Pricing: Why You’re Doing It Wrong

Mar 15

From knowyourmeme.com

I don’t know you. How can I know you’re pricing all wrong? Obviously, I don’t, and there’s a chance you’re actually doing it right, but experience with hundreds of business owners lets me play the odds. So in this post, we’ll look at the most common ways small business owners hold back their own businesses by pricing badly.

Before we go into that, a quick primer on why this is so important.

Let’s take a simple example first. Many businesses start out as sole proprietorships where the owner trades his or her time for money. (If your business is different, bear with me for a moment.) If you can bill 70% of the time (we’ll assume 2,000 hours is full time– 50 weeks at 40 hours per week) at $75/hour, you make 2,000 x 0.7 x 75 = $105,000. Now suppose you can bill at $100/hr. If you keep the same 70% utilization rate, you make $140,000. Of course, you might lose some business (many small business owners are pleasantly surprised that their volume increases as they raise their prices, but that’s another story), but you could go all the way down to 53% utilization and still make the same money you made before. Plus, you now have an extra 350 hours of time in your year, to grow your business in other ways, spend time with your family, enjoy your hobbies, etc.

Let’s say you grow your business (you priced at $100/hr and used the extra time and money to do a lot of business development), and you now have 5 subcontractors. You still bill clients for their time, but you also have to pay them. To keep the math simple, let’s say that each person costs you $60 per hour, plus you have $20,000 in fixed expenses for office space and other overhead. You keep them busy and billing 80% of the time and as junior people, they bill at $75. Now each employee brings in $120,000 in revenue and $20,000 in profit ($24,000 – $4,000 for their share of overhead). Now let’s say you increase their billing rate to $100/per hour. If you can keep their utilization at 80%, they now bring in $160,000 in revenue and $60,000 in profit. In other words, when you increased the rate by 33%, you increased your profit by 200%! Let’s say their utilization falls to 60%, they still bring in $120,000 in revenue, but your profit has gone up to $44,000! In fact, your utilization would have to fall all the way to 30% (600 hours per year) for you to make the same $20,000 profit per person. This is powerful stuff.

(When I did consulting full time and had a team, I never wanted to be above 50% utilization. I wanted to charge a good rate, work for people who valued what we did, and not do the weekly grind that chews through the lives and souls of so many people in this line of work.)

Now imagine that you want to increase utilization, and you offer a price discount to $70/hr. How much more work do you have to get to make the same profit? You need to get to 120% utilization, which is a recipe for burnt out people.

The exact amount that price and volume changes impact your profit depends on your fixed and variable costs. High fixed costs *and* low variable costs generally push prices down, to cover fixed costs and drive volume. High variable costs must push high prices. But even within those guidelines, there’s a lot of flexibility.

Now let’s look at how you’re (probably) doing it wrong.

You’re pricing based on costs

The “easiest” way to set a price when you have no idea where to start is to look at your costs and mark up. There are 2 problems with this.

  1. It can be really hard to accurately allocate your costs, include all variable costs, etc. You can go nuts just trying to think about it. Why do that when:
  2. Customers don’t care about your costs. They only care about the value they get. If you achieve some supply chain efficiencies and reduce costs by 10%, do your prices go down 10%? Perhaps, but they shouldn’t automatically. You should lower your prices if that will drive a volume change that will increase your profits.

You should have a basic idea of your fixed and variable costs. You can then sanity check your pricing to make sure you will actually make money. But don’t start with your costs. If you price based on your costs, you make the minimum you can viably make and stay in business. This would be like Apple charging $299 instead of $499 for an iPad.

Many software startups try to calculate server and support costs and derive a price from there. They are developing something innovative and valuable, but pricing it like a commodity. This will lead to problems down the road.

