Key Takeaways
- Cost-plus pricing can provide a simple, transparent pricing baseline, but cost should not be the sole basis for setting prices.
- The biggest risk is ignoring customer value, willingness to pay, demand and competitive conditions.
- Fixed markups can limit value capture and may prevent businesses from benefiting fully from cost efficiencies or product differentiation.
- Strong pricing teams combine cost data with customer and market insights to improve price realisation and margins.
- Moving beyond cost-plus pricing requires cross-functional buy-in, clear pricing ownership, effective processes and the right capabilities.
Cost-plus pricing is a pricing method where a business calculates the cost of producing a product or service and then adds a markup or margin to determine the selling price.
In the pricing and revenue management community, many pricing professionals view cost-plus pricing as a limited or backwards-looking approach. However, cost-plus pricing is not inherently wrong. It can provide a useful starting point when costs are relatively predictable, transparent cost recovery is important, or a business needs a simple pricing baseline. The problem arises when businesses rely on cost alone to determine what customers should pay, without considering customer value, willingness to pay, demand or competitive conditions.
In this article, we will discuss cost-based pricing in marketing and financial analysis. We will cover various cost-based pricing formulas and examples of companies that use cost-based pricing. We will also provide real-world examples and evaluate the advantages and limitations of cost-based pricing, including five reasons why relying too heavily on cost-plus pricing can create problems for businesses.
Table of contents for this article include:
I: Using Cost-Based Pricing In Marketing
II: Pricing Methods: 5 Things People Say When They Do Not Get Pricing
III: Cost-based pricing strategy: Communication skills vital for pricing leaders
IV: Pricing System To Build A Culture of Collaboration In 100 Days
V: Distributor Pricing Model To Lock-in Cash & Capture Value In 2021-2022
Capability Building Programmes For Pricing & Sales Teams!
Using Cost-Based Pricing In Marketing
What is cost plus pricing and how does it work?
Cost plus pricing is a pricing method where a business starts with the cost of producing a product or service and adds a markup or margin to determine the selling price. In simple terms, the price is based on what the item costs the business rather than primarily on customer value or competitor prices.
The approach generally works in three steps:
- Calculate the cost: Determine which costs should be included in the price calculation, such as production, overhead or other relevant costs.
- Apply a markup or margin: Add a fixed amount or percentage to the cost. For example, a 200% markup on an $8 product adds $16 to the cost.
- Set the selling price: The resulting figure becomes the initial selling price. In the biscuit example later in this article, an $8 cost plus a 200% markup produces a $24 price.
Businesses commonly use cost plus pricing when they need to establish an initial price for a new product or review an existing price. However, the method creates important questions about which costs to include, what markup to apply and whether the resulting price reflects customer value and competitive conditions.
These questions explain why cost plus pricing remains widely used but can also create significant pricing problems.
Cost-based pricing definition
In my experience, many businesses remain strongly committed to cost-plus pricing because it provides a sense of financial rigour, transparency and control. For teams that need to recover costs or establish a clear pricing baseline, this can be useful. However, cost accuracy alone does not determine whether a price reflects customer value, willingness to pay or competitive conditions.
In practice, many businesses still use cost as an important starting point when setting or reviewing prices, particularly where costs are readily measurable or contractual requirements make cost transparency important.
Issues of Cost Plus Pricing in the Forex Market 📉 Podcast Ep. 73!
A cost-based pricing definition is when the initial price of a product or service begins with consideration of its costs.
There are many situations where a business may consider using a cost-plus approach to set or review prices. This can be particularly useful when costs are measurable, margins need to be protected, or a business needs a straightforward starting point for a new product or service. However, cost should generally be considered alongside customer value, demand and competitive conditions rather than treated as the sole determinant of price.
Cost-based pricing
The logic of cost-based pricing is very simple. We get the item’s selling price by adding an amount of money (markup) to the item’s costs.
Cost-plus pricing
The simplest cost-based pricing method determines the amount added to an item’s cost and then adds that amount to arrive at the item’s price. This is a cost-plus pricing formula. If (C) is an item’s cost, then its price (P) is calculated as follows:
P = C + added amount
Companies that use cost-based pricing
Businesses commonly use cost-plus pricing when costs are measurable, and contracts or projects require a clear basis for pricing. Examples can include customised construction work, engineering projects, government contracts and some specialised manufacturing arrangements. However, businesses may combine cost-based calculations with market, competitive and customer-value considerations rather than relying on cost alone.
Cost-plus pricing construction
A cost-plus pricing example would be when a building materials business gives a price estimate for a job by calculating its costs to do the job first (say $56,451). Key stakeholders at the building materials company meet to discuss how much they should add to this cost by considering factors such as the number of such jobs to do in a year, overhead costs, and desired final profits. Based on these factors, the company adds $32,987 to the job’s costs; then the company would set the price of doing that job at $89,438.
