AccPM Newsletter – March 2010
Pricing is the moment of truth – all of marketing comes to focus in the pricing decision.
– Raymond Corey, Harvard Business School
Have I ever told you just how much I love pricing? In the world of product management, there are so many talented people that I always felt both jealous and just a little overwhelmed. I mean there are product managers who have an amazing depth of product knowledge, there are product mangers who know their markets inside and out, and of course there are those product managers who know how to get anything that they want done within their company done and done quickly. How the heck was I ever going to measure up to these gods of the field? It took quite sometime; however, I’m pleased to say that I found my niche – pricing.
I discovered pricing somewhat by accident while working for a large European telecommunications equipment provider. Once upon a time, when I had a brief moment to stick my head above the waters of daily product management activities, I realized that none of my peers wanted to touch anything to do with pricing. All pricing related activity was shoved off onto the finance department from which magical prices would reemerge. In a nutshell, nobody had any clue as to why we priced our products where we did. I didn’t take any action on this little nugget of information at the time; however, I started keeping my eyes open.
My next surprise came as I started to get some more insight into how the sales teams were selling the product. The first thing that seemed to go out the door was the list price. After that, it seemed to be a race to see how low we could drop the price in order to get the sale. I was seeing discounts as large as 50-60% on relatively new products. Without knowing any better, I assumed that whatever magic price the folks in finance had set was able to withstand this kind of massive discounting. It turns out that I was wrong.
Collectively as Product Managers, we spend our time on capturing a larger share of the market all the while increasing customer satisfaction. We’ve been taught that if we can do these things, then somehow big profits will somehow magically follow. Unfortunately, there never seems to be enough profit magic to go around in the world these days…
Most firms didn’t worry all that much about pricing in the past. As long as you knew how much a product cost to make, then you could tack a generous profit margin on top of that and you were set. However, this all changed in the 1980’s. This is when the long established market leaders started to get their clocks cleaned by new startups that didn’t seem to care about market share. Instead, these new competitors specifically targeted the larger firms most profitable customers (known in the biz as “cream skimming“). This was followed by a wave of companies being taken private, having their product prices raised even as market share dropped and yet still starting to rake in huge profits.
Just as a final confirmation of the importance of pricing and making a profit, need I remind you of the dot.com era? All those new companies went on a footrace to try to build the largest market share, profits be dammed. Ooops, when it all ended the quickest runners went bankrupt while the few that had actually still focused on profits were the last men standing.
I finally had a chance to sit down and talk with some of my friends in the finance department over lunch and I asked about the the magical process that they went through to set prices. You can imaging my surprise when I found out that all they were doing was taking the cost of the product, adding the current “company overhead” margin, and then adding a 35% profit margin on top of that with the expectation that it would be discounted no more than 10%. Ouch – talk about simplistic pricing! My friends pointed out to me that the company was more concerned about growing revenue than profits at this time and so that was why I was seeing some fantastic discounts being approved.
Needless to say, this was sorta like discovering that Santa wasn’t coming this year. The secret pricing knowledge that I thought that Finance had really wasn’t there – the emperor had no clothes! I spent much time after this focusing on learning as much about pricing as I could and that information has served me well over the years. As product managers, the more that you know about how your product’s price is determined, the better off you’ll be!
Come on, admit it. You like cost plus pricing. It’s a product manger’s best friend. We all know how this story goes, you find yourself in charge of a new product and you spend all of your time working on nailing down what features it is going to have and when it will become available. Then there is that fateful day when someone asks you “What’s it going to cost?”
The simple answer is that you have no idea. If you’ve got competition, then you can probably use their price as a starting point. However, if you don’t have clear competition, then you’re sorta stuck. This is when your old friend Mr. Cost Plus pricing always seems to show up.
Just in case some readers don’t quite know what cost plus pricing is, perhaps I should take a moment and define it for everyone. Cost plus pricing for a product is when you attempt to calculate all of the costs that went into creating it. You then add the appropriate level of margin on top of this cost and vola – you have your product’s price.
We all love cost plus pricing so much because it has this aura of being a “financial way of creating pricing”. I mean, if we are able to account for all costs and then priced our product above that level then we are just about guaranteed that we will be profitable.
The problem with this is that all too often, we are wrong. The reason that we’re wrong is because as the volume of products being created goes up, the costs of manufacturing goes down. If you are managing a service the same thing can be said – the more subscribers you have, the lower your cost per subscriber is.
Since your unit cost is changing with volume, your price will determine how much you sell. This will then impact volume which then impacts unit cost. Whew, it’s all connected!
A great example of how not to use cost plus pricing was provided several years ago by the good engineers over at Wang Laboratories. They invented the first commercial electronic word processor in 1976. Their product was a big hit. They used cost plus pricing to come up with a price for this revolutionary product.
The problem that they ran into was that in the early 1980’s personal computers become hot and they too offered word processing capabilities. As PC based word processing became more popular, Wang sales slowed.
This meant that their cost plus pricing required that they raise the price of their product even as their competition was reducing the cost of their products. Their pricing eventually drove away all of their customers.
So what’s wrong with cost plus pricing? Simple – cost plus pricing will cause you to over-price your product when there is a weak market and will cause you to under-price your product when there is a strong market.
So what’s the lesson to learn here? Hopefully, you now understand that cost plus pricing is a really bad idea. Instead, as a product manger what you need to do in order to ensure profitable pricing is to spend some time and decided on what your anticipated prices are going to be. Then, use this information to manage your costs. This type of value-based pricing needs to start BEFORE you make the investments required to breath life into your product.
