Cost-Based vs. Value-Based Pricing

Pricing is a very important aspect of being able to sell a product or a service. I understand this even more after I started my own business. When I started initially, the only way I used to price for our products and services was to determine the cost incurred by us and then adding a suitable margin of profit on top of that.

So, essentially, we had adopted Cost-Based Pricing Model.

We used to keep the profit to the minimum (sometimes even Zero) to be able to acquire Customers. However, this strategy did not always work. We were not winning contracts just by being the lowest in price. Even worse was the case that in spite of our conservative approach, larger companies were offering the same product or service at a price lower than ours.

One Earlier Experience with Pricing

Reliance Telecom Limited (RTL) provided Mobile Telephony services to 9 circles in India. RTL was owned by Mr. Anil Ambani. Siemens Information Systems Ltd (SISL) provided most the IT Solutions to RTL for this purpose. In 2009, RTL was merged with Reliance Communications Ltd in 2009. Reliance Communications is owned by Mr. Mukesh Ambani.

I was made responsible for providing all the products and services for RTL when I joined SISL in 2005. At that time, RTL had just acquired an eServ IN and I was incharge of providing the transition from CDR based Billing system to IN based Billing system.

In 2006, RTL wanted to provide GPRS Services (Data Services). So, they asked us for an estimate to provide a GPRS Billing system.

Providing a GRPS Billing System meant that we had to create an entirely new system. We estimated our cost for this to be Rs. 60 Lakhs. We added a profit margin of 20% and quoted Rs. 72 Lakhs to RTL.

When we went to RTL for negotiations, RTL stated that they were willing to pay Rs. 6 Lakhs for the system.

Our Management negotiated and ultimately agreed to sell the system for Rs. 14 Lakhs.

But it was not a bad deal for SISL

A company like SISL could afford this as SISL earned 60+% EBIT through Annual Maintenance Contract (AMC) to RTL.

When I think about this, I am sure if such a dilemma comes across my firm now, we will have to forego the opportunity as we cannot afford to provide a system incurring so much cost and not recovering it.

But we made it even better for SISL

Unknown to the Marketing Team and to the Senior Management, we introduced in the contract a limited number of parameters based on which the GPRS Billing System would function. Now, GPRS Billing can be done on a large number of parameters. Using each of these parameters, RTL could have launched multiple number of packages for tits Customers. For example, we did not include the Quality of Service (QoS) parameters in the contract.

Soon after we supplied the GPRS Billing System to RTL and it went live, RTL asked for addition of more parameters based on their Marketing Plans. So, we got Change Requests (CR) for including these parameters. In total, we got 3 such CRs.

A few months after GPRS Billing System went live at RTL, RTL was looking for introducing MMS (Multi-media Messaging Services) for their Customers. So, they required a Billing System for MMS.

Now, MMS Billing System was almost the same as GPRS Billing System. However, we quoted for this as a new system. We essentially configured the GPRS Billing System and the MMS Billing System was ready. So, we recovered some more.

Very soon, RTL required Roaming Billing System for Data Services. Now, we had already developed a Roaming Billing System which we had sold to Dialog Telecom (Sri Lanka) and Bhutan Telecom. We provided the same system to RTL at the price we had quoted to Dialog (when we developed the system).

We spent 2 man-months of effort in implementing Roaming Billing System at RTL and we charged them Rs. 36 Lakhs. (See TAP Story).

What was the Value of the GPRS Billing System to RTL at that time?

When we were costing for the GPRS Billing System, I had estimated how much revenue Data Services would bring to RTL. In a simplistic manner, the estimates were as follows:

  1. RTL had about 5 million Subscribers at that point of time.
  2. Suppose, RTL could convert 10% of the Subscriber Base to use the Data Services, it would mean a Subscriber Base of 500,000 for Data Services.
  3. If at an average, each Subscriber of Data Services consumed Rs. 10 per Day, it would mean a Daily Revenue of Rs. 5 million (Data Services were expensive at that point of time in India).
  4. This would extrapolate to an Annual Revenue of about Rs. 1,500 million.

I had proposed to my Management that we should charge for our system considering this fact. However, it was not possible to do so at that point of time.

Moving from Cost-Based Pricing to Value-Based Pricing

I stated the above example to illustrate the need for Pricing for Products and Services differently as compared to just considering Cost and Making Up the Cost. So, here comes the concept of Value-Based Pricing.

Value-Based Pricing actually means determining the Price that a Customer is willing to Pay.

A very good example of Value-Based Pricing is Google AdWords. Here, every Customer places a Bid for the amount he/she is willing to pay for display of their Advertisement. The Customers who bid higher get more visibility from Google and the vice-versa.

To be able to conduct meaning Value-Based Pricing, we need focusing on 4 Pillars of Value-Based Pricing.

Pillar 1: Customer Insights

Before a Product or Service can be Priced, it is very vital to understand what the Customer is willing to pay for the Product or Service.

I illustrated one mechanism above to determine what the Product would mean for the Customer in terms of Revenue. However, as you would have also noticed is that Customer may not be willing to pay in proportion to the Business Value of the proposition.

However, another fact also remains is that there will be some Customer who will always want to pay less and some Customer will value the Business Proposition & value the research conducted by your company, etc.

So, based on this fact, we need to segment our Customers – one is the Price Seekers and one is the Value Seekers.

