Cost based pricing is tacking on a % margin to the cost of the unit instead of pricing your product/service based on the value it adds to your customers. Let me try to explain how ridiculous cost based pricing is by taking it to the extreme.

Suppose you ran a coffee shop that sold just one SKU (as I said I am taking this to the extreme to prove the point). As your customers buy their cup of coffee they see a row of jars in front of them. Each neatly labeled with

1. a short definition of what it is for
2. a dollar value

There is a jar for

• mortgage
• insurance
• delivery
• coffee beans
• milk
• utilities
• bathroom cleaners
• interest
• depreciation on coffee machine
• salary for employee 1 &2
• childcare (for your child while you work)
• profit

Each jar is also marked with a respective dollar amount.

You ask your customers to drop exact amount marked on every one of those jars.

Every time the price of coffee beans, milk etc goes up you re-lable your jars.

What do you think your customers will do?

Ask your self what your customer is paying for? Did they walk into your store to get their daily caffeine fix or to help you offset your costs?

Do you practice effective price management?

Here are some questions I received from my colleagues and entrepreneurs who read my articles on pricing based on value.

Does pricing based on segmentation and value to segments apply only  for established enterprises?

Is value an irrelevant term for innovative new products  that aren’t just improvements over existing products and are truly different from anything that existed before?

Does pricing for  information goods (bits over atoms) require us toss out all our understanding of economics and look for a new one?

Pricing on value for the customer is tough when you are a startup with very low reference point to measure the true value. There are some direct value in using my product, and there are indirect benefits. How do you  measure/estimate all these?

These are valid questions, there are no pre-packaged answers for all.  But the basic premise of marketing remain unchanged even for startups and digital economy – segmentation and targeting.

Let me answer one of the questions – how to determine value to customer for new offerings – based on what I did in the past. The solution was a stopgap and served its purpose when the value to the customers was not clear. It was based on relative price – that is price relative to what customers pay for  products and services in the same class.

One of the clients had a product that was easy to explain but was difficult to define value to customers. The product was generic enough for customers of all sizes and verticals but it was clear not all of the customers had the same wherewithal to pay. Since the value was not clear neither was customer WTP and hence there was no demand curve. The product is bits not atoms and had no marginal cost. So it is fair to say this had all the complications raised by entrepreneurs.

What job is your customer hiring your product for: The first step I did is positioning the product – there are many definitions of positioning the one I mean here is creating a connection in the minds of the customer to a product/service they already know and use.  This is the hard part and the first one may not be the right one. One way to define this is by answering  “what job is the customer hiring your product for?” (Clayton Christensen). Position your products for those jobs. (Note that the usual marketing strategy is S-T-P, here it is P-S-T)

Segmentation: The second step is segmentation based on value. Since value is the undefined part here,  I looked at what is the total customer spend to solve those jobs. For instance if you are positioning your product for team collaboration, find out what different customers spend yearly on  alternatives they use. Dig deeper and find indirect costs  that are incurred due to inefficiencies of current solutions they use. Rank order the different segments based on their spend and other factors.

Targeting:  You cannot go after all segments. This is especially true for a startup with limited everything. The total opportunity size may look attractive but you need to identify those segments that are attractive in terms of opportunity size, ease of reach, other competitors serving those segments and  future potential. I chose the segment that  had the most annual spend and did not have a way to track the ROI on its spend.

Pricing to get a share of the budget: Then I priced it as a share of the average spend of the segment. For example for the team collaboration case if the  average annual spend by a customer was $1 million, I would have priced it as  0.1% to 0.5% for my offering.  As you notice, this has no relation to value but makes it easy for you to have a conversation with the customer by pricing it relative to what they pay for similar services. Your pitch could be, “for 0.1% of what you spend on X our product will help you achieve  results 1, 2 and 3″.

The net is I am not recommending this approach for everyone nor would I do it next time but this helps to illustrate the point that there are ways to price a new product when the value isn’t always clear. It was basically asking:

1. Whose budget is this going to come from?
2. What is the size of that budget?
3. How can I get a tiny fraction of that budget?

What are your thoughts?

Effectively pricing communications is one of the most difficult and essential tasks that an executive has to tackle. Unfortunately, despite the rewards for doing the job right, many executives punt and take the easy way out. This enables them to “keep their options open” (act as discounter in chief) and avoid the hard work of implementing and sticking to a real pricing strategy.

