Why Product Mangers Need To Know That Cost Plus Pricing Is Wrong, Wrong, Wrong!

by drjim on January 9, 2009

Cost Plus Pricing For Products Is Easy To Do, But It's The Wrong Thing To Do

Cost Plus Pricing For Products Is Easy To Do, But It’s The Wrong Thing To Do

Come on, admit it. You like cost plus pricing. It’s a product manger’s best friend. We all know how this story goes, you find yourself in charge of a new product and you spend all of your time working on nailing down what features it is going to have and when it will become available. Then there is that fateful day when someone asks you “What’s it going to cost?”

The simple answer is that you have no idea. If you’ve got competition, then you can probably use their price as a starting  point. However, if you don’t have clear competition, then you’re sorta stuck. This is when your old friend Mr. Cost Plus pricing always seems to show up.

Just in case some readers don’t quite know what cost plus pricing is, perhaps I should take a moment and define it for everyone. Cost plus pricing for a product is when you attempt to calculate all of the costs that went into creating it. You then add the appropriate level of margin on top of this cost and vola – you have your product’s price.

We all love cost plus pricing so much because it has this aura of being a “financial way of creating pricing”. I mean, if we are able to account for all costs and then priced our product above that level then we are just about guaranteed that we will be profitable.

The problem with this is that all too often, we are wrong. The reason that we’re wrong is because as the volume of products being created goes up, the costs of manufacturing goes down. If you are managing a service the same thing can be said – the more subscribers you have, the lower your cost per subscriber is.

Since your unit cost is changing with volume, your price will determine how much you sell. This will then impact volume which then impacts unit cost. Whew, it’s all connected!

A great example of how not to use cost plus pricing was provided several years ago by the good engineers over at Wang Laboratories. They invented the first commercial electronic word processor in 1976. Their product was a big hit. They used cost plus pricing to come up with a price for this revolutionary product.

The problem that they ran into was that in the early 1980’s personal computers become hot and they too offered word processing capabilities. As PC based word processing became more popular, Wang sales slowed.

This meant that their cost plus pricing required that they raise the price of their product even as their competition was reducing the cost of their products. Their pricing eventually drove away all of their customers.

So what’s wrong with cost plus pricing? Simple – cost plus pricing will cause you to over-price your product when there is a weak market and will cause you to under-price your product when there is a strong market.

So what’s the lesson to learn here? Hopefully, you now understand that cost plus pricing is a really bad idea. Instead, as a product manger what you need to do in order to ensure profitable pricing is to spend some time and decided on what your anticipated prices are going to be. Then, use this information to manage your costs. This type of value-based pricing needs to start BEFORE you make the investments required to breath life into your product.

How do you do pricing for your product today? Are you happy with your prices? Do they seem to be appropriate for the current market conditions? Have you ever tried a technique that is different from cost plus to set prices? Leave me a comment and let me know what you are thinking.

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{ 17 comments… read them below or add one }

Robin Zaragoza January 9, 2009 at 10:22 am

Totally agree with your point that cost plus pricing isn’t the way to go. A good follow up to this post would be viable methods of pricing. I’m actually doing a bit of research on this right now and hit up my tweeps & LinkedIn for thoughts. I got a fair amount of positive feedback for conjoint analysis to test price sensitivity. And then for setting pricing, a few folks mentioned using an excel macros to calculate price elasticity of demand.

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Dr. Jim Anderson January 11, 2009 at 1:20 pm

Robin: those are all good suggestions; however, if you are not careful you can end up wasting a lot of time and still not have the correct pricing program that you need. At the end of the day what you want to do is to price your product to reflect the value that your customer will be getting from it. This is easy to say and hard to do. How much will I save, how much will I earn by using your product are the two questions that really need answers. Once you have these answers, everything else will fall into place for you. Good luck!

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Adam Bullied January 9, 2009 at 12:34 pm

Cost-plus isn’t wrong in certain scenarios. I agree that value-based pricing is probably the way to go when dealing with hardware / tangible products; especially when shipping those in a well-established market.

But having only worked in small software start-ups, I have to say that cost-plus is the way to do it in the short-term. Quite simply, it allows you to get dollars in the door, clear a margin, and start selling.

Often, software start-ups are sitting in non-established markets or hard to define markets. This leaves a lot of complexity and unknowns for PMs trying to size that market, identify competitors and even find prospects at the outset – all of which are key ingredients to value-based pricing.

Of course, PMs should always have their eye on switching to value-based in the mid- and long-term because cost-plus doesn’t deliver the same, well, value for customers in the end.

But it can serve as a great short-term baseline to mobilize an early sales force / product and start generating cash flow appropriately to the business.

I wrote a post about this a while ago and there was some great discussion in the comments – http://writethatdown.com/archives/2008/11/first-time-pricing.

Well done, Jim – good post!

