March 14, 2014

Pricing advice: Avoid the looking-glass

From time to time over the past 30+ years, vendors have described to me pricing schemes in the vein:

That sounds like a risk-sharing win-win kind of deal, in which your customer’s costs perfectly mirror the benefits achieved.

The naive form of that argument is wholly ridiculous, however; what customers pay you is only a portion of their total cost of ownership, and in most cases not close to the majority. The plan has more fundamental problems too, and experience shows that it rarely works in practice.

Last May, I summarized and explained my standard pricing advice by:

  • There should be 2 or more simple pricing algorithms, so that …
  • … the price for any given customer is the lowest of those choices.

Generally one pricing algorithm will be suited for most of your customers, while the others will be meant for minority or edge cases. …

Core reasons for that approach include:

  • Simplicity. Your salesman on the account should be able to quickly determine which pricing approach will apply. The prospect should be comfortable that there won’t be hard-to-foresee “gotcha” charges.
  • Fairness and match to use case. For any particular prospect, there probably will be a pricing scheme that fits well.
  • Competitive flexibility. Nothing in this strategy puts much of a floor or ceiling on your pricing. You can do whatever you think is economically best.

Benefit-sharing pricing, by way of contrast, can be simple or fair, but it has great trouble being both at once. So if you propose it, messy negotiations will ensue.

For example, suppose that Tweedledee Inc. mirrors Tweedledum Corp. in all ways but one: Tweedledee uses your best competitor Humptyware, while Tweedledum runs the far inferior Dumptysoft. Thus, if Tweedledee implements your Frabulizer, their rate of rattle-breakage will drop from 2 percent to 1; but if Tweedledum buys it, their rate will drop from 10 percent to the same 1. Should and will Tweedledum really pay you 9 times as much for the same thing as Tweedledee? Not a chance. So if you try to price on the basis of measurable outcomes improvement, you’ll probably just get into a huge price negotiation mess.

I do see one scenario in which I might consider benefit-sharing prices — when you’re in a messy price negotiation anyway, and benefit-sharing could close the gap. For example, if you want $1 million for what you claim will be a $20 million benefit, and the customer offers $750,000 for what they more conservatively estimate as a $10 million outcome, you could let the last $250,000 ride on some agreed-upon metric tracked over time. But even that is a questionable stratagem, in that it amounts to a bet that your salesman’s optimism will actually prove to be correct.

Bottom line: Keep your pricing simple, which it isn’t if it depends upon your customers’ internal operating metrics.

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