One executive that is willing do this hard work and walk the talk is Hugh Grant, CEO of Monsanto. While we have criticized him in the past for a statement he made about holding the line on pricing despite signs of a price war (and thus inviting competition to attack using price) the fact is that this was a rare and as it turns out, relatively minor misstep. For proof look not further than Monsanto’s Q409 earnings call.

This is from Carl Casale, EVP and CFO. “As I just mentioned every financial and operational choice we make should drive farmer profitability. Embedded in our growth rates for seeds and traits is the underlying belief based on our technology, that we have created more value then we have priced for and that irrespective of the swings in commodity prices, the farmer should receive a positive return on the investment from the use of Monsanto seeds and traits… This pricing conversation correlates to my second tenant. If we succeed in increasing grower profitability our execution then drives our earning growth.” Yes, the CFO…let me say that again, THE CFO, is explaining how value-based pricing works at Monsanto

Hugh Grant then explains Monsanto’s pricing philosophy.  “We priced our Roundup Ready 2 Yield against the incremental yield that we deliver so we’re not pricing it against the competitors offerings. We’re pricing it against the new bushels that we deliver on farm and that’s the deal that we have with the grower and if we’re successful in delivering those incremental bushels, its going to be a significant product. But that’s been our pricing philosophy…”

“I’d look at two ends of our portfolio, one end is SmartStax on 200 bushels per acre corn and a 10% yield improvement and if you take last week’s corn price at $3.50, that’s a 20 brand new bushels at $3.50 is $70 of value and that $70 of value times three acres in a bag more or less is $200 of brand new value.

So whether its last week’s price of $3.50 or today’s price of $4.00, or the doom and gloom pricing of $1.95 there’s a very positive economic return at that far end of the portfolio…”

And on the balance between pricing and market share… “So in a world of (flat share) I feel really good because we priced for the value that we deliver and that was a tough call, but it was the right thing to do given the technologies that are coming and we increased our technology penetration in a difficult market.”

There isn’t much analysis that needs to be added to these words. Monsanto has achieved the ultimate objective for pricing; using it as a tool to continually increase both revenues and profits.

When pricing digital versions of their print offering most marketers do not have a pricing strategy. They have not analyzed which segments prefer the digital version (or which segments they want to target), what net value does this version add over the print version and how the offering should be positioned. here are key exceptions like The Wall Street Journal and Financial Times. But mostly pricing digital versions are done in one of following ways:

1. A dominant player in the value chain (channels like Amazon ) sets the  price
2. A dominant competitor has set the price and the marketer decides to follow
3. Price it as a percentage of the print version (usually using cost based argument)
4. The extreme form of this is the Free argument – the digital versions are given away

All  these methods are neither based on marketing strategy  nor driven by profit goals. The marketers become price takers than price setters.

Here is an interview with Alexander van Boetzelaer, of Elsevier, who is changing this and taking back control of the pricing of their digital subscription.

Elsevier is strongly committed to continuously evolving our pricing structure in line with customer needs. We see this as a journey that will take time. We will continue a gradual offering of new subscription options that have been developed and tested in close cooperation with our customers. Listening to, engaging with our customers and responding to their feedback are key to this journey.

They recognize that pricing digital versions is an experiment that requires study of customers and their needs. Pricing is driven by what customers value rather than by costs, competitors or channels. That is effective price management.

Compare this to “give it away for Free – your competitors are giving it away – make money from something else” argument.

Pricing is about capturing a fair share of the value you add to your customers.  This method of pricing is called value based pricing. The opposite of this is called cost based pricing that is  internally focused and ignores  customers.  Your costs are irrelevant to pricing, as long as you are not selling below marginal cost and beyond break even point. After all if you are making a loss on every sale or on the whole operation then it makes no sense to be in that line business.

That said, a marketer can use costs signals to introduce price increases while assuaging customer concerns about fairness. I do want to stress that this is a pricing tactic and not a strategy. In their paper titled, Perceptions of Price Fairness, researchers Gielissen, Dutilh,and Graafland  validated their hypothesis,

Hypothesis 2: Options to pass on production costs are perceived to be fair.

When customers see the price increase is a result of cost increases, they are  willing to accept the new prices. Once the high prices become established, these become the new reference price and can remain sticky even when the original cause (production cost increase) is no longer valid.  We see that in the earnings results of CPG brands that used commodity price increase in 2008 to push through their price increases. Since they hit their peak in 2008, prices of food and utilities have come down but the CPG price increases remain.

