Customer - Based Pricing

Many managers use the cost-plus method of pricing. This method is attractive for its deceptive simplicity: to obtain the price, managers simply calculate their costs and mark up these costs by a certain percentage. The resulting figure is the price.
The use of the cost-plus model is extremely widespread and I have witnessed its use in everything from everyday consumer products to complex software packages. Often the managers who utilize this model do not even make a conscious decision to do so, but rather achieve the same result intuitively, by setting the price according to the profit they would like to make on the product or service.
Despite its attractive simplicity, the cost-plus model can lead your company down a very dangerous path. Using this model, your company may lose sales revenue, lose market share, or even price itself out of the market. Consider this: do your customers really care about your costs or do they care about the value you bring them? This article describes the dangers of cost-plus pricing and offers a simple, workable alternative. This alternative, the Economic Value to the Customer (EVC) model, can you help you avoid these pitfalls, and also help you to strategically grow your business by allowing you to understand what it is that your customers really care about.

THE SIMPLICITY TRAP
Simplicity is the biggest advantage offered by the cost-plus pricing model. The model also offers the often irresistible mirage of guaranteed profits. However, the model’s biggest drawback is that it completely ignores demand for the product as a factor in the pricing process. For example, a company that decides on a certain markup for its products may find itself underpricing products for which there is high demand (thus leaving money on the table), and overpricing products for which demand is weak (thus losing sales and market share).
Additionally, the cost-plus model assumes that per-unit costs are known prior to pricing. Actually, it is a widely known fact that costs change with the number of units produced or sold, and the number of units sold is highly dependant on the price. Thus cost-plus pricing suffers from a circular-logic problem.
Nevertheless, cost-plus pricing is not always wrong. In fact, companies vying for government contracts are often required to use cost-plus pricing (for example, some Iraq reconstruction contracts). Cost-plus pricing may also be appropriate in cases where large numbers of individual product prices need to be constantly updated (for example, in a supermarket). However, these exceptions only emphasize the rule: Cost-plus pricing is very often a bad idea.

ECONOMIC VALUE TO THE CUSTOMER: A WORKABLE ALTERNATIVE
Now that I have, hopefully, convinced you that cost-plus pricing has serious drawbacks, it is time to present the alternative: Economic Value to the Customer or EVC. This method of pricing is customer-centric, i.e., the price is based on the value generated for the customer rather than on the costs incurred by the supplier
Here’s how to implement this pricing strategy:

• Identify all the features that differentiate your product from competing products.

• Quantify how these differences impact the economic value the customer generates from your product.
• After quantifying the surplus (or shortfall) in value the customer gets from your product compared with available alternatives, price your product in a way that will create an economic incentive for the customer to adopt your product over those offered by the competition.

The following simple example illustrates the application of the EVC method:
Company A is in the process of introducing a new machine, identical in all but size and reliability to other machines available from the company’s competitors. The new machine is bigger than competing machines, but is more reliable. After conducting some market research, the company comes to the conclusion that the added size of the machine will cost the average customer about $200 over the life of the unit (in transportation and storage space costs, for example), while the added reliability will translate into savings of approximately $600 (in reduced maintenance and down time). This means that, everything else being equal, the unit will produce an EVC of $400 over competing products. Of course, the company should not charge a premium of $400 over the competition, since this would eliminate any benefit to the customer.

In fact, the company must leave a lot of the surplus created to the customer, so that the customer is motivated to choose this product over the available alternatives. For example, if the company chooses a price which is $200 higher than that of the competition, customers will still consider the new product a great value. You must remember, however, that customers often do not look beyond the sticker price, and your marketing efforts must effectively educate your customers as the true nature of the value created by the product.
In many cases, calculating the EVC can be much more complicated. In the real world, not all product features are identical, and similar product features generate different economic value for different customers. There are statistical tools and methods designed to cope with such problems, however, in most cases, employing the logic and process of the EVC method even without these sophisticated tools will generate results that are far superior to those achieved through the cost-plus method of pricing.