A lot of people liked or commented on one of our memes this week. It said:
Costs don’t drive pricing. Willingness to pay drives pricing.
I always appreciate everyone’s comments, even those that disagree. Ben Blaney mentioned a webinar on “pricing” where all they did was talk about costs. I sometimes feel like I harp on costs too much. I feel like I’m saying “water is wet”, but so many people don’t get it.
After teaching Value-Based Pricing for many years, here is the best explanation I’ve come up with to show why companies should stop using costs to set prices. I define value-based pricing as charging what a customer is willing to pay. I like the nuance of that because then we get to (need to) determine what drives WTP, but that’s not the point of this blog. Here is the explanation of why costs don’t matter to pricing.
Imagine you have a product that costs you $20 to buy/build/create. The $20 is all-in. Whatever costs you think are relevant. A buyer is willing to pay you $100 for your product. How much should you charge? I don’t know about you, but I’d charge $100. Charge more and the buyer won’t buy. Charge less and I’d be leaving money on the table. I would charge $100.
Now, what if the product costs $50 and the buyer is willing to pay $100. How much should you charge? Duh, $100. What if the product costs $75? Same answer.
Now the tricky one. What if the product costs $150 and the buyer is only willing to pay $100? The answer: you don’t sell the product to that buyer. If there aren’t other buyers willing to pay more than $150, then you probably shouldn’t be in that business.
Yes, costs matter. They matter to whether or not to be in a business. They matter to whether or not to accept a single piece of business. But they do not matter to pricing.
Feel free to borrow this story. Use it. Let me know how it works for you. There are nuances that don’t make every pricing situation this simple, but in general, this is right.
What is the best technique you’ve found to explain to people why costs shouldn’t drive pricing?