Brands, despite their current pricing strategy, should implement tactics that take advantage of short-term market conditions. While we saw how P&G, Nestle, Cadbury, Heinz and Unilever taking  advantage of cost increases we also saw Lindt’s not using the increase in cocoa prices to increase its prices. The result is a 90% drop in their profits.

The net of this is, your costs are immaterial to your pricing strategy but short term price increases can be used as effective signals to fix faults in your pricing.

I saw a post by an artist, Ms. Michelle Moyer, of White Dog Studios, who makes and sells jewelery. Michelle is thinking about pricing her wares correctly. She says,

I think that artists undervalue their work far too often. I think that artists undervalue their work far too often. When I go to shows or browse online and see handcrafted pieces selling for a price that I know will barely cover material costs, if at all, I cringe because this sets the market lower for my work. I believe that my work has value and that incorporates not just the material costs, but the time it takes for me to develop the design and make the piece.

I want to highlight a great point Ms.Moyer makes, it is the effect of reference price. While there is no common value for crafts, presence of lower priced items sets a lower reference price for her customers.

Ms. Moyer  talks about rest of her pricing in terms of material costs and labor costs, and about how much artists value their work. Pricing is about capturing a share of the value you create for your customers. Your costs are irrelevant to your customers. Pricing needs to be based on value added to customers. It is not about what you value or what you think the value is, it is what your different customers think.

The value is not the same across all customers. In the book Game Changer, retired CEO of P&G Mr.A.G.Lafley talks about “who is your WHO?. The “WHO” refers to the customer. Mr.Lafley, goes on to say

“As you work to better understand the WHO, you’ll discover that people use your product for different reasons. They may have different occasions for when and how to use it; differences about what they think is a good value, and what they are willing to pay. One size does not fit all”

Ms. Moyer  is practicing a type of multi-version pricing,

I try to offer a range of pieces at various prices. For example, this bracelet, for sale on my Etsy shop, is only $20, which I believe is a fair and affordable price. This bracelet, on the other hand, took much longer to design and create, so it is priced at $70.

This is good but the multi-version pricing is once again based on costs rather than on segmentation or customer value. Taking a lesson from Game Changer, there are opportunities to find  the reasons people buy the bracelets, different occasions and how the customers use the bracelets.

Segmentation and targeting  are not new and are mastered by many of the B2C brands. The chief among them is P&G which arguably was the first to do formal customer research. It is easier said than done. It does come  easy to companies like P&G that have done it for so long and can afford to invest in customer research, gather insights and invest on new product lines to monetize those insights. When they do studies that follow the customer they can find what is important to different customers, develop products and price them correctly.

But it is not easy when you are a small business or when you make products for there is no “common value”.

Related article: Small Business pricing.

Next week will see the Institute of Clinical Research 30th Anniversary Conference & Exhibition, taking place on March 17th & 18th at the ICC in Birmingham. Of course, I will be there to:

• Cover the meeting for CRfocus (along with a team of roving reporters!)
• Help with the organisation and operation of the meeting (ICR is the parent organisation of CRfocus)
• Chairing a session on the tension between pricing and patient value, and how you can accurately assess either

I also plan to Twitter live from the conference (I’ll be too busy to live-blog like I normally do from such meetings). You can see my most recent “tweets” on the main CRfocus webpage, or follow me on Twitter itself. I’m also hoping to have time to do some other neat things, such as one or two audio interviews with delegates or speakers, and post some photos live from the meeting…

This is going to be a great conference, and I’m looking forward to it immensely. If you haven’t registered yet, take a look at the conference programme, and come along (we have passes available from a half day up to the entire meeting).

I’d love to see you there…

The CRfocus blog is pleased to be sponsored by the Institute of Clinical Research 2009 Annual Conference & Exhibition.

ESSENTIAL UPDATES

AND LIVELY DEBATES

ICR understands the importance of maintaining your competitive edge in the current environment. Therefore, this year’s conference is packed with opportunities to hone your professional skills, stay abreast of the latest regulatory developments and keep up to date with the hottest innovations in the clinical research industry.

There will also be plenty of opportunity for you to make new contacts and network with influential figures from across the industry.

