1. Customers tend to focus on hourly rates, rather than total project cost, let alone value for money.
2. It’s easy to offer deep discounts to get people off the bench and back to billing.
3. Customers are nervous because the whole reason they need a service is because they don’t know how to do something themselves and they may not even know how to evaluate providers.

When business owners get back on their heels, they find clients eager to challenge them on hourly rates.  They end up working long hours at lower rates, or sometimes for free.  What’s worse than not getting enough work and not making enough money?  Working too much and not making enough money.  This ends up destroying a lot of small businesses, because the love for the work that caused the owner to start their venture in the first place dries up.  As the downturn hit and clients cut back, Smiley’s owner found herself working more for less money and she had to reduce her staff.  She felt she provided good value, but was losing business to competitors with lower rates.  In addition, while her nominal rate was pretty good, she ended up discounting it during the proposal phase, which reduced revenue by about 15-20%, but reduced profit by almost 50%.

So we put together a battle plan.

We started with #3.  Smiley’s founder sensed hesitation in the buying process, and often countered with discounts.  However, this hesitation is because the buyer has to make a leap of faith that the provider can deliver.  Lowering the price does not lower the perceived risk– it may even increase it.  Companies may not come out and say “I’m not sure you can deliver and I’m worried about my career if you don’t.”  They may even say that price is the problem, or mumble something about you being more expensive.  So first, we decided there would be no discussion of discounting initiated by Smiley.  If the customer asked for a price break, there would be a discussion of value (issue #1).  If the customer still wanted to discuss price, Smiley would discuss lower priced options (see below for more discussion of issue #2).  If the customer still complained about price, Smiley would ask “What price do you want?  And if I gave you that price, would you sign today?”  Note that you don’t actually have to give them the price they want.  You just want to know if price is masquerading for something else.  Maybe they don’t really have budget.  Maybe they are trying to “lock in” a good price for the future.  Maybe they want to use your quote against another vendor.  Find out, but don’t commit to any discounts until you know if that’s really the problem.  If they want a price break, ask for something in return.  The best thing is to reduce the scope of the project.  If this is not practical, ask for payment upfront, early payment, a video testimonial, or something else that shows both parties are collaboratively creating and sharing value.

Now that we knew we were not going to just start throwing money at risk, we had to address customers’ concerns with hourly rates.  There are a few projects that were standardized enough that Smiley could do them on a fixed fee basis.  Smiley raised the price of these.  Some work still had to be done hourly, however, and Smiley’s owner had trouble quoting her rates confidently.  She sounded almost apologetic asking for money.  If you want to be a premium provider, you have to give a premium experience, and that includes quoting your rates and prices very confidently.  If you walk into an Apple store or a Lexus showroom, you won’t find salespeople apologizing for the price.  They simply quote it.  And if you say “but I can get a PC for half the price”, they can talk to you about why their offering is better.  You can agree, and buy it, or disagree, and go elsewhere, but they aren’t going to sell you the Mac at the PC price, or the Lexus at the Honda price.  When you are confident about your pricing, that shows that you’ve been around the block a bit and increases the customer’s confidence in you.  So the whole idea on issue #1 was the simply quote the price.  (She practiced in front of a mirror.)  If customers mention cheaper competitors, never apologize for your price.  Explain that of course they are cheaper, because of x, y, and z (in this case, because Smiley used industry veterans and competitors used recent college grads).  Note that the customer still has a choice.  They may decide that cheaper is better for them.

Before you let them go, though, let’s get to issue #2.  Rather than simply discounting, especially when benchwarmers are burning a hole in your cash reserves, think about some ways to transform the project to make everyone happy.  Maybe the company really wants to go with you, but simply doesn’t have the budget.  You can break the project into smaller chunks and do them sequentially.  Or perhaps parts of the project are mission critical and others are on the checklist but not really as important.  Smiley’s battle plan for price objections therefore included ways to change the scope of the project without undermining pricing integrity.  In addition, Smiley developed ways for customers to save money on non-urgent projects.  Smiley developed a retainer plan and offered discounts for work with more distant deadlines.  This way customers could save money by planning ahead, and Smiley benefited by doing work in time slots between more pressing projects.

How did it go?  Smiley’s owner has not discounted outside or her defined plan, or lost a deal.  Her passion is back, and she added “actually having a pricing plan paid for my new patio.”

Have a pricing battle plan ready, so that in the heat of the moment, you can simply execute your plan.  Small business owners who have done this report less stress, faster deal closing, and higher margins.  Why?  Let’s look at two examples, one today and one next week.

First, a software company selling to other business was trying to figure out how to respond to quote requests based on number of users and other parameters.  Each time they got a request, they tried to figure out what they needed to do to win the business.  Since price was the most obvious lever they had, they spent a lot of time and energy debating the right pricing and discounting.  This led to an over-emphasis on discounting, and an under-emphasis on other aspects of the solution, which were often much more important to the customer.  In many cases, they offered discounts preemptively and unnecessarily.

