The twin tyrannies of pricing

Posted on 26 May 2020 by The Manufacturer

The fundamental objective in pricing for all companies is to sell their products at prices that most accurately reflect the value delivered to the customer. However, we know from experience that few companies have mastered this science.

Those that manage it command significantly healthier and more sustainable margins than those companies that struggle with pricing. Xi Bing Ang says the challenges that arise are actually related to the nature of a company’s marginal product cost.

There are essentially two worlds. In the first are companies that sell products that have marginal costs – all manufacturers fall into this category, which we will call the cost-plus world. Every unit of the product, be it a machine, a spare part or a unit of consumables, has a cost to manufacture and ship.

There is then a second world where a company’s product has zero marginal cost. Offerings such as software and data are examples of what we will call the costless world, where generally speaking the contribution margin from selling an additional unit is the price itself.

The tyranny of cost-plus

In a cost-plus world company, product cost is very visceral. For many manufacturers, the entire organisation is orientated around measures such as standard costs and gross margins. Due to this, they often succumb to the trap of pricing their products based on defining a target margin and marking up from unit cost to a price.

Unsurprisingly, this pricing philosophy will always be sub-optimal profit-wise as it fails to adequately reflect the value to customers. The main challenge is therefore how to break this cost-plus mindset and shift towards more value-based pricing.

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The tyranny of costless

In the costless world, when selling products such as software, the fact that there is zero marginal cost means that there is a temptation to close a deal at any price because every pound is considered ‘pure profit’.

This is why software companies often struggle to maintain price integrity across their customer base: it’s not uncommon to open up a book of business in costless world companies and see customer discounts ranging from 5% to 95%!

With the macrotrends driven by Industry 4.0, these two worlds will continue to collide and manufacturers will therefore need to be able to enact robust pricing strategies in both models. While these two worlds have their respective pricing shortcomings, the good news is there are lessons they each can learn from the other.

Lessons cost-plus can learn from costless

1. Talk about applications, not product groups

Software companies call them ‘use cases’; manufacturers tend to call them ‘applications’. In reality, they are one and the same: what the customer is using your product to do.

We find that, on balance, cost-plus sales reps unfortunately tend to orientate sales conversations more on their product groups and technical specifications, rather than on benefits and applications. The latter, and not the former, is what drives customer value and price.

2. Use portfolio price psychology

Costless businesses don’t have the constraints of a physical product in terms of packages they can offer, and therefore tend to utilise and experiment with portfolio line-ups to influence customer choice by using, for example, Good-Better-Best software feature configurations, or super-premium ‘decoy’ offers to make lower tiers look more affordable.

In addition to building great products, cost-plus companies should also spend more time crafting a portfolio positioning strategy that drives the right customer price-value trade-offs.

3. Track usage (and analyse it)

Software companies do this as a matter of course, whereas it’s still considered ‘advanced’ for manufacturers to gather customer usage metrics.

With the increased affordability of technologies such as sensors, telemetry and the broader Internet of Things, it will continue to become more palatable (and necessary) for cost-plus companies to improve their customer insight to drive not just product development, but also to unlock innovative monetisation strategies such as predictive services and outcome-based (e.g. X-as-a-service) pricing models.

Lessons costless can learn from cost-plus

1. Embed a discounting backstop

In the heat of a customer negotiation, we find it is common for costless sales reps to concede large discounts, due to the mentality that “every pound is still incremental profit”. In a typical manufacturer, however, there is a natural backstop to this discounting behaviour called cost/margin.

If you’re a manufacturer about to move into selling costless products like software, it will be key to ensure you have strong internal discounting controls to mitigate this slippery discounting slope.

2. Don’t ‘pad’ the customer

We often see software or data companies that have a practice of ‘padding’ a customer’s purchase with additional features/modules in the hopes of ‘sweetening’ a deal (without reflecting this in price) or making the customer stickier.

With costless offerings, this is very easily done, but the risk is that over time, a customer discovers that these padded elements are not of value to them, and end up demanding further discounts, or worse, feel that they have been disingenuously sold something they didn’t actually need!

This is less likely to happen in the cost-plus world as every SKU typically has to be accounted for.

3. Communicate new product timelines clearly

Costless companies like software providers on balance tend to have more dynamic and shorter product release cycles compared to cost-plus companies like manufacturers.

This is a double-edged sword as they often run into problems such as insufficient or unclear communications on the nature and timing of product launches and version upgrades, causing customer confusion and occasionally, frustrated sales reps that are unable to accurately account for timelines when they try to sell solutions to customers where features are not fully built out yet.

As business models evolve, manufacturers experience commoditisation of physical goods, and the need for new revenue streams in non-physical goods increases, it is crucial that they heed these lessons to ensure their pricing strategies reap the profit rewards they seek across the entirety of their offerings portfolio.

Xi Bing Ang is a Senior Director with Simon- Kucher & Partners Xi Bing Ang is a Senior Director with Simon- Kucher & Partners specialising in pricing strategies for industrial companies as well as software and data services providers.

Simon-Kucher & Partners is a global consulting firm specialising in TopLine Power®, which encompasses strategy, marketing, pricing, and sales.

Founded in 1985, the company now has 1,400 professionals in 39 offices worldwide. Simon-Kucher & Partners is regarded as the world’s leading pricing advisor and thought leader.