Programme highlights include:

• Essential regulatory updates, plus “GCP Question Time”
• Intensive half-day sessions on oncology, organ transplants & cardiovascular medicine
• Lively discussions on EDC, off-shoring and global contracts
• New Professional Development stream with certificates & CPD points
• Debates on controversial questions with the chance to vote

For details of how to register and to view the full conference programme click here

If you dig past the current economic doom and gloom spread throughout the media, you’ll come across the idea that a recession can actually be a great time to be innovative and entrepreneurial. If this can (and does) happen in the wider sphere of business, I would argue it can (and should) also happen in the development of new medicines.

Despite the instinct to stop training, stop advertising and stop investing in R&D, this is the very last thing we should be doing. Some will survive the next couple of years by simply cutting costs, but they will emerge into a world where the old models no longer apply. The rules will have been changed by maverick organisations who kept looking for the next big thing, and individuals who could ‘think the unthinkable’.

This ‘unthinkable’ might be a genuinely new idea. But, like stories, there are only so many, and once we start constraining ourselves into a specific sector, genuinely new ideas are rare. A far more approachable category of unthinkables is those ideas that pop into our heads from time to time but are swiftly forced out again because we can’t see a way to make them feasible, beneficial or politically acceptable. If we can set aside the voices of criticism and negativity (whether internal or corporate) and try to view these unthinkable ideas in a different way, we might be able to do something with them.

This generally requires someone to look from a different perspective, to change how we interpret an idea or situation, perhaps as radical as taking a view diametrically opposite the ‘conventional wisdom’ to see whether the boundaries we imagine simply disappear. (As an exercise, try to think of ways to interpret the current recession in a positive way.) This, in turn, requires a dynamic kind of optimism or, to borrow the vocabulary of an American politician who is likely to define the next few years, “hope, for change”.

Of course, the problems facing us in clinical research are exacerbated, but not created, by the current economic turmoil. Patent expiries on blockbusters reduce the revenue we can plough back into R&D; regulators raise the bar for the size of patient safety databases; governments base reimbursement decisions on evidence for patient value; and drug discovery hands us candidates that we can’t find enough patients to test, let alone enough professionals to conduct the studies… It would be easy to get depressed by this ‘perfect storm’, even before the recession hit!

But, for a moment, try to look at this situation from a hopeful, positive perspective. If the current recession can be viewed as an opportunity for the next generation of innovators to change the way business will be done for the next decade, can’t the same be true for clinical research? If this is what it takes for us to change the way we evaluate new medicines, creating a model that is a step-change more effective and efficient than at present, then would it be unthinkable for me to say that we can view our situation in a positive way?

This management tip from The Intelligent Leader is worth noting (here).  I like it because it’s a concrete example of how a firm moved from product to value-based pricing — Cemex is differentiating what is often considered a commodity product.

Differentiation by combining basic product value with another attribute(s) — in this case a firm time commitment — is the key to this transition.  Whether it is more service, less risk, tighter time windows, there usually is another attribute that your best customers value.  More importantly, they’re usually willing to pay for it.

In 1867, Otto von Bismarck described politics as “the art of the possible”; it’s easy for commentators (myself included) to pontificate without the responsibility to implement those suggestions in the ‘real world’. With this in mind, I’m cautious of being too critical of the recent announcement of a deal¹ between the UK Department of Health and the ABPI on parts of the voluntary scheme to replace the Pharmaceutical Pricing Regulation Scheme (PPRS). This was accompanied by a consultation² from the Department of Health on a statutory alternative.

This is important in an international context, as pricing systems in many countries are benchmarked against the UK. Healthcare payers around the world will be watching with interest, to see how far prices can be squeezed in return for investment in research infrastructure, and how deeply economic models of patient value can be built into reimbursement negotiations.

Last year, I wrote³ about the beginnings of this process, as an Office of Fair Trading report recommended that the current arrangements be overhauled. I was broadly optimistic, because the OFT proposed changing the system from a complex network of controls on profits and post-launch price changes to one based more on the value of individual medicines, based on economic evaluation of their benefit to patients. However, the settlement is based on an across-the-board price cut… While it gives stability and predictability for the next 5 years (the statutory scheme will be reviewed annually), the settlement appears to be a polishing of the same ‘blunt instrument’, sweetened by a commitment to speed the uptake of newly-registered medicines.