You have no idea what your value is

It’s hard to price based on value, if you have no idea what your value is. This is where a lot of people go wrong. They come up with something that they want to sell, or something that they can make, or something that they can build, and then try to figure out how to price it. This is when they usually revert to cost-plus. The interesting question is not what can you sell it for, but what do customers buy it for? Customers need or want to do something. Depending on the customer, the way that gets expressed is very different. For example, if you need a car for transportation, your best bet, economically, is to buy a reliable used car. Yet many people buy new cars. And new cars run anywhere from a little over $10,000 to well over $100,000. Different buyers place different value on the different things.

To get an idea of your value, think about what your customers would do if they didn’t buy from you. Would they “do nothing” (keep doing what they do today)? Buy from a direct competitor? Buy from a larger company? Buy from an indirect competitor (competition for the local sports bar includes not just other sports bars, but people’s own homes, and even the internet). In some cases, the alternatives are dire. If you just developed a cancer drug that cures otherwise incurable cancer, your offering’s value is very high. If you sell something that’s directly substitutable, you have no pricing power– you are at the mercy of the market.

“Value” is really perceived differential value. This means that value is in the mind of the buyer. You can influence this perception, but ultimately the buyer decides. It’s also differential– compared to one or more alternatives. One problem many well run small firms have is competing against “cheaper” alternatives that aren’t cheaper. For example, a boutique firm charges $200/hr and can complete a project for $50,000. A larger firm with less qualified staff charges $100/hr, but it will take more people, more time, and the total bill will be at least $60,000. Without help in perceiving the value, many buyers choose the “cheaper” $100/hr option.

Notice further that your value is probably not related to the exact number of hours you work. So don’t price by the hour. All you do is invite complaints that you’re overpriced and join in a race to the bottom.

If you have a virtual good, try to scale the price the same way the value scales, at least in general terms. For salesforce.com, they assume that value scales by the size of the enterprise and the needs for different features, and the number of users. The type of features required dictates the edition, which then determines the per user cost. It’s not a perfect match for value, but it’s reasonable.

You are trying to be cheaper, not better or different

Many small business owners don’t know how to compete against larger, more established players, so they think they have to be cheaper to attract business. Unfortunately, most of the value buyers don’t want “cheap” they want “value”, and the lower price actually undercuts the value message. One enterprise software company could not get traction in the market until they increased their price 50X. Buyers just didn’t think they were credible because their prices were too low.

There can be only one (cue Highlander) low cost provider in any market. In most cases, unless you have some defensible, sustainable cost advantage (think Southwest airlines), this will not be you. So don’t get in a price war with bigger competitors. All you do is transfer money to your customers’ pockets, and greatly reduce your income (see the introduction for some examples). You have the advantage that you don’t need a huge slice of the market, so you can focus on a niche that perceives a lot of value in what you do. For example, Wal-mart can’t provide great service, but it can provide cheap bikes. If local bike shops tried to compete with Wal-mart on price, they would lose. So they sell more sophisticated bikes, with great service, catering to a different part of the bike market. Almost any market can be segmented so you can deliver great value to a small niche, at higher prices and higher margins than the broader market. A corollary is that you can also segment the market to provide “enough” value at low prices to be very profitable if you have the right cost structure. This is how Microsoft came to dominate desktop computing.

When you pursue your market segment, you will find prospects in nearby segments who don’t value what you do the same way you do. That’s OK. The sooner you can identify that they are not really in your market segment, the more time you can save. As a small business owner, every minute that you waste is a minute not spent growing your business, enjoying your family (did anyone start a small business hoping to spend less quality time with their family?), or sleeping.

When I did a lot of corporate consulting, the message was that we could do detailed, quantitative analysis (including measurable results) beyond what your time could do, at a fraction of the time and monetary investment of someone like McKinsey. This made it easy for prospects to understand if we were a good fit. If someone had $10M to hire McKinsey, they were going to hire McKinsey. If someone thought they could handle it in-house, they wouldn’t talk to us. But if they needed some analysis, ideas, and implementation for between $25,000 and $250,000, it would make sense to have a conversation. The value we would deliver would typically be several million dollars of profit improvement, discounted for the perception of risk. We used proprietary tools to let us do things you couldn’t do in Excel, and we didn’t bill by the hour. We wanted to align with customer value as closely as possible.