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Dr. Jim Anderson January 11, 2009 at 1:30 pm

Adam: oh, you just knew that I was going to have to reply to your comment! Hey listen, I’ve been there, done that on the startup scene and I fully understand what you are saying. Generally the company is so focused on creating the product and getting the financing needed to keep the lights on that product pricing is the last thing on everyone’s mind (I mean come on, it’s a great product that everyone will want, right?) DON’T DO COST-PLUS PRICING! Yes, I know the temptation is great, but you could be leaving a lot of money on the table. Do it right from the start – understand what problem(s) your product solves for your customers and pricing it accordingly. Hey, that’s why we all make those slick ROI calculators, right? I say this because once you start with cost-plus pricing, it’s going to be very hard (for you and for your customers) to go back and correct things.

Remember: the flaw with cost-plus pricing is that how you calculate it is a moving target. I took a look at your post (nice post by the way). It was an interesting mix of math and “gut feel”. I think that the comments were moving in the right direction – pricing is not a “fire and forget” type of thing. You really need to create a pricing strategy for a product and then refine it as the market give you feedback. I’m sure that this isn’t the final word on this topic!

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Lou January 9, 2009 at 4:14 pm

Great post. My former employer was a manufacturer of physical products so it was easy to discover costs and they used cost plus pricing (set by sales, which in itself is a problem). The problem that they ran into was getting traction at launch due to low volume and high costs. For products that had been in market for a few years and were driving considerable volume, the price was too low–we were driving a considerable amount of volume, but leaving a lot of money on the table for our distributors to take.

So, I am aware of the pitfalls of cost plus pricing, but now find myself in a world of software where it is difficult to quantify costs. I can determine a market price by comparing to competitive offerings, but the challenge now is to determine effort to develop features and be profitable. Especially when you are using existing staff that gets paid regardless if they are developing my feature. Can you comment?

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Dr. Jim Anderson January 11, 2009 at 1:47 pm

Lou: great comment – it sure sounds like you’ve been around the block a few times! In the end, you need to be aware of costs but you don’t have let them play too much of a role in pricing. As you have seen, it can really screw up your pricing! Instead what you want to do with your software products is to determine what the customer’s value for them is. What problem are you solving and how much money is this going to save / create for your customer? One simple way to create a price is to look at the ROI for your customer and decide if you want the payback to be 1, 3, or even 5 years. Then set your products price accordingly.

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Jeff January 9, 2009 at 9:59 pm

At the end of the post, it is suggested that we anticipate our costs before we start development of a product. I’m not clear on why this strategy is better than cost plus pricing (or I misunderstood you).

If I under valuated our expected price, I would tend to plan less funds for development thus cutting out features/options that might help sales once the product is finished and ready to ship. Any thoughts?

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Dr. Jim Anderson January 11, 2009 at 1:39 pm

Jeff: good question. Let me see if I can make this clearer by using an analogy. Say you were told to create a new car that could be sold to first time car buyers. Even before you started a design, you could guess-estimate how much the car needed to sell for: about $20,000 after all fees were accounted for. What this means is that you are going to have to create a design that costs less than $20,000 or we won’t be able to make a profit on this product. That means you are going to have to throw out the fancy all-wood dashboard, the satellite radio, the 20 speaker sound system, etc.

This isn’t the best example, but hopefully you get the point – you need to make sure that your costs don’t exceed your price. Hmm, almost seems like setting a price for you product should be done before the development starts doesn’t it….?

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Saeed Khan January 10, 2009 at 12:04 pm

Perhaps because I’ve always focused on software — and very few software companies actually track costs in detail! — I’ve never even considered cost-plus pricing.

This is not to say that software pricing always makes sense or is given it’s due diligence, but cost-plus pricing is rare in my experience.

Have you encountered this in software very much?

Saeed

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Dr. Jim Anderson January 11, 2009 at 1:43 pm

Saeed: yes I have. One reason that I think that I’ve seen it in the world of software products so much is that nobody ever seems to take the time to come up with a better way of pricing products. Generally gross generalizations are made on costs (because, as you said, nobody really knows what was spent).

You’ve got my interest now: what pricing schemes have you been seeing / using for software products?

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Steven Hainews January 15, 2009 at 3:47 pm

In terms of product pricing, it’s a conundrum. As Dr. Jim says, you want to understand the value to the customer. To do this, you have to know who the customer really is, and what they value. This introduces a couple of important thoughts. One – know the “who.” Who’s the customer target and what does this customer type value? For example, if you’re dealing with procurement people, they only know one thing and will beat you bloody if you don’t fall in line with their expectations on price. If however, you appeal the needs of the user or decision maker, you’ve got a better chance. This brings us to the second key point: The value proposition. The value prop. is the way to figure this out. In a B2B world, if the product helps the customer in productivity, cost management, or revenue, and you can demonstrate this with basic arithmetic, you have a fighting chance. If your value prop. matches the customers’ – you’re on third base. If however, you’re in a competitive situation, get out your calculator. Remember, cost is always part of the equation. Just don’t go to cost plus on your first pass.