Cost-plus pricing methods
Another form of cost-plus pricing example is mark up pricing. Markup pricing is used by businesses that buy lots of different goods and resell them at a fairly consistent pace like a distributor/wholesaler or retailer. They’ll have thousands of SKUs (Stock Keeping Units), products and many different product categories. Many commercial teams find it difficult to calculate the additional amount separately for each product (i.e., using the standard cost-plus formula as above). So, they often end up setting the price of an item using mark up pricing.
Markup pricing
Another cost-based pricing method is markup pricing. It basically adds to the item’s cost some standard percentage of that cost. A company may use the same markup percentage across all its products Alternatively, a company may use a separate standard percentage for each product category. Alternatively, a company has a separate standard percentage for each type of product that it sells.
The markup represents the standard percentage the company applies. The amount added to an item’s cost (C), expressed as a percentage of that cost. Below is how we calculate a markup (M) cost-plus strategy:
M = (added amount/C) x 100
Cost-plus pricing strategy examples
To calculate a retailer’s cost-plus pricing strategy example based on markup, the markup must first be converted into a proportion (by dividing it by 100) and then multiplied by the cost. The result of this multiplication is then added to the cost. This method of calculating a cost-plus price formula is written as follows:
P = C + [(M/100) × C]
For example, to set your initial prices on a line of luxury biscuit boxes for Christmas, a retailer might apply a 200 per cent markup. If the retailer pays $8 for a particular brand of luxury biscuit box selection, it would use the following calculations to set a price of $24 for this line of luxury biscuit boxes:
P = $8 +[(200/100) X $8]
= $8 + (2.0 x $8)
= $8 + $16
P = $24
Cost-plus pricing method
A good question that I am sure you now have after reading this formula is what makes up the markups that companies use? It is a question that many procurement teams also ask these companies. For many distributors and retailers, markup levels are governed by tradition (they have always done it this way) or simple rules of thumb (a lot of rough estimates and guessing). For example, a wholesaler might apply a standard markup to merchandise costs, although the appropriate percentage varies significantly by industry, product category, customer segment and competitive conditions.
Keystoning cost-based pricing in marketing and merchandising
In some retail categories, businesses have traditionally used so-called keystone pricing, where the selling price is set at approximately twice the item’s cost (a 100% markup).
Restaurants have also historically used food-cost percentages and markup rules as starting points for menu pricing, although the appropriate approach varies by restaurant, menu category, location and operating model.
An interesting point to note is that when goods pass through multiple businesses before reaching the consumer, successive markups can be applied at each stage of the distribution channel.
The earlier $24 example assumes the retailer buys the biscuits directly for $8 and applies a 200% markup. When a distributor is introduced, the retailer’s acquisition cost increases to $9.60. If the retailer then applies a 100% markup to its acquisition cost, the final selling price becomes $19.20. This is a separate simplified scenario from the earlier direct-to-retailer example, which used a 200% markup.
Using the luxury biscuit example, a simplified pricing structure might look like this:
Manufacturer: $8.00
Distributor: $8.00 cost + 20% markup ($1.60) = $9.60 wholesale price
Retailer: $9.60 cost + 100% markup ($9.60) = $19.20 retail price
Consumer: $19.20
This illustrates how successive markups can significantly increase the final price paid by the consumer. In this example, the retailer adds $9.60 to its acquisition cost, representing a 100% markup on the distributor’s $9.60 wholesale price.
Cost-plus margin pricing
Another form of cost-based pricing is cost-plus margin pricing or gross-margin pricing. Many businesses use cost-plus margin pricing because they want the process of calculating a price to be heavily influenced by the profit goals of the organisation. Many managers aim to maintain a specific margin percentage to meet their targets. Consequently, they set their product margins at a certain level aligned with their profit goals and work from there.
In contrast to a markup, which is the amount added to an item’s costs as a percentage of that cost, a per cent gross margin (or cost plus margin pricing) is the amount added to an item’s cost written as a percentage of the item’s price. Cost-plus margin pricing (or sales margin formula) looks like this:
%GM = (added amount/price) x 100
There are two ways to use a per cent gross margin to set a price
The first one is to change the per cent gross margin to a markup percentage because this often feels more intuitive (or easier). The second method is to calculate the product’s price directly from the gross margin percentage which would look like this:
P = C/[1 – (%GM/100)]
When the gross margin percentage is higher, the item’s price becomes considerably higher than its cost. When it is small, the item’s price is only a little above the item’s cost. It is little wonder then, that you’ll hear many managers discuss high per cent gross margins (+30 – 55%) as the guideline they generally expect prices to conform to even in margin constrained businesses.
Big gross margin percentage means higher prices and more profit contribution dollars
Although the use of gross margins in the pricing setting helps to bring to pricing the influence of the selling organisation’s profit goals, the cost plus margin pricing method makes price review time a scary prospect. Many customers will ask for gross margin – markup equivalents to understand how you calculated your price rise. Some customers may be unwilling to pay a higher price. This happens if you have cost-plus pricing or a rule of thumb to back up your margin percentage calculations.