Now that I do proposal software, the message is “killer proposals made easy.” This automatically excludes the majority of the small business market that doesn’t have any need for proposals. And for people who already think proposals are easy, well, they obviously don’t need us. Only businesses that spend too much time putting together proposals and trying to close them are going to care. Is it “cheaper” to use Word and email? Sure, at least in the short term, but for some part of the market, the investment is worthwhile.

Another example is Draft by 37signals. This is a simple iPad sketching app. It costs $9.99, which is considerably more than other apps which have a lot more features. Why does 37signals charge $9.99? It’s for people who want only simple sketching, and want to share their sketches via email, or another 37signals app, called Campfire. If this is all you want to do, this app will do it better than an app with all kinds of extra complexity and features. Furthermore, 37signals doesn’t want everyone looking for a sketching app to buy this. They know there are cheaper alternatives. They are targeting the portion of the market that wants to work within Campfire. This way they make good money on the customers who value their product, and deliberately keep out those who don’t care, thus keeping down time and expense supporting customers outside of their core market.

You don’t believe in your own value

After I have a conversation with a small business owner about value, they often say, “OK, but I can’t charge that, that’s twice what I charge now.” Why not? Because fundamentally, they don’t think they are worth it. They are embarrassed about their current prices, let alone the potential future prices. If you don’t believe in your value, you can’t expect your customers to believe in it, either. Don’t kid yourself and inflate your value, but if you have the numbers to back it up, be proud of it. When you talk about pricing, never sound apologetic. Make price part of the value. If you walk into a Ferrari dealer, they will tell you all about the car, including the price. They don’t go into an embarrassed whisper. (So I’m told.)

You fear price objections

A related problem is fearing price objections. When someone tells you that you are too expensive, it’s a great chance to explain why you are different, better, and an overall better value. It’s also the only way you can know if you’re charging enough. If you never get price objections, you have a big problem. When you explain your pricing, without apology or reference to your costs, your customer can either agree and buy (great outcome) or push back. They may not perceive some aspects of the value you profess. They may not even be in your target market. Or, they may simply not have the budget. We’ll discuss this scenario more in “you have no plan for negotiation”.

You surprise your prospects with your price

Prospects should not be shocked when they see the price. (“Sure, the Ferrari sounds great– can you send me a proposal? … “What, this is way out of my budget, I only had $20,000.”) Even if you don’t know the exact price when you start discussions with a client, you can give a range, or a “starting from…” For example, I recently had someone inquire about a pricing workshop. I gave a brief outline of some options in an email, and noted that prices depend on the solution, but start at $5,000. That was more than he wanted to spend, so we all saved a lot of time. If instead, we had been embarrassed to talk about price, I might have wasted my time and his finding out more, creating a proposal, etc, only to find that it was never a fit. Even if there is a potential match, don’t surprise your prospects. If you can’t quote a price on your website or in your initial discussion, start discussing prices as soon as you have collaboratively developed a potential solution. Some people say this puts you in a bad negotiating position. I say it saves everyone time and helps you become a real partner to the customer. You can start upfront with some ranges (“in past projects like this, we have charged between about $40,000 and $100,000. I know that’s too big a range to be useful, but we can adjust who does what and how much we get done in this phase to suit your needs”). After more detailed discussions, you can offer a preliminary proposal with a menu of options. This way the customer pays for what is valuable to them, and you don’t waste your time on things that aren’t valuable. Whatever you do, the price should not be a shock on the proposal.

You have no plan for negotiation

Now even if everything has gone relatively smoothly, you will often get drawn into negotiations. This is often a symptom that you didn’t understand what the buyer(s) really needed and how they make their decision. In some cases, you need to help buyers understand their own problem, because they may not have the expertise to diagnose it properly and formulate the right solution on their own. In any case, customers will push back on pricing, even after hearing your value message. The important thing here is to have a plan and execute it. Many people forget to prepare for this step, and then, in the heat of the moment, end up discounting the heck out of their business. (“I just closed a deal that I really didn’t want” is a lament I have heard far too often.) This is such an important topic that I devoted 2 posts to it, one devoted specifically to services. The short version is: be prepared to trade value– don’t just give away value. For example, a customer might get a discount in exchange for paying early, pushing the delivery date back, doing a case study for your web site, committing to a certain volume, accepting a reduced service level, or some other mutually beneficial exchange. Be willing and able to take something away if the customer doesn’t value it. The plan should never be “just discount up to X%.”

