- Running a successful business machine requires you get your price right
- Introduction to pricing: the adage of the expert and the hammer
- Pricing Model for (Sm)all Business
- Step one is to get back to the basics of what price is:
- How Supply and Demand Works
- So here are a couple of objections:
- This brings us to the 3 factors to get your price right and charge a higher price.
- Factor 2: Estimate the value you offer – total value is the maximum price you can charge.
- Factor 3: the competition
- Here is the good news:
Running a successful business machine requires you get your price right
Price is one of the essential elements of any business. Get it wrong, and you’re doomed. But get it right, and you can make a killing. So how do you set your prices? There are four things to consider: your costs, value, and the competition.
I start with an Introduction to pricing and what entrepreneurs often get wrong.
Then I cover how Supply and Demand work to set prices,
And explain the four elements that determine your price.
Introduction to pricing: the adage of the expert and the hammer
I have no idea where this story comes from, it isn’t my invention, and many versions are out on Google. But where doesn’t matter: I heard it as a story about a cargo ship operator who couldn’t start the ship’s engine. Without an engine, the ship was stuck, potentially costing the operator millions of dollars in demurrage, late deliveries, and missed shipments.
The operators brought in repairer after repairer to fix the engine, but nobody could get it to start.
In a last-ditch effort, they called in a wizened old repairman who charged high fees but was rumored to deliver every time. He showed up with his old coveralls and wooden toolbox, inspected the engine, and quoted a price of $50,000, due upon engine start. Nobody had come close to solving the problem, and the owners were desperate, so they happily agreed.
Agreement in place, the repairman, picked up his hammer, tapped a part of the engine, and it roared to life. The problem was solved.
The man provided an invoice for the $50,000, but the owners balked. After all, all he did was tap the engine, he was there for a total of 5 minutes, and 3.5 of that was negotiation! So they demanded an itemized invoice.
The repairman was happy to comply. The invoice had two lines:
- Line one: Hitting engine with a hammer: $1.00
- Line two: Knowing where to hit: $49,999.00
The problem most entrepreneurs face is that they focus on the cost of hitting the engine with the hammer and ignore the value of starting the engine. As a result, they make no money. They force themselves to continually look for new things to hit with hammers rather than charge for actual results.
Pricing Model for (Sm)all Business
Pricing is a real pain.
The beauty of the capitalist economic system is that you get to set your price.
The challenge of the capitalist economic system is that you have to set your price.
So, business owners tend to look at what something costs and set a price accordingly.
Services businesses often look at the cost of labor and multiply that by three:
- 1/3 for the person delivering,
- 1/3 for overhead and
- 1/3 for profit.
If you do this, you end up in a negotiation where you have nothing to support the price other than the cost, which only accounts for a third of the price.
So if your client pushes back on price, giving in a little is straightforward. In the name of winning a sale, you reduce the profit and maybe eventually even eat into the overhead.
As a result, when you negotiate on price, you end up with more work and less money, which is the opposite of what we are looking to do.
This mistake is rooted in the belief that the company delivering the service sets the price. And we assume it has something to do with cost.
This assumption is wrong; price does not depend on cost.
Think about the repairman ‘s story. If he had charged his cost times two or three and added marketing and transportation costs, he might have supported a price of $5 or even $10. The operators might have talked him down to $7. But he’d be nowhere near his value.
There is also the opposite extreme where the business owner tries their hand at extortion.
I recently discussed price with an advisor who saved a client $400,000. He had only charged a couple of thousand dollars because he knew the cost would be low, and before doing the work, he didn’t want to make a real commitment. But once he saw the result, he wanted a piece of that $400,000.
Suddenly he was a big fan of value-based pricing and wanted to know how to do it.
But that isn’t value-based pricing; it is trying to get more money from something you already did.
Pricing happens before a transaction,
you can always charge a success fee, but you must agree to that upfront.
The repairman agreed to do a job based on performance. His fee for not starting the engine was zero. His price for starting the engine was clear upfront. This isn’t extortion; it is understanding the value of what you offer.