5 potential limitations of cost-plus pricing
Cost-plus pricing can provide a simple and transparent starting point for setting prices. However, relying on it as the primary pricing method can create several problems, particularly when customer value, demand and competitive conditions differ significantly from the underlying cost base.
1. How can you work out your costs?
In the classic case of cost-plus pricing, prices are set by adding a margin to the “costs”. The first real issue is a simple one – how can you calculate the costs?
This may seem a simple question. However, we have to decide what costs we should include. Is it total average costing, marginal costing, etc?
Think of a cost-based pricing example where a company sells 100 teddy bears.
If someone doubles the order to 200 bears, what would the cost of the bear be for the calculation?
Should they set the price for the new bears at the average cost (i.e. dividing the factory, rentals, machinery costs, etc across the new bears)?
Also, should they reduce the cost for the original 100 bears as the same factory is producing more bears?
Or should it just be the marginal cost of the bears?
In an extreme example, if the marginal cost of bear production is zero, should they give that bear away for free?
We might have heard somebody say, “I have worked in companies where average costing was not giving us a ‘low enough’ price.”
What ended up happening was that they started to remove costs that were deemed “not appropriate”.
2. What margin should you add?
If it is hard to work out costs, working out the margin or mark up to add is even harder in price setting. What is a good number, i.e. 10%, 20% or 600%? Honestly, it can be whatever you want it to be.
3. Cost-based pricing gives a logical reason to not innovate.
This is a slightly funny way of looking at things but highlights the inherent flaws in this approach.
If the business relies strictly on a fixed markup over cost, an 80% reduction in production costs would also reduce the dollar amount captured through that markup. This illustrates a potential weakness of relying on cost alone: efficiency improvements do not automatically translate into higher value capture.
Why? Because the dollar value captured through the markup would also fall when the underlying cost falls. The markup percentage may remain unchanged, but the business would not automatically capture the additional value created by its efficiency improvement.
4. Cost alone does not recognise the value customers place on the product or service.
What if you have a highly differentiated product or service? Customer willingness to pay may be significantly higher than the cost-plus price suggests. A beer may cost relatively little to produce, for example, but customers may be willing to pay very different prices depending on the location, experience and perceived value. Similarly, business-class customers are paying for substantially more value than the underlying cost difference alone would suggest.
5. Cost transparency can give customers more leverage in price negotiations.
What if your clients in a B2B environment know that you are applying, say a 50% markup when their business only achieves 25% margins? They are likely going to use this to negotiate a price decrease.
I have been in meetings where customers have said, “We make 20%, so you are part of our supply chain and so you should not make any more than 20%.” It is never a good idea to give your clients an incentive to start these conversations.
When Cost-Plus Pricing Becomes a Problem
Cost-plus pricing provides a straightforward way to establish a price from the underlying cost base. However, when it becomes the primary pricing strategy, businesses risk overlooking competitor prices, customer willingness to pay, demand and the value created by the product or service. The question is therefore not whether cost-plus pricing is good or bad, but whether it is being used appropriately for the commercial situation.
Pricing Recruitment For Pricing Managers!
Points to Note:
One major limitation of relying too heavily on full-cost pricing is that it can leave value on the table. An input-based approach may produce a price that covers costs and delivers a target margin, but it does not necessarily reflect the value created for customers. Businesses should therefore consider customer value, competitive positioning and demand when reviewing existing prices rather than treating cost as the final answer.
Consider what value your product actually offers and where it is differentiated. Then calibrate your pricing against market positioning, competitor prices and customer willingness to pay. Monitoring price-value differentials by product and segment can help identify where prices are too high, too low or appropriately positioned.
Whether you are in the Government Contracts game – or B2B sales, understanding the value your customers place on your product or service is key.
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A closing cost-plus pricing example
If you are the sole provider of a highly differentiated product, the cost to produce the service may have less influence on the price than customer willingness to pay and the value created.
Value-based pricing is not simply about charging a higher price. It is about setting prices according to the value customers receive and the willingness to pay, while considering costs and competitive conditions as important inputs into the decision.
Ask why the team is talking about full cost pricing at meetings, especially if you are reviewing prices. Ask which cost was added or whether direct labour was applied, especially if you are trying to price a new product. You will soon realise you have a serious pricing problem.
If you would like to learn more about how to build a world-class pricing team for your business, download our complimentary e-book, Five Ways to double EBIT or free pricing recruitment guides.
Don’t waste another dollar on the wrong pricing team strategy.
Capability Building Programmes For Pricing & Sales Teams!
Pricing Methods: 5 Things People Say When They Do Not Get Pricing
Pricing methods. How do you remove the misconception? There is a proverb from Geoffrey Chaucer that says, “Many a true word is spoken in jest.” Meaning, a humorous remark may turn out to be true after all.
In this short blog, we will take a lighter approach to highlight common misconceptions that pricing professionals often hear. This could even be thought of as a way to learn by asking questions – in the Socratic style.
