April 28, 2009

How to price

I’m involved in a couple of pricing conversations at the moment that both started, as they always do, with, “How much should I charge for …?”

There’s questions, and then there’s BIG questions? Charge too little, don’t make enough money, go out of business. Charge too much, don’t sell enough stuff, go out of business. So, how much?

For a question that’s been around for as long as business itself, you’d have thought there’d be a pretty good answer by now. Here’s the slightly scientific one,

  • Forget sunk costs.
  • Work out incremental costs – how much does it cost you to sell each additional unit, including the cost from you’re suppliers and everything you have to do before it gets sold?
  • Work out the demand for your product (in units) at every price point you’re considering – this is called a demand curve.
  • Find the point on the demand curve that produces maximum total profit (price minus costs times units sold).
  • That’s it.

The problem comes in step three, working out how many units you’ll sell at any given price. It seems like a good idea but is, um, practically speaking anyway, most of the time, um, impossible. You can only really do it with actual paying customers (otherwise the data is extremely, by which I mean extreeemly unreliable), and then you need a sample of thousands to get a decent demand curve. And after all that, if you experiment with actual paying customers you run a distinct risk of pissing them off.

So, after all the maths behind all the models in all the books, we’re left with educated guesswork. I bet you knew that anyway.

Pricing for new products is low data. Accept that pricing is inexact and let your first few customers help you find the ball park. After that, work hard and listen hard.

Value creationThis chart might help. Working from the bottom up, the left side shows that you buy things in from suppliers, add your own costs and sell at a premium over your combined costs, customers benefit more than they paid. The right side shows that your efforts should add value and allow you a healthy profit whilst leaving enough on the table for customers that they’ll be happy they got involved.

If you’re running a business in the pursuit of skippiness, figure out what price lets you reinvest in the organisation and the product whilst keeping shareholders skippy and customers keen to help. Charge that.

(Picture credit – I knocked it up but it leans VERY heavily on one I first found in Strategy Maps by Kaplan and Norton.)

(Whilst thinking about this question I was reminded of the fantastic Camels & Rubber Duckies post by Joel Spolsky on his blog, Joel On Software. Much longer, includes much more theory, really intended for a software audience but well worth the time for anyone struggling to come to terms with pricing.)


Making Promises