If you agree to do a job for a price, do the job well, and then afterward insist on a cut of the benefit that is not value-based anything. It is swindling.
But I get the need.
The accountant, in my example, was tired of being squeezed on price. He wanted to make a living and not work as hard. So here was someone who saved significantly as a result of his work – couldn’t he take a bit of that and call it value?
Well no. But there is a way to set prices so that you don’t get stuck in price negotiation; you aren’t pricing based on cost, you don’t have to extort, and you can charge much more, just like the repairman.
Step one is to get back to the basics of what price is:
Remember, the buyer sets the price.
We think the seller sets the price, and I did say earlier that you set your price, but that is wrong. You are responsible for the price, but the buyer decides if it is correct. So if you set the price at a dollar and nobody buys, you will reduce your price. The buyer’s willingness to buy is always what drives the price.
Price, therefore, has nothing at all to do with cost.
Price can’t depend on your cost because your buyer knows nothing about the cost of delivering the service or producing the product. The buyer determines the price and only knows the value to him or herself.
The price depends on the balance of supply and demand.
The buyer is looking for value and can get it from you or anyone else. If they perceive many options, supply is high relative to their demand; they will search for a better price.
Alternatively, if they can’t find the value anywhere else, they will have to buy from you at any price up to the value you offer.
Understanding this balance is useful because it gives you a roadmap to increasing your prices. So the rest of this post explains how pricing works and how to use that knowledge to set your prices more effectively.
How Supply and Demand Works
Like anything that people spend much time thinking about, the details of supply and demand can get very complex and lead to many deep discussions about human nature.
But ignore all of that. At a high level, supply and demand are easy to understand. Here it is:
All you need to know about supply and demand to get your price right (and charge a higher price:
If demand is high and supply is low, price increases (or you can charge more).
If demand is low and supply is high, price decreases (or you can’t charge as much).
Here is how this works in a practical, everyday sense:
Imagine you are selling a service; you charge $100 for that service and have a line of people going out the door. You can’t possibly deliver the service to everybody, so what do you do? How do you reduce demand?
The best way to do this is by increasing the price. Those who want whatever is being sold enough to part with more of their money do so. Those who don’t want it badly enough drop out of the market and buy something else.
Most business owners don’t use price this way, so they end up working too hard.
Most business owners work harder and try to keep up with demand. The logic is that any client is a good client, and you must keep them all happy.
But the better course of action is to narrow your niche.
A narrower niche means that you reduce your offering and increase your price. As you get better and better at delivering, your cost will decrease, and you can increase your price, even stave off competition.
If you don’t believe me, go pick up any book on marketing. Each will instruct you to narrow your niche and precisely define your offering.
It is supply and demand, just with a different name.
Of course, this works the other way around too. If there is too much of something and not enough demand, the sellers lower the price to encourage buying.
If you are selling your service for $1000 and don’t have enough customers, you’d try lowering your price (which brings some of the priced out people back to your offer.) A price reduction may take the form of either reducing the amount you charge or increasing the services you deliver for the same amount. Both are a price cut.
You know your niche is too narrow and the price is too high because there are not enough people interested in buying what you offer.
This process is straightforward and logical, and we see it around us every day all the time. Yet I get pushback on this all the time.
So here are a couple of objections:
The Mercedes objection: luxury items are priced according to the manufacturer; there is no supply/demand relationship.
Luxury items are perfect examples of supply and demand. Without a limited supply, luxury items would cease to be luxury.
Think of a Mercedes; there is a very high demand for Mercedes cars, and many people want one.
Mercedes tightly controls supply. The company produces a limited quantity, and they ferociously protect their brand so that nobody can manufacture a Mercedes car, which would increase supply.
Demand is high, and supply is low, so prices are high. Mercedes sells to the top level of demand and charges a premium for access to their cars.