Below are some of the common statements people say when it comes to pricing. We suggest you keep a bingo card and tick it off if you have heard of them. If you did, then you can give yourself a pat on the back. The next step and more challenging one is to try to win over the person to the side of pricing and revenue management.
Introduction to Price Optimisation 💰 Podcast Ep. 74!
How many of these statements have you heard before?
1. “You cannot just increase prices.”
This is one of the most common statements that you often hear. It is based on a fundamental misunderstanding of the pricing profession and pricing methods. Hence, we listed this one first. As if you cannot get past this one, you have no chance of getting buy-in with our implementing pricing optimisation. A good answer to this question will enable you to move on to more complex questions such as below. See our blog on premium pricing strategy.
2. “Is this some sort of pseudoscience with magic numbers?”
This one can come up or a variation on it when the concepts of psychological pricing, relative pricing, anchoring or numbers such as $5.99 are brought up. This should be viewed as a good thing as it opens the door for more discussion.
3. “Our sales force will never accept this price testing method.”
This is a great indication as to how the business is actually set up and who carries power. It can also give you great insight into why margin erosion may be appearing. At this point, it may be a smart idea to think about how sales teams are incentivised.
4. “You need to know our costs or drive our costs down more.”
This one follows directly from the one above – if not a sales-driven organisation, it may adhere loyally to a strict cost-based pricing strategy. Do the finance team have a large say in pricing strategy? This gives a great indication as to where your work should begin
5. “It will not work for us – as our industry is different.”
We left this one to last – as it is probably one of the most common comments. The funny thing is that we have not seen an industry yet where pricing improvements cannot be made.
We do not intend to belittle the common queries made by non-pricing professionals. Of course, they can be valid concerns when not answered with a clear and comprehensive solution.
Let’s explore what can be improved. Your sales team defines price as what’s on the invoice. The CFO defines price as ‘what we take to the bank’. Your customer says the price is too high. Your pricing manager says that price doesn’t match our standard terms. The distributor says they can’t make any money on your line. However, it’s still Monday morning!
So what defines and indicates price?
Can you improve net price realisation and take more money to the bank? I prefer price as what goes to the bank, after all, discounts, returns, warranties, commissions and other deductions before determining the final price.
There are several elements to price management. The first is achieving the optimal price for each good or service. The second is managing your product mix and services to achieve the optimal price for a set of customer transactions.
For many firms, the difference between what’s invoiced and what’s banked is over 10%, made up of co-op, early pay, volume rebates, freight allowances, returns and other factors, defined and imagined. The difference between list price and invoice price is often over 20%.
For example, if a business has a 10% operating margin and can increase realised prices by 1% without materially affecting volume or costs, much of that incremental revenue can flow through to operating profit. The precise impact depends on the business’s existing margin structure and cost base.
Do you spend as much time thinking about price as you do thinking about costs? We will discuss 6 things that you need to be attentive to that can help improve your pricing and profits.
Here are 6 steps to consider that can improve your pricing methods and profits:
-
Have a clear, executive-level pricing proprietor.
Most organisations do a great job of managing pricing execution and deals flow. Your pricing manager may be doing a good job tactically, however, they should also be thinking strategically. It is great to have a capable and experienced owner of pricing strategy who can think ahead into what to do more in the future.
Systematic pricing reviews remain an important part of effective pricing management, particularly when businesses need to respond to changing costs, customer demand and competitive conditions.
What to do: Delegate one of your executive team, most likely the VP of Marketing or CMO, with building a pricing team and enabling them to develop a pricing improvement plan and process.
-
Optimise your product range.
Classify your customers and understand which ones are price sensitive. Have a basic price fighter in your range that will meet their needs without disrupting your full product line pricing.
What to do: Look at your product pricing methods vs. your user segmentation again.
-
Align sales compensation with profit growth.
If your reps are paid with basic wages (not for profits or price improvement), what incentive do they have to fight for the best price?
If you were selling and could make 5% commission on $1000 with little effort, or 5% commission on a $1010 sale with some effort and risk, what would you do? The 1% price lift is worth a negligible amount to them but a huge amount to your bottom line!
What to do: Consider having, at a minimum, your sales leaders receiving an incentive on the expansion of either average selling price or gross margin.
Pricing Recruitment For Pricing Managers!
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Revisit your ‘price waterfall’ annually.
Check on all price deductions made prior to the final net price.
Are programs such as co-op still pulling their weight as you’ve shifted your pricing strategy to inbound marketing, pulling away from distributors to create demand? Do customers take an early pay discount when paying after the early pay period has expired?
Once you have established your price waterfall, compare it to your leading competitors. When you do, you are pushed to match invoice price plus you have more attractive trade terms. Oftentimes, your customers and sales team aren’t discussing in a price negotiation.
What to do: Conduct a review of you and your competitors, pricing methods, selling terms and price structure annually.
-
Understand your customers’ value.
Do those who set your prices truly understand your customers’ value? Do you have a pricing playbook and value pricing method which continuously reinforces the value of your products What diagnostic tool did your team use to improve pricing?
What to do: Ask your customers why they buy from you. This is a value discovery program.