Then they put together a plan.  The software would cost $X per seat, with volume discounts available at certain quantities.  They defined additional discounts if customers would commit to certain contract lengths, or if they would pay up front.  This tied discounts to exchanges of value, rather than just giving away money.  All quotes would come from this plan.  (See software to automate this pricing process.) Sounds great until customers push back against the price, right?  The CEO new this would be a problem, so the plan defined what would happen at this point.  First, rather than just discounting, the sales team would try to understand if price was really an issue, or just fishing for discounts.  (Many of us have trained our customers to do that.)  Then they would explain the value to the customer.  If there were still price objections, and the company still wanted the business, they had a predefined threshold for additional discounting.

What happened?  Most companies just took the quoted price.  A minority pushed back, and most of them were happy with the additional value conversation, and/or taking advantage of the predefined discounts.  Only a handful went to discretionary discounting.

By having a plan and having confidence in it, sales increased, stress decreased, and margins went up over 20%.

What’s your pricing battle plan?

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?

First of all, Netflix is a data-driven company.  They have lots of data and they are constantly trying to use it more effectively.  They sponsored a $1M contest to see if independent teams could improve on Netflix’s algorithms to suggest movies you might like based on what you have already seen.  They know how much money they make on what kinds of subscriptions.  (They even got in trouble a few years ago for “throttling” or slowing down the shipment of “unlimited” DVDs to people who watched a lot.)  So they knew, before they changed prices, what kinds of changes in demand and volume and price would be profitable for them.

Speaking of profit, the goal for Netflix is making money, not shipping DVDs or streaming videos.  Since they pounded Blockbuster, they have emerged as the leading source for movies and TV show reruns.  And you can make a good case that they have been underpricing for some time.  Streaming is the future, so Netflix is not interested in subsidizing the DVD business for $2/month on top of the streaming fee.  If you want DVD’s, you need to pay $8/month at a minimum.  This will allow them to actually make money on the DVD side of the business.  Some people will probably quit and rent from kiosks like RedBox instead, but these are customers at the margins.  Netflix probably has good data to estimate what portion of their subscribers are likely to leave for kiosk services.

What about other alternatives?  Does anyone really want to drive to Blockbuster anymore?  Amazon Prime members get free streaming videos, although their selection is probably even worse than Netflix’s on-demand line up.  Cable companies and Apple offer on demand rentals, usually with a much better selection of new releases, but these videos cost about $5 a pop, on top of your cable subscription, so it’s not exactly a cheap option.

In other words, the value from Netflix for cost and convenience is pretty hard to beat, even at the higher prices.

Netflix has a couple of weak spots, though, related to content.  When they started, they were small, and useful threat for the studios against the dominance of Blockbuster.  (Blockbuster got greedy, which is why we have new release movies for sales for less than $20, but that’s another story.)  Netflix also managed to acquire streaming rights from Starz, which were cheap at the time.  When that agreement expires, Netflix expects to fork over much more money to the studios.  They also need to expand the on demand library, which might enable them to get out of the DVD business altogether.  The amount of content available and the price Netflix will have to pay for it are still up in the air, but Netflix is getting ready for a larger showdown with the studios.

Unless you’re a Netflix customer, none of this may matter to you. But what lessons can you apply to your business?

First, do you know how profitable your customers are?  Most businesses make over 100% of their profits from about 20% of their customers.  They break even on 70% or so, and actually lose money on some customers.  Your pricing plan should encourage those money losing customers to either make you money or take their business elsewhere.

Can you model the impact of price, cost and volume changes?  If you know your customer profitability looking backwards, that’s helpful.  But what you really want to do is figure out what it will look like in the future, based on certain assumptions, like changes in price, volume, and costs.  Businesses have an almost inherent fear of “losing customers”, even though losing customers can increase profits, especially if price increases are involved.  Unless you have a model to help you understand the bottom line impact of price, volume, and cost changes, it’s hard to make good decisions, and you’re likely to underprice out of fear.

How dependent are you on key suppliers?  Netflix is a distributor.  They deal with much larger studios (and cable providers, whose pipes are necessary to bring online content).  The studios are afraid of Netflix turning into an online Blockbuster, which could then control the industry.  They are well connected politically, and despite being strategic idiots, they have good lawyers who know how to extract the most value from a given transaction.  If you are beholden to key suppliers, your cost structure and pricing structure are also beholden to those suppliers.

By the way, I don’t think we’ve helped anyone push through a 60% price increase this year, but we’ve a couple of companies increase prices more than 30%, with minimal impact on sales and a huge impact on profit.

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.)

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.

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.