Now, imagine that Mercedes floods the market with cars. They double their production tomorrow. Suddenly, they would end up with lots of inventory, and they would need more buyers. How do they attract more buyers?
They have a sale. They lower the price.
The objection people raise to this is: it is the brand; Mercedes is expensive because of the brand.
Absolutely: the brand is what limits supply; Mercedes creates a solid brand to ensure that their cars are not confused with other cars. Without the brand, Mercedes would just be another car.
The brand also increases demand by generating excitement about the product – because of the brand; more people want to buy a Mercedes.
The Diamonds Objection
Diamonds are another often quoted example, but it is the same story. As a trained diamond sorter with diamond industry experience, I assure you that the ONLY reason diamonds are expensive is high demand and limited supply.
When Cecile Rhodes started De Beers, he had a huge problem.
He was increasing the diamond supply, but as beautiful as diamonds are, the demand was limited. Nobody had a use for diamonds. Increasing supply without a change in demand meant that prices would plummet.
So, De Beers created a complicated system for accessing the diamonds that forced buyers to buy both high-quality stones that would sell and low-quality stones that wouldn’t. This was a way of limiting supply.
De Beers grew demand by promoting diamonds as necessary in love and marriage. They created the engagement ring tradition to explode demand.
Even today, diamond miners have spent vast amounts of money differentiating from manufactured diamonds to ensure that mined diamonds stay rare.
Manufactured diamonds can be of better quality, possibly for less cost.
If manufactured diamonds were everywhere, say at the grocery store next to gum, and buyers saw them as the equivalent of mined diamonds, the price of mined diamonds would plummet.
So, diamond miners have invented complicated machines to help the supply chain tell the difference between manufactured and mined diamonds. They have also spent tens of millions of dollars on ensuring that manufactured diamonds carry a different name.
The only reason distinguishing between manufactured and mined diamonds matters is to limit supply.
The services objection: this only applies to goods, not services.
Somebody somewhere invented the notion that services are different than products.
It was probably a consultant.
Services and products are identical. Both solve a problem. Both require production.
If your service is identical to someone else’s service, and there are limited buyers, you will compete on price.
On the other hand, if you can create a unique service in high demand, you can charge whatever you want.
This idea underlies blue ocean/red ocean strategies or any competitive strategy that encourages you to enter a non-competitive market. It is just supply and demand, rephrased and repackaged.
For a while, I worked in innovation for a small consulting company. So we figured out how to make open innovation work for large-scale projects. Nobody else could get this right.
We were able to compete with much larger consultancies and charge huge premiums.
We were the only ones who could deliver, so the competition did not set our price. It depended on the value we brought to the buyer, our ability to communicate that value, and nothing else.
Ultimately: Saying your service is a service and therefore not a product is an excuse
that allows you to work very hard, earning very little.
Remember: the buyer always determines the price. If the buyer is unhappy with what you charge, they will try to get a lower price or search for alternatives.
When we were negotiating the price of innovation, we would start by estimating the value. In many cases, the benefit would be hundreds of millions of dollars.
If I can add a billion dollars in value to your company, how much will you be willing to pay? Could I charge you $5 million? $10 million? $100 million?
Those billion dollars are waiting for you: I am just going to unlock them. What is that worth?
This brings us to the 3 factors to get your price right and charge a higher price.
Factor one is cost
(Note: Cost is step one on the price calculator).
First, remember nobody cares how hard it is for you to deliver anything to them. Cost does not matter when setting the price to the external world. But it does matter for you: you do not want to sell anything at less than the cost to deliver.
(Caveat: sometimes you sell less than the cost to build trust and relevance, demonstrate value or gain experience, but this must be temporary.)
Now to prove to you that cost does not matter for your customer, consider this:
If I can convince you beyond a shadow of a doubt that I can get you a thousand dollars for a charge of $250, will you do it?
What if I tell you that it only takes me five minutes and no work to get you the thousand. Do you care?
I ‘d be willing to bet that if I were to hand you $1000, you would happily pay me anything less than that amount to receive it. You would pay me $250 in a heartbeat. No matter what that $1000 cost me.