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Set expectations of annual price improvement.
Most businesses are worried about losing market share. Therefore, creating a culture of price improvement will ensure pricing is always top-of-mind for your commercial function.
What to do: Establish an annual price improvement goal and analyse on a regular period.
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Price optimisation is not about selling less at a higher price. It’s about eliminating the leakages and practices that enable you to capture improvement in a systematic way in your net price realisation. How much time do you or your team spend thinking about these questions? How much time is it worth thinking about to get a 10% expansion in operating profit?
In a very competitive business environment, companies need to capture the full value of their products. They can do it using different distribution channels in order to be successful. The good thing about focusing on the steps mentioned above is that they are very easy to implement and can start making profits almost right away.
See our blog on how pricing can help when making a business plan. Also, see our blog on 5 real issues with a cost plus pricing strategy and transformation pricing.
Capability Building Programmes For Pricing & Sales Teams!
Cost-based pricing strategy: Communication skills vital for pricing leaders
Why is communication a prerequisite for pricing leaders?
At Taylor Wells, we are often involved in the implementation of pricing teams and functions in businesses. Where they were previously or where they have not been seen as core to the commercial proposition of the business. This can be when the dreaded adherence to a faulty cost-based pricing strategy or cost-plus can be very strongly defended.
Among pricing experts, cost-plus pricing is often criticised for legitimate reasons. For some stand-alone projects, a strict cost-plus approach can weaken the incentive to improve efficiency. If the price is determined by applying a fixed markup to cost, lower costs can also result in a lower selling price and therefore reduce the dollar value captured through the markup. Conversely, a higher cost base can produce a higher price without necessarily reflecting greater customer value.
Introduction to Price Optimisation 💰 Podcast Ep. 74!
Another limitation is that a cost-based pricing formula does not, by itself, account for customer willingness to pay or competitor prices. Ignoring these factors can result in prices that are poorly aligned with market conditions.
In this blog, we do not intend to cover any of the well-known weaknesses of a cost-based pricing strategy but instead touch on some of the pitfalls that can happen when a new pricing lead or revenue manager seeks to gain buy-in for a pricing optimisation program or movement towards value-based pricing. At Taylor Wells, we are ardent believers that a pricing leader is also a business leader, i.e. not a segmented function such as purely finance, risk or legal. If you really want to transform pricing in a large company, you need to win buy-in from sales, marketing, finance, the C-suite, operations. In other words, all departments. It’s certainly not easy to do this. We feel underappreciated sometimes with the task at hand.
How to broach the elephant in the room? Cost-based pricing may not be the best approach in every situation.
I was chatting to a friend the other day from a company where I used to work at. I was asking about the commercial strategy and who is setting a pricing strategy. He said, “How can they set prices when they do not even know the costs?” At that point, I do not have enough time to go down the road of explaining value-based pricing. Also, I do not want to criticise my friend who seems so committed to cost-based pricing strategy. Opinionated people exist. They stick to what they believe in. They see it as a form of hearsay or lazy/shady marketing waffle when they hear anything different.
It can be an exhausting experience – winning buy-in from multiple functions for a move to value-based pricing. However, it is vital to build any pricing transformation. In fact, we view it as laying a solid foundation for the transformation. Otherwise, you are sure to find the optimisation program will flounder as if on quicksand.
There are sometimes strategic and tactical reasons to use cost-plus pricing. When used in the right circumstances, cost-plus pricing can provide a simple and transparent pricing baseline, particularly where costs are predictable and contractual or regulatory requirements make cost recovery important. However, it should generally be tested against customer value, demand and competitive conditions rather than used as the sole basis for pricing.
No pricing method is easier to communicate or to justify. Cost-plus pricing is inherently fair and nondiscriminatory to customers. That is if the business is 100% sure of its cost position. Most are not, however, and the cost base of products are often guesstimating rather than precision.
Cost-plus pricing and value-based pricing start from different points. Cost-plus pricing begins with the cost base, while value-based pricing begins with customer value and willingness to pay. In practice, businesses can use cost information alongside value and market information when making pricing decisions.
Providing useful and understandable explanation and evidence on Cost-based pricing strategy
Taylor Wells commits to an education-based form of marketing pricing and pricing recruitment. We strongly believe in the ability of pricing to deliver sustainable profit and revenue boosts to even the most established business. When you are a pricing professional, the benefit of value-based pricing is almost self-evident. Still, we sometimes need to remember how we discovered the profession in the first place.
Usually, a light-bulb moment when value-based pricing becomes clear to us. The challenge in spreading the word to others is helping them to have their own light-bulb moment. More often, the trick can make them believe that they thought of it themselves!
Pricing Recruitment For Pricing Managers!
Implications
Cost-plus pricing can be useful in situations where businesses need a transparent and consistent way to recover costs, particularly when costs are predictable and contractual or commercial requirements make cost recovery important.
However, cost-based pricing can become problematic when businesses use it as the primary basis for setting prices. A cost-based price may not reflect what customers are willing to pay, how much value the product or service creates, or how the business is positioned against competitors.
