At this point, you’ve done the hard work.  Hard work meaning that it’s hard to go back and change it.  So you’re stuck pricing what you created.  The typical train of thought goes like this:

Product > Cost > Price > Customer

Now when you get to the customer, you don’t know if you’re delivering the right value, making it harder for sales and marketing to find prospects and close sales.

Imagine instead if you had started with a customer problem.  You could then figure out how customers tried to solve that problem today and how much better, if any, your solution would be.  How much would it be worth to the customer?  Given that value, can you product the product or deliver the service profitably?  What might you have to change?  At this point, it’s easy to change, because you haven’t done the hard work yet.  This train of thought looks like this:

Customer > Value > Price > Cost > Product

How do you think about price and value?

If you’re better, be better, NOT cheaper.

If you believe your offering is worth more than the competition, but you don’t know how to ask for it, if you’re somehow embarrassed about the price, here’s an exercise you can do as a buyer:  Go test drive your favorite car– preferably something expensive and Italian, but as long as it’s (really) expensive, it doesn’t matter.  This sounds like fun, so far, right?  Then tell the sales man that you love the car but you just can’t see paying $X, since it pretty much does what the Kia across the street does for $20K.  Ask if they’ll match the Kia price.  If you don’t want to drive any cars, pick a different category.

The point is that no one is going to sell you a brand new Ferrari for $20K.  They might laugh, but they will be able to tell you why the Ferrari is different from the Kia, and why, if the Ferrari is really right for you, it’s a good deal.  And way, if it’s not right for you, you should just head on down to the Kia dealer.

If you can’t do this from the seller’s side when someone challenges you on price when you offer more value, you are destroying your business.  Don’t fret, lots of businesses do this and recover.  So have your story ready.  Bonus points for having a lower-priced, lower-value offer ready for price sensitive customers.  (They key is to make sure you have a good fence between the different levels of value and different price points.)

I mentioned that Apple does not price based on their cost (the 3G iPad includes about $5 worth of extra parts and costs $130 more than the Wifi-only model) and that in the hypothetical scenario, Apple would lower their price if and when they felt the market alternatives made that necessary.  In other words, the magic fairy was irrelevant.  (It’s also worth nothing that Apple doesn’t build the things anyway, they have offshore labor build it for them.)

This seemed to resonate.  But I wanted to ask some more questions.

“Are customers raising issues with the price?”

“No.”

“Are prices slowing down or reducing sales?”

“No.”

“OK, we’ll talk about price increases in a moment.”

Seriously, folks– never limit yourself on pricing.  If the market thinks your prices are too high, they will tell you.  If they do, that’s a good thing, it shows that you’re at least in the right ball park.  If you never get a price complaint, you aren’t doing it right.

1. Write down your costs.  Of course, you won’t know your real costs, so just use estimates, preferably from 2-5 years ago.  These costs won’t include much nuance about fixed overhead, variable costs, service costs, customer acquisition, or anything else that will really help you understand your profitability, but that’s OK.
2. Build in a margin, based on your detailed cost estimates from step 1.
3. If sales reps discount below this margin, require that they get approval for the deal.
4. After spending a lot of time on email/phone/calls/meetings, and maybe even some analytics, approve 100% of the deals that require approval.

Whatever you do, do not attempt to understand the value of your offering in the market compared to customers’ alternatives.  How can you go wrong with cost-based pricing, especially with your detailed and accurate cost model?

April Fool’s, or they way most companies price?

You want to ask questions until you no longer get meaningfully different answers. At this point, you know what you need to know.

For example, suppose you want to understand the value of selling a data backup service to a CIO. You ask the CIO why he cares about this. He responds that “obviously, we need to be able to continue our business in the case of data loss in our main data center.” This makes sense, but doesn’t tell you how valuable it is to continue their business.

So you ask “how much money do you lose if you can’t continue your business?” The CIO does not want to share that information, fearing you will use it to increase the price of your backup service. He assures you that he has done a cost estimate. You know from a back of the envelope calculation that they are a $1B business, so they do $3-5M in revenue per weekday. If they are out of commission because of a datacenter failure, they won’t lose all of that revenue, because some orders will be deferred, but they will likely lose over $1M per day, plus the cost of overtime and other opportunity costs from dealing with the aftermath. Since this is a risk-based value, you need to know the CIO’s estimate of risk.

