Monday, January 17, 2011

Pondering pricing

right priceWhat is the right price for a product or service?

This seems to be the question as the week starts, coming up in many guises.  I am meeting next week with a  group that owns a large medical imaging facility: a key question is how they price the service (marketed as ‘product’ in the form of 1-hour slots to use the device).  A friend is debating how much to charge for painting murals in residential settings.  A US contractor approached our design partnership to ask if a simple software job could be contracted for completion in the next three weeks.

What all of these have in common is the need to set a price.

Classically, the proper price of anything is what the market is willing to pay for it.  It has to be more than the cost or producing the goods or delivering the service, and close to the maximum that the customer is willing to pay.  It is bounded by what the competition would charge; boosted by brand reputation.  It’s limited by who goes first in a negotiation: if the seller puts out the first number, the buyer will only push down from there.  Thus it’s always best to have the buyer make the first offer so the price can go up from there.

So, in practice, how can I set the “right” price?  (And, echoing last week’s thinking, does it differ from a ”fair” price?)

Simple pricing is established once the production costs are known: what the materials cost and the value of the resource time.  Then I set price at a 20% margin for a service, a 5x multiple of build cost for product. If it’s a risky job (as when I shipped a device to a US customer only to have it held by Customs), then the premium has to be higher.

But this sort of estimate often has no relation to what a buyer would actually pay. I priced the software job that way, and have been advised that we seriously underbid the job.

Price demandMarket pricing can be established by surveying the cost of similar goods and services, or by asking potential customers what the likely value would be.  A conversation with the local Cambridge imaging center gave me some guidance on their model, while a market survey is guiding my friend’s pricing (interestingly, the British refuse to specify a number, while the Dutch do readily).

The microeconomic model of demand and supply are supposed to give guidance, but in practice is unusable as a guide.

Cash-flow pricing works if I can estimate what benefit the customer would get from the product over time.  If their discounted cash flow over several years adds up to significantly more than the price I am charging, then there may be room to raise the price without impacting the sales volume.

This has been most useful in the business development work that I’ve been doing: valuing a business that we are trying to fund or sell.

Strategic pricingFinally, there is value pricing, in which a good salesman makes the case for premium pricing.  This is the best way to set a price, especially if I am offering a tailored product or boutique service.  There are also consumable accessories and supporting services that can raise the overall price (think about the extended warranties offered by many electronics stores at checkout) and extend the payments that I receive from the sale.

In my situation, market pricing strategies seem to work best, coupled with a willingness to learn from experience: assessing my effort and reward, the customer’s satisfaction and recurrence, after each transaction.  I never feel like I got as much as I could have, but I usually feel like I got fair compensation for my work.


Nel said...

The blog is very good!

Dave Hampton said...

Many thanks, Nel: I really appreciate the compliment