Businesses with a genuine cost advantage may also have an opportunity to capture more value than a standard markup allows. Rather than automatically passing cost savings through to customers, they should consider whether those savings create additional economic value that can be retained through better pricing.
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Conclusion
Cost-plus pricing is not inherently a bad pricing method. In the right circumstances, it can provide a simple and transparent baseline for recovering costs and establishing an initial price.
The problem is relying on cost as the primary determinant of price. Costs tell you what it takes to produce or deliver something, but they do not necessarily tell you what customers are willing to pay or how much value your product or service creates.
For businesses looking to improve profitability, cost-plus pricing should therefore be treated as one input into the pricing decision rather than the entire pricing strategy. Combining cost information with customer value, willingness to pay, demand and competitive positioning gives businesses a stronger basis for capturing the value they create.
Capability Building Programmes For Pricing & Sales Teams!
Pricing System To Build A Culture of Collaboration In 100 Days
Pricing system: Our brains have hidden depths – and there’s a lot of untapped potential within us all. Whether it’s psychological tricks or proof of concept, our minds are biologically programmed to be receptive to external influences and cues.
In recent years, executive teams in Australia have increasingly found themselves wrestling with complex business problems such as pricing system issues.
They have been encouraging their teams to collaborate and embrace new pricing skills, team management skills, pricing system and practices to improve performance and in much shorter time frames.
Yet, dealing with a consistent stream of resistance and complacency from their people and customers has been a tough problem many businesses have not overcome.
For some executives, it was a no brainer, they were captivated by the pricing potential in the business and wanted to be the one who generated significant wealth for the business and its customers.
Introduction to Price Optimisation 💰 Podcast Ep. 74!
Many businesses were transitioning to the next phase in operations, and this in turn required a complete re-think of their current pricing system and sales operations.
The problem was, though, they also saw a proliferation of people problems attached to moving the business from cost-plus pricing system to more sophisticated pricing strategies and analytics.
Many gave up.
At first, CEOs and executive teams asked their managers and teams to work together to make the pricing project a success.
But often the message to ‘play nicely’ and accept new pricing practices were not getting through to the bottom line.
Teams across supply, pricing, sales and finance functions would resist or at best comply with broader directives to embrace more sophisticated pricing and sales strategies and analytics.
So, businesses started to recruit some serious leadership muscle and brainpower.
Pricing Recruitment For Pricing Managers!
What a smart pricing system can do
Instead of telling people to change their outdated thinking and pricing processes like it is their patriotic duty, smart leaders began trying to understand the psychological resistance to changing prices in the first place.
Most businesses found that value-based pricing was being labelled ‘consultant jargon’ by key leaders and influencers in the business – i.e., difficult to execute, right in principle but not in practice, etc.
They heard people say that dynamic pricing only works for airlines and would never work in this business…
Companies observed their sales, supply, operations and finance team’s insecurity surface as they began to change the most basic of operations and price administration.
So leaders started to launch campaigns to their peers, teams and stakeholders in an attempt to re-brand alternative pricing approaches as “pricing transformation.”
They also began to teach stakeholders and customers on how to think, feel and implement more sophisticated market strategies. They also re-framed their value relative to their customers’ key value drivers and better KPI’s (not just volume targets).
Once the sales teams started to see the results of reconnecting with customers using pricing as a device for wealth creation across the value chain, more teams became interested in working together to achieve collective goals.
Very quickly, the mission for all teams was to find innovative ways to deliver more complex business outcomes.
As more businesses and stakeholders within these businesses started to engage in the “pricing transformation,” resistance decreased.
Silos, turf wars and unhelpful patterns of thought diminished at the same rate as teams internalised better sales and pricing into their everyday thinking and routines.
Today, value-based pricing is an established approach across many large businesses, while algorithmic pricing and AI are increasingly important areas of pricing and revenue management.
It may sound like a straightforward marketing campaign, but for today’s leaders, a subtle rebranding of pricing projects as a ‘set and forget’ practice to a ‘transformative learning’ process has gained status across industries.
When you associate pricing with transformative learning, you introduce 3 crucial psychological and pricing devices:
- psychological (changes in understanding of the self)
- convictional (revision of belief systems)
- and behavioural (changes in price practice and habits)
Taylor Wells observes some of the best leadership executives using some form of psychological intervention to identify and address a range of people and business problems, from team performance, change management, recruitment, to strategic planning and implementation.
People are your biggest asset and your biggest liability.
Team underperformance can create significant costs for Australian businesses through lost productivity, poor decision-making and ineffective execution.
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Conclusion
Many businesses have not overcome the tough problem of dealing with a consistent stream of resistance and complacency from their people and customers.
Companies also saw a rapid increase of people problems attached to shifting the business from cost-plus pricing system to more sophisticated pricing strategies and analytics.
Capability Building Programmes For Pricing & Sales Teams!