“How do you calculate the risk of an outage or disruption?” you ask.

“We don’t have good metrics on that, but I know I don’t want to lose my job, or have my people and my customers have to deal with it.” At this point, you’ve established a pretty good value case, right? So you present the quote, confident that you and the CIO have established a shared view of value and have a great solution. A week later, you haven’t heard back and wonder what went wrong. You call the CIO and leave a voicemail. He emails you back saying that your solution looks good but they don’t have the time or budget right now. He promises to call you back when it’s a priority.

What went wrong? The CIO had other, more pressing challenges. If you had asked, “how does data backup compare with your other priorities?”, you might have heard, “it’s important, but we’re not doing anything until we migrate to the new version of our order management system.” In a different situation, you might have heard, “The CEO has made 24x7x365 business operations my number 1 strategic priority for the upcoming year and she sent me a clip from an online news article about a company that had suffered an outage for 2 days with the comment ‘this better not happen here.’”

Now you have two very different views of perceived value in these two situations (never mind the differential part, for now), although it appeared they both had the same value at the first level. If the CIO said something like “oh, sounds expensive”, you might even note “Price Objection” as your reason for losing the deal in the Customer Relationship Management (CRM) system. Product managers might see “we’re losing 60% of our deals because of price objections” and decide to lower prices.

This is just sales 101, though, right? What does this have to do with pricing?
Nothing, and everything.

First, you may be tempted to lower the price to sweeten the deal in the first case. However, you still won’t get the deal, because price isn’t the issue. At least not yet. However, if you have already offered a concession, when the CIO does call back to talk about your solution, he will start with the discounted price and negotiate further from there.

What can you do with price?
If price is not an issue, then lowering the price does not help. However, there are times when price is not a serious issue, but it can help. For example, if you know you have professional services personnel who are not currently billing, you may offer a discount on implementation services for a limited time. Even better than the savings for the buyer may be the ability to achieve some other goal with the extra money. Even better, if you are about to raise prices, you offer a compelling reason to sign now.

To give you an example, a company I worked for in the past was having trouble closing a deal. They warned the customer that prices were tripling next year. The buyer thought they were bluffing. It turned out to be an expensive gamble. Not everyone has the ability to negotiate with the threat of a 300% price increase, but if you have strong value, you can encourage prompt buying.

However, every time the TSA ups the ante of ridiculous reactions to the last terrorist threat (or lobbying dollars from the well-connected), the perceived differential value of *all* airline travel decreases. Do I want a nice dose of radiation and a somewhat nude picture of myself sent to a server somewhere (TSA was caught lying about the ability of machines to store images. Of course they can store images!)? Or perhaps I’d like to be sexually assaulted (there’s really no other word for it) by a frustrated TSA official? Or perhaps I’d rather just do a video conference. Or drive, if the distance is short enough. Or just change my plans.

As someone who flies a fair bit (and whose loved ones fly, too), I have a pretty big interest in air travel being as safe as reasonably possible. However, I accept that 100% security is impossible. (Especially once I pull out of the airport and onto the freeways.) We’re not even making a “trade off” of time, dignity, and constitutional rights against safety. There’s no value on the other end. For all the billions spent, how many terrorists has the TSA caught? 0. Passengers have caught a few. Law enforcement has caught some. Again, TSA: 0.

Back to the airlines’ executive offices. The CEOs of these companies should be doing the talk show circuit, talking about how this is an intrusion of big government into business, etc, etc. Considering how much airtime these types of issues sometimes get, you’d think it would be fertile ground. And perhaps they would have more sway than the folks who actually travel. But they don’t, because they are afraid, too. Not of actual terrorism, but of taking any responsibility. One of the primary jobs of a CEO is to maximize the profitability of the business, which is tied to perceived differential value. In this case, the differentiation is not from immediate competitors, but from other substitutes– other modes of travel, or communication, or just staying home. If your market starts destroying your value prop from the “outside”, you need to do something about it.

Lo handed out 1,000 red velvet cupcakes in one day at 8 locations– Red Velvet Events’ headquarters and the offices of existing clients. This celebration, backed by Twitter and Facebook campaigns, highlights RVE’s creative style. It also shows existing customers that they’re special, and probably led to more worth-of-mouth advertising than a traditional business development campaign. Plus, Lo garnered press coverage in the Austin Business Journal (and all over Twitter). Perhaps best of all, being different is fun. “We go all-out for our clients on projects– this was a great way for us to go all-out to show appreciation for them and do something fun at the same time,” said Lo.

