The formulas, tricks and trade secrets of Private Equity

Cost Driven Pricing

Sample Chapter

Correct pricing is of paramount importance in any business. Pricing directly relates to demand, which directly relates to sales, which directly relates to profit, which directly relates to value, which directly relates to carry. Yes, the C word. If a business charges too much, it won’t be competitive. If it charges too little, it won’t be profitable. At worst, a business that doesn’t price correctly will be competed out of the market or driven to a loss-making state. With the right pricing, a business will lead its field, build brand loyalty, have the cash to expand, and be highly profitable.

There are generally three different pricing strategies as follows:

  • Cost driven pricing: this involves adding up all costs and adding a profit margin to arrive at price.
  • Competitive pricing: this involves using the prices of competitive products to arrive at your price.
  • Price-driven costing: this involves understanding the ideal market price and incurring costs accordingly.

As per Peter Drucker’s Five Deadly Business Sins:

The third deadly sin is cost driven pricing. The only thing that works is price-driven costing… to start out with price and then whittle down costs is more work initially. But in the end it is much less work than to start out wrong and then spend loss-making years bringing costs into line – let alone far cheaper than losing a market.

Drucker’s argument on cost driven pricing is certainly robust and prescient. It talks about delivering on required specifications and required price; the two go hand-in-hand. Whereas, the typical method of pricing is to design a product based on initial market testing about specifications, and price it according to the costs incurred for the desired (and assumed) specification. This ignores the relationship between specification and price; customers only want a particular specification if the price is right.

As my introduction on cost driven pricing suggests, pricing can create effect all the way down the food chain (all the way to a firm’s carry). With that said, I thought it would be an interesting topic for today, especially for investees that are proactive in developing new markets (and new pricing).

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