You think you need one price

Following on from the previous point, if you have different discounts for different scenarios, you have, in effect, different prices, even if you only sell one offering at one price. No matter what “optimal” price point you pick for your offering, you will leave money on the table with some customers, and price others out of the market. You can use good/better/best offerings to subsegment your market. This is what car makers do with different trim lines, what Apple does with different iPad models, and, more subtly, what restaurants do with early bird specials and movies do with matinee and senior pricing. Software is particular amenable to this kind of thinking, as it’s easy to create different editions with different value to slightly different audiences. Salesforce.com is a great example. Their core offering ranges from $2/user/month all the way to $250/user/month.

You’re too busy

“I can’t keep enough inventory. Everything sells out as soon as it’s available.”

“I’m so stressed out about all the projects we need to deliver. I’m not sure how we’re going to get them done.”

These are the good problems to have– far better than the reverse. Yet they can still make life miserable for the small business owner, her employees, and family.

I like to say “you don’t have a supply problem, you have a pricing problem.” Many of the folks making these complaints haven’t raised prices in years. They are not even keeping up with inflation, let alone increases in the perceived differential value of their offering. Being “too busy” is a symptom that you are not managing demand well. Going back to the introduction, what would you rather do: work half the year on the best projects, or delivering to the best customers, who really care about what you do, or working all year, getting really stressed out, losing out on family time, and making the same money. The market sets the maximum price you can charge (as limited by your perceived differential value), but it’s up to you to charge it. Going back to planning for negotiation and needing more than one price, you can use pricing to help move demand to off-peak times. My accountant charges the same rate whether it’s April 14th or the middle of July. (Don’t tell him I said that.) I’ve seen print shop owners who don’t want to charge rush fees because they don’t want to penalize great customers. Then they complain that they are always doing rush jobs.

Thinking that you have to get it all right the first time

No matter how strategically and cleverly you think about pricing, no matter how well you think you know your market, things change and you will need to revise your pricing from time to time. This can be simple tweaks, like a small price increase in January (good to do small, regular price increases so customers are used to them and you never end up having to do a huge price increase to stay in business), to changing discount programs, to completely changing the way you price.

Communicate as openly and honestly as you can with your customers (goes back to not shocking them). If you provide something valuable, your customers will understand that you need to change the way you price it sometimes. Chargify had to do this twice. First, they caught a lot of flack because customers felt let blindsided (they also did away with their Free plan– no one gets as upset as those paying nothing suddenly learning that they have to pay for what they used to enjoy for free). The second time they announced a price increase, they outlined their reasons 2 months in advance, asked for customer input, and got a much more supportive response. I don’t think they were trying to “trick” anyone with a low price that they would have to raise, they just had to make a course correction. Many companies, including software companies, change the price they charge new customers, while keeping old customers on their familiar payment plans. This keeps your customers from getting upset and is helpful if it’s viable technically and economically.

You’re doing it right

If you’ve made it this far and you’re thinking, “none of this applies to me,” then you are doing a great job and I might want to hire you. All these things are much easier said than done. Even as a “pricing expert”, I have been guilty of all of these things at one (or more) time or another.

Take a look back through this list and see where you can apply some tips to improve your pricing, your business, and your life. Small improvement can mean amazing changes. As one of my customers said to me a few months after a price increase, “thank you for my new patio.”



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2 Comments

  1. Michael Katz
    Mar 21

    Terrific post. Very helpful, thank you. I particularly like your point about fearing price objections and the importance of getting push back as a sign that you’re at an appropriate level.