What can you do that’s different, that’s better, rather than just following the traditional path? What will you have to offer, other than price, when the customer is making a buying decision?

If you’re truly in a commodity market, you are in fact at the mercy of the market.  Either focus on your cost, or differentiate to decommoditize.

Few businesses are in true commodity markets.  And for a lot of these businesses, especially at the SMB level, the first barrier to improved pricing is the one the business owner can control most directly: themselves.  Many business owners look at their costs, tack on a “fair” profit, and call it a day.  Or they look at the competition and price a bit below them.  Even when costs go up, they often have trouble raising prices.

Your pricing is ultimately limited by the perceived differential value of your offering.  I’ll go into more detail on the value side in a later post, but for now let’s think about the amount of value you can capture.  You work really hard to create value for your customers.  You work proactively to make them successful.  Don’t sit back passively when it comes to capturing your share of that value.  Pricing is the monetization of value, and you should be just as proactive about that as value creation.

So don’t be the limiting factor on your pricing.  If you think you should be achieving higher prices but you haven’t asked because it makes you uncomfortable, you need to fix that.  If you are used to giving big discounts when you get nervous in sales cycles even though the value is there for the customer, you need to fix that.

Here are some exercises to help you think about this:

• The Series of Increasingly Outlandish Prices.  From Steve Blank, author of 4 Steps to the Epiphany.  When the customer asks for the price, keep getting more and more outlandish until the customers pushes back.  For example:  “It’s $1M dollars.  Per month.  Plus $2M for setup.  Plus 20% maintenance.”  The point is to help discover the price for a new offering, but it’s also useful to force you to think beyond “I think it should be about $99.”
• Double Your Price.  Someone bursts into your office and holds a gun to your head.  They tell you that you have to double your prices in a month.  (Maybe it’s your accountant.)  What would you have to change about the way you sell, your products, your services, your customers, to achieve this?  While you may not be able to actually double your prices, you can make dramatic improvements.  We used this method to double consulting prices, although it took us 2 years, not a month, to actually do it.
• Visit a Porsche Dealer.  Test drive the fastest convertible on the lot.  When it comes to negotiating the price, keep insisting that you are deciding between this car and a Hyundai Sonata that seats 5.  Keep asking the sales manager to come back with a better price.  After they get done laughing and throwing you out, compare the reaction of the car salesreps to your reaction when customers try to chisel you down on price.
• Say It to the Mirror.  It may sound silly, but if you have trouble asking for the price you think you should get, practice saying it to the mirror.  Not just the price, but why this is a great deal for the customer.  Make sure there is no hint of apology in your voice or your body language.

There’s no shortage of stats in sports, just as there’s no shortage of KPIs in business.  While these numbers are interesting and sometimes even useful, they often provide little insight into true performance, and may even distort performance in a way that reduces overall effectiveness.  For example, some baseball statisticians think On Base Percentage is more important than batting average, but everyone focuses on batting average.  In business, there is a huge focus on revenue at the expense of profit.

The reason for this mismatch is not that teams hate winning or business don’t want to be profitable– it’s just that it’s easier to measure some things than others.  It’s easy to measure revenue or points scored.  It’s harder to measure profit, because cost is such a tricky subject.  And no one records whether those points came off a double screen or were set up by a teammate’s cut that drew away defenders.  (Still, we have it easy.  A friend in Africa fighting AIDS described how one of the big challenges was even measuring the scope of the crisis so they would know how to allocate resources and whether those resources were effective.)

Now some researchers at Queen Mary University in London have done some graph-theory analysis of World Cup matches, developing a way to visualize the balance of a team’s attack, and the “centrality” of each player.  Check out the graph for Holland v Spain.  I’d love to see them go a step further, and put a goal at the end of the pitch, and weight each edge of the graph by the chance of successful completion.  For example, a number of short passes may have a 90% completion rate, while a long ball might have a 50% chance of success, but may be more likely to lead to a goal.

Similarly, in the corporate world, a lot of effort gets expended on deals that make $0 profit (or even negative profit).  If you know where your profit comes from and know how to price those deals appropriately, you can have a huge return not just on investment, but on effort.