clean up past pricing mistakes and pad your margins on less sensitive products. Software is useful in helping manage this, along with coaching your sales managers.

Optimizing Cost vs. Value For the Pricing Function

There’s a broader theme here: identify the aspects of your price setting process which truly matter for your industry and focus your attention and automation efforts on those key points.

Most software solutions are ultimately focused around guiding and controlling pricing decisions in a couple of key areas. No software package exists that addresses everything I’ve shared in this article: the scope is to broad and there is too much variation in the details by industry (and even company). You’ve got to start with a higher level view of how to structure customer pricing conversations across the organization before you explore automation and analytics.

What pieces of the process matter most for your business? Leave a comment below…

Want to take a deeper dive into pricing? Check out some of our other work…

Common Topics

There’s also our guide to pricing terminology. If you’re looking for help trying to improve pricing for your business, we’re available as a pricing consultant.