This is certainly not the value-based pricing many had hoped for. In the days following its announcement, Jim Furniss of Bridgehead Consulting told me that he thought “the opportunity provided by the OFT report for a much-needed reform to reflect the realities of the modern pharmaceutical industry has been squandered.” Were Jim and I being too hopeful? In the short term, perhaps, but not in the longer timeframe. Implementing a value-based model across the whole range of pharmaceuticals so quickly was probably impractical, but there have been pilot schemes (such as Velcade, where the NHS will be able to recoup the costs of treatment of any patient who shows no or minimal response) and these need to be applauded, nurtured and expanded.

So, is this re-negotiation of the PPRS an equitable balance to the large investment that government has made into NHS R&D over the past few years, a ‘quick fix’ to shore up public finances while ignoring the opportunity to put patient value at its heart, or a practical compromise to help the NHS’ depleted coffers while a more sophisticated, value-based model is being developed? I’d certainly like to think that it’s the last of these, but to be confident I’ll need to see strong signals from government that a more sophisticated pricing model is indeed the intended way forward.

References

1. Association of the British Pharmaceutical Industry (ABPI) press release (18^th June 2008): “Big Progress In Government And Industry Drug Price Deal”, available via www.abpi.org.uk/press/press_releases_08/180608.asp [accessed 25th June 2008]
2. UK Department of Health (18^th June 2008): “Consultation on a statutory scheme to control the prices of branded NHS medicines”, available via www.dh.gov.uk/en/Consultations/Liveconsultations/DH_085523 [accessed 25th June 2008] This consultation closes on July 15^th 2008 (part) and September 25^th 2008.
3. Smith A (2007): “Who Wins From Value-Based Pricing? Everybody!”, CRfocus 18(3) p4

A question was recently posted in a number of Product Management discussion groups. It read (in part):

…I am working on adding a subscription based pricing model for our product. I have read articles that talk about the “rule of 17″ that suggest a monthly payment should be 1/17th of a perpetual license fee.

I have structured the models so that the “crossover” between the License fee model (including maintenance streams) and the subscription model was sometime in the first half of year 2. I have seen 3 year models as well.

What do you use or what have you seen? Have you offered both model for a time and if so what are the conflicts (if any) that arise?

It can sound very tempting to provide a subscription alternative to your own enterprise software, but you need to think beyond simply price, and think through the evaluation model, the sales model, the expense model (you’re now taking on the cost of hosting/operations), and how you go to market, convert leads etc. I’m assuming here that the subscription pricing is for a hosted or SaaS version of you current on premise software?

The approach to take is to start from first principles, and define the value proposition for the end user or customer.

There is a real tendency if you already have an on premise solution to:

1. ensure you don’t cannibalize the revenue coming in from that solution
2. use the pricing of the existing solution to determine the price of the SaaS version

If you go down either path, the subscription solution is likely to fail.

The first one will always put the existing product ahead of the subscription based product. This is what happened with Siebel on Demand. The existing business had to be protected from encroachment or cannibalization by the on demand business and it hampered the on demand business significantly. Your company will really need to shift it’s thinking to manage this well.

The second is tied to the first, but also ignores a really great opportunity you have to define a true value-based and scalable pricing model that could generate more revenue and have significantly higher customer retention than the current pricing model.

Spend some time with the target customers and understand the value proposition from subscription based pricing, and do some price sensitivity testing with them. This should really help you understand how the pricing can provide value. It may also show that there is no appetite for subscription based pricing, but I’m assuming that is not the situation in your case.

One of the interesting things about subscription pricing is that the money will often come out of OpEx budgets in companies whereas for traditional enterprise pricing, it will come from CapEx budgets. Now a dollar is a dollar, usually, but whose budget it comes out of make s a big difference in how people perceive price.

Additionally the pricing model has to take into account the true value delivered by the software. It is very easy to think of per seat per month or per user per month pricing. It certainly worked for SalesForce.com. But the beauty of subscription pricing is that you are not tied into that model or one model for that matter. But whatever you do, keep it simple! Enterprise pricing is ridiculously over complicated. Use the subscription pricing exercise to address that problem.

Figure out what the key units of value are from a customer perspective and use those for the pricing. There may be multiple models based on user scenario. While you don’t want to force existing customers to move to subscription pricing, you’ll have to figure out a transition pricing model to move them over (and possibly back) if needed.

Think of it this way. If one of your competitors came out with a competitive subscription based offering to your current product, would they simply take your pricing and apply the “rule of 17″? No, they’d figure out a compelling value proposition and pricing model and use that as a weapon against you. Get one up on your competition and do it before they do.

Saeed

P.S. Here’s an article on subscription based pricing that may be helpful.