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« Cost Plus » dies hard ! Why ?

In this short article and a next one coming soon, we try to provide a quick overview of the major evolutions of the pricing discipline (that is, the art and science of setting and managing prices) in the last 40 years, with the purpose of suggesting or highlighting some key lessons for B2B companies.

Pricing: from Cost to Value

The focus on pricing is perceived as relatively new in the management field. But it has already come a long way since the “cost plus” method, which now seems so outdated to specialists and managers, although still used in many companies.

Until the end of the last century (the 1990s), one could mention three levels of sophistication:

  • Cost-plus pricing
  • Competitive pricing (taking into account competitor’s prices)
  • Value-based pricing

Pricing has evolved taking into account a growing number of factors, leading to an increasingly flexible and segmented approach: costs, competition, value to the customer and finally the context of each transaction.

The “cost plus” method allocates margin levels to each product category in order to cover the cost and generate a surplus, which may at first glance appear as a safe practice to managers. Its main drawback however is to overlook the company’s environment, which leads to ignore sales opportunities (too high price) and to neglect the full potential of remuneration by the market (price too low).

It is therefore a flawed instrument for anyone wanting to drive and maximize the profitability of a company.

Competitive pricing consists of setting prices in line with those of competitors in order to be reasonably close to the “market price”.

This more realistic method suffers from several weaknesses:

  • There is no evidence that competitors are more expert in setting prices,
  • Information, in B2B, is generally fragmented and often misleading. As a result, a lot of companies think their offers are among the most expensive on the market
  • The very notion of “market price” is debatable and shortsighted, as it tends to eliminate disparities in situation and to conceal the flexibility of customers on prices.

In a nutshell, competitive pricing is more effective in driving sales than in increasing profitability.

A more consistent approach, “value-based pricing“, was introduced in the 1980s and 1990s, finally bringing the client into the pricing scope through the value it gets from the company’s products and services. The price is defined as a fraction of the value created for the customer, more precisely the perceived value.

With value comes “differentiation” (bringing a value distinct from that of competitors) and “segmentation” (providing differentiated responses to client categories that have different expectations or product usage).

It is worth noticing that many companies put words like “customer-centric” and “value through differentiation” in their strategic statement.

However, the pricing approach used internally in these same companies is often a mix of cost plus and a more or less formalized competitive pricing.

Why is that?

Without pretending to be exhaustive, we believe that two factors deserve special attention:

1.) The notion of value is not so easily measured.

Companies strive to understand clients’ needs and expectations but devote little attention to value, that is, to the economic measurement of the benefits that the customer derives from the use of the company’s products and services.

In B2B companies especially, time and resources, skills and methods often lack.

As a consequence, people know how to develop offers that meet the expectations of different customer segments, but find it difficult to figure out the pricing power of these offers.

We met a company that had heavily invested on a revolutionary process delivering products with superior features compared to current alternatives.  When launching the new range, the choice was made to sell it at the same price as the previous products. Since the company did not try, at any stage of the product development, to quantify the additional value provided to the customer, marketing was not able to justify a price premium over what was perceived as the “market price”.

2.) The transformational challenge is stronger than C-suite thinks it is.

Even the top executives who are most aware of the potential impact of price on the company’s profits rarely devote as much attention, resources and efforts to pricing as they do for managing other less impacting variables, such as cost.

Pricing is seen as a purely tactical lever, properly controlled by the sales people (that’s why they are paid, right?).

However, managing price in a value-based approach is a transformational challenge: it has a strong transversal dimension (R & D, marketing, production or operations, finance, HR, marketing and sales, etc.) and covers subjects such as governance bodies, internal processes starting with the early design phase, skills, resources and practices or methods, information systems and sales enablement tools.

Conclusion

Companies have made significant progress in their ability to develop customized and value added offerings.  They do not perform as well in the art and science of measuring the “pricing power” of these offers and then capturing a fair fraction of it.

On the contrary, they often remain faithful to outdated pricing approaches that fall short of maximizing profitability.

Leaders are accountable for launching and supporting the pricing initiative. No one else will and the situation is not likely to improve on its own.

Is it worth recalling here that a 1% price increase has a 5 to 10 times more efficient contributory effect on EBITDA than an equivalent increase in volume or decrease in costs?

 

An article from our partner Powering France

Author: Philippe Plunian, Partner at Powering, www.powering.com

 

 

 

 

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