I quite often get asked about early-stage pricing strategies. The question often is: how should I price what I sell?
My response typically comes down to two things:
These two things may sound simple, but the execution requires a lot of work and the temptation to fall back to “cost-plus” is strong.
This logic applies to physical products, virtual products (software) and people-based services. It also applies regardless of whether you are selling B2B or B2C.
To kick off this three-part series, we look at cost-plus pricing.
Starting with what your cost is and adding an amount as your profit or margin is known as “cost-plus” pricing. If this has been your approach so far, take comfort in the fact that it is the most common one used by companies of all sizes. So, right or wrong, you are in good company.
Cost-plus is not ideal because you are almost certainly either leaving money on the table by not charging enough, or aren’t selling as much or as easily as you could because your price is too high. Remember those supply-demand curves you learned about? Turns out they are relevant!
The cost-plus approach is commonly applied to physical products, because it makes sense to ensure the item’s price is higher than the amount you are spending to make it. The challenge with this is that you have no idea if your customers will buy what you are selling at this price. Maybe you have built in too many features. Or you used expensive materials that seemed awesome in the design phase of your dream product, but when you go to sell it, you find out that your customers don’t see the same value in them that you do.
Another challenge with using this approach for physical products is the cost of the “channel.” By the time you add in the margin required for a distributor and a reseller, and maybe even a retailer, you’ll quickly find your product has to sell for twice what it costs you to make it. And that is before you add in commission for your sales team or any profit for yourself. (We’ll explore channel pricing more later on in this series.)
Scale is another difficulty with using cost-plus for physical products. When you are starting out, you are not selling in high volume, so you aren’t buying in high volume. The good news is that you are selling to early adopters, and they may not be as price sensitive. The bad news is that you risk wasting valuable time, and your price is ultimately originating with a third-party supplier and an uncertain margin expectation.
When it comes to virtual products, the issue with using a cost-plus approach is that your variable cost is probably close to zero—your expense is the long period of time it has taken to design and develop the software.
A potential exception to the cost-plus approach is services, because they have some relatively well-defined market rates. By definition, your cost is market-based and will not change based on volume. In this regard—but not in any other way, so don’t beat me up for this—people are a commodity. The salary you are paying employees comes from a negotiation, and margins are fairly common and consistent. For example, in the technology space, where services are complementary to other products (such as software installation or customization services), a margin of 15% to 30% is common. Temporary staffing agencies typically make a 50% margin. The real challenge in pricing services lies in understanding your utilization: if you are not achieving high utilization, then your prices will be too high, and if you lower your pricing, then you will lose money.