August 26, 2011

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

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.

Contact Blue Elephant Consulting

If you are interested in finding out more about how you and your products can boost your firm’s bottom line and gain more market share, get in contact with Blue Elephant Consulting in order to find out how a consulting or training program could be customized to meet your unique needs.

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