Vincent Ryan is a senior editor at CFO.
The Many Minuses of Cost-Plus
Many companies employ cost-plus pricing, simply adding a desired margin to the cost of a product. But cost-plus has little to do with market reality, says Reed Holden of Holden Advisors. Because costs are often averaged across product categories, more-profitable products and services can appear less profitable than they really are. "If a competitor is highly specialized and understands the true costs better, it can attack you in your most profitable areas," Holden says. "And you will be led to believe it isn't wise to respond when it is."
Cost-plus is useful for one thing: setting a price floor, a minimally acceptable return on investment. The ceiling, of course, is the perceived value of the product. Measuring the perceived value is hard to do; it's a specialized form of market research. A key part of that research involves "value mapping," which tells a company what the customers' perceptions of its product's value are versus its competitors' products.
Some companies have lost sales volume and salespeople when switching from cost-plus pricing to a value-based approach, but gross margins often improve dramatically. One company eased its switch by developing a proprietary tool that demonstrated how the use of its products can lower a customer's total costs, which helped persuade customers that the company's not-quite-so-low prices were still a good deal. — V.R.
The Price Is Wrong
Any one of these five signs could mean it's time to change your pricing strategy, says Reed Holden of Holden Advisors.
1. Unit-sales growth slows down. When sales volume stalls, it may mean that the market is saturated, competitors are swiping your customers, or your pricing is out of line with your product's perceived value. If the market has moved beyond a high-growth phase, it may be time to switch from aggressive penetration pricing to a more stable and profitable stance.
2. Discounts fail to drive incremental volume. If discounting doesn't drive more sales or increase total profits, why do it? During the recession, many companies overused discounts to keep customers. Continuing to discount during the recovery just because customers expect it is a recipe for disaster.
3. Competitors introduce new offerings. A new player's offering may change the value equation in the market. "If the competition has leapfrogged you on value and continues to price low, you may not be able to maintain your current strategy," says Holden. A niche product may be called for, or marketing may need to work on stressing other product differentiators.
4. Lower-cost competitors enter the market. If a market is in high-growth mode, the first company to adopt penetration pricing could gain economies of scale and have an ongoing competitive advantage, Holden says. Will your resources and cost structure allow you to compete in a price war? If not, lower-value "flanking" products may be needed to protect more-differentiated offerings.
5. Competitors start missing their numbers. This circumstance could indicate changes in the market related to customer preferences and buying habits. Or, your competitor may have developed a weak spot that you can exploit. — V.R.
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