The 3 Rules for Applying Costs to Pricing

A couple weeks ago I taught a pricing class to about 40 professional marketing people.  We started out discussing Value Based Pricing and how it’s more profitable than cost plus pricing.  We then went on to discuss when costs matter and how to use them in pricing, which is almost never. Great discussion followed and it was obvious they intellectually understood the concepts.

A couple hours later one of the students applied a version of cost-plus pricing to their portfolio.  I had to remind him that costs don’t really matter.  Then another student did it.  Then another student.  I started feigning dejection each time someone mentioned costs, and of course they laughed.  By the end of two days of this, the students were finally internalizing the concept.  Whenever they said the word “cost”, they would say it thoughfully, timidly, verifying they were using it correctly.

That’s when I realized, cost plus pricing is deeply ingrained in us.  As shoppers we expect companies to use cost plus pricing. It feels fair.  It feels secure.  As business people, it is very hard to disavow cost plus.  So, let’s try again.

There are 3 rules that govern how costs should effect pricing (if you’re using value based pricing). Read them and go ahead and disagree. Then think hard about them. Just like the students, you need to get them out of your system.

The 3 rules

1. Fixed costs NEVER apply to pricing. Use projected fixed costs to determine whether or not to enter that business, not to set prices. Past fixed costs are sunk costs and are mostly irrelevant.

2. Variable costs do NOT apply to setting prices in negotiated markets.  (Negotiated markets are like automobiles, where each customer negotiates their best price.)  Instead, use your variable costs to help determine your floor.  What’s the lowest you are willing to accept if you have to go down that low.

3. Variable costs DO matter when setting TIOLI prices.  (TIOLI or Take It Or Leave It pricing is where you set one price and many customers decide whether or not to purchase, like in a grocery.)  In most cases as you raise price you win less business.  You need to estimate your demand and profitability at both price points.  Since your profitability depends on your variable costs, then obviously these costs matter.

These are not complicated, but they do seem hard to internalize.  Send your objections or questions to me.  I’ll do my best to address them.  If you want to be as profitable as possible, heed the following management advice:  Disagree, then commit.

 

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by Herederos de Rowan