Well, okay, there is the pain principle: In a very competitive market, price equals the cost.
There is one scenario in which cost matters: it matters if you are in a competitive situation.
If you have competition and there is limited demand, buyers will search out the lowest price. The competition will force you to lower your price. When the price goes below cost for someone in the market, they drop out. The price goes to the next lowest cost, and they either accept the price or drop out.
The price goes down until supply satisfies all demand, and the price is painfully close to cost.
You won’t charge less than your cost because you would be better off going out of business. You won’t raise your price because you can’t.
So, you end up grinding away, delivering the same product or service as everybody else, making skinny margins.
It is painful.
There are nuances, and economists spend lots of time and energy understanding markets like this.
Commodity markets work this way: if you mine and sell iron ore, you sell at a price set by the marginal cost of the highest cost producer.
Every once in a while, demand spikes, and prices shoot through the roof. Sometimes demand tanks, and you are in a painful cost-covering position.
It is easy to fall into a painful market situation.
There is a considerable body of continually expanding knowledge about operating more efficiently and effectively.
We even have endless productivity hacks to help us operate more efficiently in our lives.
Most companies, small businesses, and freelancers end up in competitive situations. If you have a product that makes money, someone will come along, duplicate that product and try to take your best customers.
Yes, you can try to protect yourself with patents and other barriers, but you will eventually fail.
You only need one competitor to drive down the price. That competitor will generally go after your best customers, not your low-margin customers. So, you can fight it all you want but, in the end, competition is coming.
This leads to a drive to be more efficient or work harder with what you have, and that drive can be overwhelming.
However: working harder is the wrong thing to do; this leads to less profit and more work.
And: you probably are not in as competitive a market as you think.
Calculate your cost to deliver in order to set your price floor.
You do not want to be stuck charging your cost, but you can use this as a floor and never charge less than your cost. Assessing your costs helps you ensure you make money, and it gives you a reality check. If you really can’t charge more than your cost, you are probably in the wrong business.
To calculate your cost add up the cost of all elements you require to deliver. Multiply this by some multiple (tradition is three) and don’t charge less.
Factor 2: Estimate the value you offer – total value is the maximum price you can charge.
We define value very specifically:
You must start with communicating transformation.
(Note: defining the value corresponds to Step 2 of the pricing template.)
- Cecile Rhodes didn’t sell diamonds by telling people how expensive they were. He connected diamonds to LOVE, and the desire for that transformation created demand, which drove up the price of diamonds.
- The repairman did not sell pounding the engine with a hammer; he promised the opportunity to get moving again.
Transformation exists on many levels, and the more emotional a transformation, the more valuable your offering.
But not all transformation is emotional. You can also transform me by making me less busy or enhancing my earnings potential.
My accountant might take 20 minutes to do my tax return. Still, he is saving me hours of annoyance and frustration and giving me confidence that my taxes are correct. He shouldn’t charge me just for 20 minutes; he should charge me for the value of the confidence and time saved.
So, ask yourself: what transformation do you (or your product) offer, and what is the value of that transformation?
- Analyze all elements of the transformation.
- Where do you save time or money?
- Where do you add time or money?
- What is the comparable value of the transformation by other means? If, for example, you give them access to MBA level analysis they could only get if they earned an MBA, then include the value of the MBA here.
Transformation is not the only part of the value equation.
If you are absolutely 100% convinced that the billion dollars are immediately available to you, you will be willing to spend anything less than the billion to get them. $900 million would be a bargain.
But 100% is a high bar. Reality is never 100%, so to understand the amount of money you can get for the value you offer, we consider four factors:
- What the value is worth – in this case, a billion dollars- you would pay less for $1.50.
- The probability of receiving the value. If I am waving the bills in front of your face, you will pay more than if I have to do a lot of work to deliver the billion.
- The effort you have to put into realizing value, what it will cost you.