The Best Distributor Pricing Model to Improve Profitability 🏪
What’s the best distributor pricing model for B2B firms selling and/or distributing products that are increasingly commoditised and competitively priced?
As markets change and whole industries are disrupted, the business models in the distribution sector are firmly in the process of continuous improvement. However, change is not consistent.
There are two types of business transformation happening in Australian distribution right now. The first comes from relentless commoditisation eating away at cash flow and profitability; basically last dash cost improvement exercises. For these businesses, it’s a fight for survival. The second comes from creating radically different business models and processes that are inherently value-based. These businesses are looking for innovation, growth and largely doing by establishing their value and worth using price and revenue/growth initiatives.
The distribution industry then is changing overall for the better. And, now more than ever, distributors are seeking to reconnect the business to their customers. Procuring higher-margin products and services that customers really need and value. Getting rid of stocks that are leading to soaring running costs. And pricing products and services at the optimal price rather than underselling themselves. Unfortunately, many pricing transformations fail to deliver their expected results.
In this article, we will continue to discuss the new distributor pricing model. We will look at how change and improvement are taking place at every corner of B2B distribution firms from procurement, finance, operations, strategy, product design & rationalisation, and IT upgrades. We argue that pricing – underpinned by a full investigated of value (internal / supply and value chain / go-to-market) – is the lever to capitalise on new B2B distributor value drivers while abating increasing and immediate competitive tension.
At Taylor Wells, we strongly believe that better people, value capture mechanisms and price data analytics can help distributors build competitive advantage and improve profitable growth more effectively than traditional approaches.
By the end of this article, you will learn the 5 best ways to capture more value using the latest distributor pricing model.
Issues of Cost Plus Pricing in the Forex Market 📉 Podcast Ep. 73!
Pricing: The Most Powerful Lever for Distributors
Pricing is the most powerful lever for increasing and improving gross margins and boosting profits for a distributor. Because price typically flows more directly through to revenue than volume or cost changes, even a small improvement in realised price can have a disproportionate impact on profitability when volume and costs remain broadly stable.
Price is top of mind for most customer procurement teams so you need to ensure that your prices are right. Procurement teams focus on cutting costs, and they see your line of business as a means to do it. You need to demonstrate the value of your product portfolio. So that they don’t cherry-pick at line items and request excessive price reductions.
Unfortunately, most distributors struggle with striking a fair and equitable value exchange. The price data structures are commonly full of holes and skills shortages and unreliable and price complexity slows down vital progress. Especially for list price strategies and price optimisation purposes.
Take for instance a B2B distribution business we know that had more than 20,000 SKU items, 2,000+ customers and 5 different market groups. The business could potentially have around 75 million price records. Though it is improbable that 75 million prices would be actually needed in commerce, this illustration shows just how complex the distributor environment can get without the right price management in place.
In the future, then, to be a successful distribution business, consider price optimisation. Price optimisation helps distributors sort out price complexity, but more importantly speeds up profitable revenue growth. Improving pricing helps sales teams generate more profitable sales and executive drive business strategy.
Overcoming Misconceptions: Key to Optimise Price
Skilled salespeople and even pricing teams still believe that increasing prices also means losing deals. Most especially if the competitors offer the same products. They may also argue for vigorous excessive discounting to make big customers happy and achieve their volume goals. However, the truth is more nuanced as revealed by qualitative and quantitative research.
So, how do pricing teams overcome these misconceptions and increase their win rates? Experienced pricing teams can improve their win rates with the best estimates of The Total Value to Customers (TVC). And by how much customers are actually willing to pay now for both commodity products and value items and offers. Some of which are: one-stop shopping in all categories, a wide range of brands and models, convenient and fast delivery, flexible return policies, financial assistance for small and medium-sized businesses, and product expertise.
The urgency for change is stopping margin loss. Reducing prices continually is a race to zero profit. In the long term, it’s more logical to create pricing tactics on each customer’s willingness to pay and then sharpen understanding of the non-price elements that the customer values most as team capability and understanding of customer value improves.
Building a Distributor Pricing Model to Create Value
Some distributors have been pioneers in embracing pricing as a discipline. A growing number have invested in establishing pricing teams with a directive to provide profit margin improvement every year. They are also developing price architectures that reinforce pricing discipline and link to pricing analytics and other tools or software to capture value.
We have identified 5 key components of creating an income-generating distributor pricing model. A model that builds considerable, steady increases in margins, even during the economic crisis:
1. Create a dedicated pricing organisation.
We know a major foodservice distributor in Melbourne, for instance, where discretionary pricing by sales and excessive discounting was widespread. The business was facing jaws of death situation and they decided to establish a new pricing team to help them control pricing and protect margin. However, integrating the new pricing team was not easy. It took the business a couple of years to create a streamlined pricing organisation with support in branches locally.
The pricing team reported to the chief operating officer and had a directive to steer annual margin expansion. They decided to gain support in the business and build credibility by launching quick-impact measures in pilot locations. Their approach was to create enough eagerness to start a pull from several branch managers instead of a push from the ivory tower. They got some traction, but there were also key lessons learned and not everything they did work.