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Dr. Jim Anderson January 16, 2009 at 10:00 am

Steven: I couldn’t have said it better myself! You danced around one important point – the folks in purchasing don’t care about value, they only see price. However, if you’ve been able to sell the higher levels on value, then often they’ll tell purchasing to “just buy it” and then you are home free…!

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Adam Bullied January 16, 2009 at 11:25 pm

Yes, I agree – there is definitely a gut-check factor I have used while doing cost-plus. It’s not entirely based on the hard numbers.

Also, allow me to clarify the scenario in which I’ve done this – a B2C product moving in to a B2B space by white-labeling the technology. Hell, we don’t even know yet who are customers will end-up being on either side other than in broad strokes…

I know, I know – I should probably be banned from Product Management for admitting it. But all witch hunts aside, do you run with an idea and see how things pan out, fail, refine, rinse, later, repeat – or just give up because you can’t define market segments?

Same goes with value props, vision statements, and all that stuff. It’s all necessary and important – but it all takes time to develop; especially at the very outside of the idea existing itself. You can jump on this stuff soon or let it develop – in either case, it will need to change rapidly as you go.

But we can’t forget how difficult it is to enter a new market where there are very few competitors to baseline (that you know about anyway), and your value prop is rough or isn’t yet written down.

Of course, provided you aren’t negatively impacting your product with silly and random features – I can tell you with 100% certainty I don’t want to be the PM that goes in front of the board of directors and says, “you know, we didn’t do that $50k deal because I just didn’t feel like we knew the value were were delivering to the client and therefore had no confidence in our price. Cost-plus pricing is wrong.”

I want to be the PM that tells the Board and the VCs, “we did the deal and we are continuing to evaluate our pricing strategy as we develop the product, identify the value prop and our market opportunities, and analyze competitors in the space. We are looking at X, Y, and Z. But yes, we have $50 in the bank with very limited development work to be done, and it will actually pay for us to fix 10 critical bugs.”

Again, you take a risk, probably fail, dust yourself off, rinse, later, and repeat. If folks in the organization (from the CEO down) aren’t willing to do that for every aspect at the outset (product, features, pricing strategies, overall strategies) then you are more than likely doomed from the get-go.

But maybe I’m just really, really crazy 🙂

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Dr. Jim Anderson January 17, 2009 at 9:34 pm

Adam: ouch! You’ve got yourself in a tough spot. By the way, you’re not crazy – your the CEO of your product with all of the glory and bumps & bruises that comes along with that position!

I’ve got a post coming up that will be published on January 30th that might help you out a bit here – it’s on how to price a new product that nobody has seen before. This sounds a little like the spot that you find yourself in.

Sneak Peek: The trick turns out to be that you have to TELL your customer what they need to compare your product to. Make sure that it’s something expensive and not something cheap so that your pricing will hold up.

Give it a read on the 30th and let me know if it helps out…

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Roger L. Cauvin January 18, 2009 at 12:37 pm

Jim, I think you hit the nail on the head when you wrote in one of your comments that pricing should be done (or at least a first pass at it) before development of the product. There needs to be some convergence of cost-based and value-based pricing to ensure that the product will be profitable and is actually worth developing.

I just wrote a blog entry about this convergence here. In the past, I have written about negative pricing, which I believe is the key to pricing a product based on value.

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Dr. Jim Anderson January 18, 2009 at 1:11 pm

Roger: Thanks for reading! I like your thoughts on “negative pricing”. You bring up a good point that I didn’t spend a lot of time on – there is no such thing as a “fixed price”. The market changes, your customers change, etc. Your prices should be viewed as a moment in time, they can be changed. If you spend the time to study the market and what’s really going on, then you can dynamically adjust (yes, prices can go up!) your pricing so that you are maximizing profit AND maximizing sales.

It’s not an easy job, but then again if it was then anyone could do it…!

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Adam Bullied January 18, 2009 at 1:18 pm

CEO of the product is not an approach I take. I’ve seen PMs think that way and then start to actually act like the CEO of the company, which usually ends with a pink slip.

I’m part of a team building a product – there are less than 10 of us. The CEO of the company is the CEO of the product, not me.

A tough spot? Sorry, but hardly the case. I didn’t think what I wrote indicated that I was having difficulty with these decisions – sorry if it came off that way.

We’re making profit on the first deal we ever did – and will continue to do so on all others we do. We’re not copping out and taking a loss leader like so many start-ups do today. If we find we are losing deals based on price, we will tweak it and try again with the next prospect.

Iterate, research, tweak, go again. Nothing is right the first or second or third time out – you have to keep making it better, which is what we’re doing.

Remember, PMs need to be strategic. But they can’t keep their head up in the clouds too long / too often – or it will end in them forgetting to actually get something done instead of just thinking about it.

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