- How long it will take you to realize the value or the delay in gratification
Getting the price right is a function of the transformation, the probability of getting that transformation, delay (how long it will take), and the effort the customer must expend to get the transformation.
So, to justify a higher price, I have to convince you of the value, give you an idea of how probable achieving that value is, and show you you will get it quickly and with minimal effort.
Show that you know what you are doing in order to bump up the probability of success.
(Note: Defining your probability of success corresponds to Step 3 of the pricing template.)
Even if your transformation is impressive, if you have no credibility, you can’t possibly command a premium.
So, once you have communicated the transformation, you have to support the notion that you can deliver that transformation.
Think of the sales equation as a lever balanced on a fulcrum. If the trust and relevance are low, the probability that you can deliver is in question; then, you will have to balance your price with a considerable amount of relative value:
The opposite is also true: establishing significant trust and relevance will allow you to charge significantly more relative to value:
“Trust and Relevance” is a relative measure; it is your prospect’s perception of trust and relevance compared to others in the market.
So, ask yourself, as compared to others in the market:
- Why should people trust you?
- How can you demonstrate relevance?
- How relevant is your offering?
At this point, also consider how much work your prospect would have to invest in order to achieve the same transformation. You CAN get married without a diamond, and you could study taxes to get comfortable with your tax return. But this is effort and time; it is work. You only have limited capacity and have your work to do.
If you save your clients hours and days of work, this is valuable.
If you offer the expertise that they would have to hire elsewhere or dedicate time to acquire, this is valuable.
So, ask yourself: how much effort does your client have to put into getting this result on their own?
- What would it take them to do this work on their own?
- What would they have to learn?
- What resources would they require?
For the pricing template, rank gives yourself a rank of low, medium, or high. High means your trust and relevance are high, your customer will not have to exert much effort, and your delay to gratification is short. Medium means you would be about average and low means you are on the low end.
Factor 3: the competition
No matter how valuable the transformation you offer, if many others provide the exact same transformation, your will struggle to charge a higher price.
So the next element to consider is the competitive situation. Ask yourself: what are your competitors charging for a similar transformation and similar level of confidence.
The range of competitive prices indicates what you can charge, but don’t blindly accept their prices. See how you compare and what you can do to set yourself apart.
There is an opportunity in differentiation because you probably do not differentiate yourself well (just like everyone else).
Because of this, you don’t stand out in the market, and the only way you can compete is on price. YOU make price a big deal. You end up apologizing for having to charge money, and they get stuck in competing based on efficiency.
If you have built an expensive production line and try to squeeze every last penny out of that line, then go ahead and compete on efficiency. That makes sense.
But honestly, you probably don’t have an extensive, expensive production line. Most businesses don’t invest heavily in fixed infrastructure. Most companies are small and have limited infrastructure.
In most cases, businesses compete on price because they are lazy (I don’t mean to call you lazy, but aren’t we all at some point?), or they don’t realize there is another way.
They often offer prices with fear and concern, so they squeeze their own price.
Most business owners fear price; they do everything they can to justify price based on how much effort and work they put into delivery.
The disconnect is that the client doesn’t care about how much time and effort you put into delivering anything. All they care about is the value they are getting.
If you want to break out of the effort–pricing trap, you must demonstrate your value.
So here is how you set yourself apart and determine your price.
If you want to charge a higher price for your product or service (the same thing, remember), or even if you don’t want to set a higher price, but you want to stop worrying about price and stressing about getting it right, go back to supply and demand.
You remove the focus on price by focusing on the value and the opportunity. In your negotiation, your copy and the way you market focus on the three elements that drive the pricing decision (remember, the buyer makes the pricing decision, not you):
Here is the good news:
Remarkably few companies do this.
I have worked with dozens of companies across many markets. Almost everybody focuses on doing work while neglecting to design the work so that they stand out.
So if you focus your time on steps one and two, you will find that there is less competition. Suddenly, you are in a blue ocean, a non-competitive space. You will have the opportunity to set your price and make more money with less effort.