However, after only 3 months, the pricing team was generating impressive incremental EBIT growth. The organisation invested more in its pricing team to further improve its capability. The foodservice distributor is now officially a revenue-generator (rather than a struggling distributor). They have continued to generate additional margin through focused pricing initiatives, particularly in margin-constrained and high-growth segments. They have a reputation for performance with their customers and trusted strategic partners.
2. Use world-class processes in the pricing team.
Consider using best-in-class roadmaps, frameworks and inputs from pricing sales and marketing teams to define better pricing setting and management processes. This includes steps, owners, inputs, and outputs. From here, your business is in the position to achieve the thoroughness, structure, or oversight required for consistent profit maximization. Everyone is clear on what they need to do to achieve shared outcomes.
3. Adopt advanced analytics and digital transformation.
More than ever before, leading distributors are switching to advanced analytics to determine pricing opportunities. Using advanced analytics and embracing a digital transformation will improve the company’s margins significantly. Not only that but will also minimise human error and pricing variability. They should also establish pricing teams who in turn provide the business with evidence-based price guidance, benchmarks and data/quote tools to create better pricing decisions.
4. Tie sales with revenue and margin growth.
World-class sales organisations are tying compensation increasingly to both revenue and margin growth. But traditionally, the compensation of sales reps has been aligned to volume instead of margins. Sometimes leading to revenue growth at the expense of profit.
For example, we know an electronics distributor that was experiencing serious margin erosion in spite of solid sales growth. The company later discovered that its sales reps (that were solely compensated on sales growth) were offering free shipment and expedited shipping and reducing prices in order to “win” deals. However, a change in the compensation model and pricing strategies has improved both sales and margin growth.
5. Build trust and buy-in.
Building trust with sales teams can be achieved by getting results quickly and working with the right people. For example, working with general managers first to handle pricing initiatives in specific branches gets cut through much quicker than working directly with branch or sales. And then, once done with pressure-testing for impact, share results with the broader sales teams who in turn will ask you to roll out for them (rather you asking their permission). To build credibility within the broader sales-and-marketing function effectively, utilise general management in price trials and tests.
Discussion
Price improvement is not just a financial lever for immediate profitability. It is also a change management lever enabling B2B distribution to address the destructive issue of commoditization.
However, moving from a basic cost plus distribution pricing model to value-based pricing isn’t easy. It requires a value culture. Price management can be a big issue for distributors with thousands of SKUs and customer groups and multiple market segments. The combination of cost-plus and net pricing negotiations over time have created great deals of price complexity for B2B distributors. Which now, in turn, require much better price management and pricing-specific technology.
Distributors increasingly seek higher-calibre talent to successfully transition to new pricing models and ways of thinking – and at every level and department in the business. In pricing for examples, distributors are now hiring high calibre pricing executives to redesign price architectures, transform cost plus thinking to value-based price setting, design performance rebates that grow share of wallet. And the reason behind this is strategic. Essentially better hires can think of better strategies to ensure the business get the full value they deserve. What’s more, they have the skills to implement a value-based business strategy. And here lies the secret of business longevity for distributors.
Pricing Recruitment For Pricing Managers!
Implications
- Research and industry experience suggest that end-to-end pricing transformations can generate significant earnings improvements, often with less impact on volume than businesses initially expect.
- Sales teams can sell more and better. They not only issue more accurate quotes to customers, they also improve customer experience. Customers hate waiting for prices when they are ready to buy.
- Distributors’ value to the customer increases as the firm focuses more on improving their performance in areas that matter to the customer: i.e., supply chain, customer service, technical expertise, innovative products.
- Rigorous pricing processes reduce missed opportunities, minimise the risk of excessive discounting and impose global consistency.
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Bottom Line
Distributors work in a fast-paced setting. Oftentimes, they are processing thousands of deals and transactions each day. Everything should be quick and easy. But often it’s not. Managing inventory, supply and cost fluctuations can be a nightmare. Let alone, restructuring your pricing and revenue management to realise additional price premiums.
However, with the help of a good pricing team, distributors do move successfully from a trading business to a customer-focused business and margin growth occurs. Over time, they develop an effective price architecture that not only helps them manage prices but also focus on what matters to their customers.
Sometimes, success can mean winning mega-deals in high growth segments, but oftentimes success in pricing is under the radar and focused on the longtail of products and customers.
The pricing team, then, should support a distributor to implement the latest distributor pricing model to continually make more revenue and margin regardless of how commoditised or competitive the industries are and guide the business strategy on new growth opportunities in the best way possible.
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For a comprehensive view on integrating a high-performing pricing team in your company, download a complimentary whitepaper on A Capability Framework for Pricing Teams.
Are you a business in need of help to align your pricing strategy, people and operations to deliver an immediate impact on profit?
If so, please call (+61) 2 9000 1115.
You can also email us at team@taylorwells.com.au if you have any further questions.
Make your pricing world-class!