Many Companies start 2 separate brands – one for Price Seekers and one for Value Seekers.

However, this may not be possible for small business houses like our. Or for that matter, it may not be possible for divisions of a large company.

So, for such a situation, we adopt a strategy where we spend a little to determine the kind of budget our Customers are willing to spend for a Project and then put them in a Price Seeker or a Value Seeker class. Based on this classification, we quote a Price to the Customers.

For this particular Bid for this Customer in Thailand, we set up a partnership with a System Integrator in Thailand who had been supplying systems to this Customer for the last 10 years. Through this Partner, we got insights about the Customer and also they used their links within the Customer to get insights about our Competitor’s relationship with the Customer. We had to part with some of our profits as a result as the Partner would take away some of the Revenue.

However, this is also not so easily done. We bid for a Project in Thailand. We determined that our Customer was a Value-Seeker. Also, we got insights into the price our only Competitor was likely to quote. However, our Competitor was the incumbent provider of that product and we had to displace them to win the contract. So, inspite of our Customer being a Value-Seeker, we quoted lower than the Value to this Customer to displace our Competition.

A Much Bigger Challenge for us was to determine what Value we would add to the Customer. We were selling an Interconnect Billing System. The Customer already had an Interconnect Billing System. Now, there were some regulation enhancements required to their system like they wanted a much more efficient Partner Portal which would reduce the work load on their Internal Staff and possibly lead to reduction in man-power required. Also, they wanted a Mobile Application for their Partners which would possibly result in faster settlement of payments and also faster settlement of disputes. However, these would not lead to significant improvement in the Revenues for the Business.

Ultimately, we found an area which could make a huge impact to the Revenues for the Business. We developed a Neural Network Based Least Cost Routing Module. Now, using this Artificial Intelligence enabled module, they could route their calls in the best possible way to maximise their revenue.

However, this would come at a cost to the Customer.

Pillar 2: Pricing Economics

Common notion is that if the Product or Service is priced low, the chances of its sale are higher. However, this is not always true.

I, for one, very rarely purchase a product or service at a discounted price. I almost never take anything, in work or personal life, which is offered for free. I am sure there are many Customers like me.

The most important aspect is that we need to determine which Costs are relevant to us and which are not.

I try to explain with an example. I wrote a book which my publishers priced at Rs. 648 per copy. My cost of publishing the book was about Rs. 1,20,000. Now, the publisher was selling the book through various channels like Amazon, Good Reads, etc. Amazon had put up a price of Rs. 1,250 for the book. The publisher offered to sell me copies at Rs. 200 each. I bought a few.

I tried to sell my copies through a Book Store in Bangalore. The Book Store offered me Rs. 300 per copy. However, after some time, I was unable to sell any copies and I still had quite a few copies with me.

Now, I had to decide whether I would continue to sell at the same price or at least at the cost price OR I would sell them at a lower price. If I did not sell at a lower price, the chances were that I could possible never be able to sell the remaining copies.

Price Elasticity

Another very important aspect to consider is Price Elasticity.

If we come across a situation when we have to increase the Price of the Product or Service, there is a common notion that the demand will decrease. However, this is not always true.

If the Product or Service is Price Inelastic, then lowering or increasing the Price will not effect the Demand.

I cannot quote an example from our experience as I have not come across the situation in our company. However, we faced such a situation when dealing with Bhutan Telecom. Now, Bhutan Telecom was totally dependent on Siemens for the supply of IT systems. Changing Siemens Systems for any other Vendor would mean a huge investment for Bhutan Telecom. Though we used to always quote lower price for Bhutan Telecom (as we had to supply everything to Bhutan at a lower cost), we were always at a position that we would normally get the price that we quoted.

Pillar 3: Pricing Management

Pricing Management is about managing what you want to charge for the Product or Service versus what actually ends up in your Bank Account.

Differently worded Pricing Management is actually Discount Management.

The most important aspect here is that Discounts should always be given at a Cost.

So, when we give a discount to our Customers, we always reduce proportionate amount of features in the product.

I gave you an illustration earlier in our Reliance Story.

Discounts should always come with some Pain for the Customer. If it does not, it can termed as a Stupid Discount.

Pillar 4: Pricing Psychology

At the end, it is not the Price that drives the Customer’s Behaviour. But it is the Perception of the Price that drives the Customer’s Behaviour.

When we tried to sell the AMC for our products, we used to give our Customers 2 choices – a BASIC package and a ENHANCED package. The BASIC package would provide for 8 * 5 support with no onsite visits. The ENHANCED package would provide for 8 * 7 support and limited number of onsite visits.

Most of our Customers would opt for the BASIC package and a very few would opt for the ENHANCED package.

So, we repackaged our AMC. We now made the BASIC package as the COPPER Plan, the ENHANCED package as the SILVER Plan and we introduced a GOLD Plan in which the Customer would get 24 * 7 support and unlimited onsite visits.

Introducing the GOLD Plan tremendously increased the sale of the SILVER Plan. And quite a few even purchased the GOLD Plan. Now, almost none of the Customer would opt for the COPPER Plan.

Always start Selling from the Highest Option

One of the most important aspects of handling the Customer Psychology is that we must always start selling from the highest option. The trick is that we must introduce the highest option first and then gradually come downwards making the Customer aware of what he/she will not get in the next option.

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