Customers Dont See It As Their Job To Ensure You Make A Profit

There is an interesting 40 year old Harvard Business School Case on selling contact lens to chickens. The key question in that case is how would you price it? The lens cost pennies for pairs of 1000s. Anyone who did not consider the value to the chicken farmers was taken to task by the professor. While the cost is relevant, the right way to price is based on the value creation to the customers and how much of price rent they expect.

Peter Drucker calls cost based pricing as one of the Five Deadly Business sins.

Most American and practically all European companies arrive at their prices by adding up costs and then putting a profit margin on top. And then, as soon as they have introduced the product, they have to start cutting the price, have to redesign the product at enormous expense, have to take losses -- and, often, have to drop a perfectly good product because it is priced incorrectly. Their argument? "We have to recover our costs and make a profit."

This is true but irrelevant: Customers do not see it as their job to ensure manufacturers a profit. The only sound way to price is to start out with what the market is willing to pay -- and thus, it must be assumed, what the competition will charge and design to that price specification.

The cost gives you the basis, so you know you can't price any lower than that. But when your sales team know the cost they may pressure you to keep dropping the prices to generate sales. They are incented to close sales and will resort to trade commissions, especially near end of quarters to make their quota.

In his recent post, Seth Godin says, "You're not selling a commodity unless you want to." If you forget this and yield to the temptation of market share and the sales team pressures you will be committing the deadly sin.