How do you determine prices for your products and services? Start by looking at value from the customer’s perspectives rather than your costs, says columnist William Cohen. Here’s why.
Price is one measurement of value. Some think the customer’s preference for a particular price is irrational. Sometimes it is easy to explain why customers insist on paying more for a product when lower priced products of equal or better quality are available. When there is limited information available about the product and potential customers have no experience with it, it is perfectly rational to assume that the most expensive product is of the highest quality and worth more. Similarly, if a price reduction fails to increase sales, maybe it’s too small relative to the original price to attract much attention. Or other factors may be seen as far more important such as reputation for the reliability of the supplier, but this is not irrationality. Drucker’s conclusion was that the customer is not irrational and that marketers must examine these issues from the customer’s perspective to uncover the real issue so that it can be dealt with.
Start with the Customer’s Perspective
The marketer must start with what the customer wants to buy rather than what the supplier wants to sell. For many years foreigners saw more pictures of one American more than any other. It was not a picture of an American president, a famous general, a religious leader, or a founding father. Rather, it was a man who sold safety razors. He wasn’t the first to sell a safety razor, and he didn’t invent the safety razor. His razor wasn’t any better than anyone else’s and it was more expensive to produce. The man in question was King Gillette and his picture was on the packaging of every blade. Every blade cost him less than one cent and he sold each for five cents. That’s a nice markup, but it was a win-win. Since the blade could be used at least six times, the buyer got a shave for less than one cent. That was one-tenth of the going rate for a shave in a barber shop in those days.
Gillette understood his customers. He priced his razors at about 10% of the price of his competitor’s safety razors and positioned his buyers to enjoy a tremendous cost savings at the same time. He realized that the customer was not buying either razors or blades. That’s only what his company manufactured. The customer was buying shaves.
According to Drucker, this is what pricing is all about. Any marketer willing to use the customer as his basis of pricing could acquire industry leadership almost without risk. To enable us to do this, we also need to look at cost, but not until we start with the price and determine it from the customer’s perspective.
Concept of Chain Costing
Do you have a favorite gasoline station where the price difference is as high as 5 cents a gallon? If the drive is a mere five miles across town versus the gas station one a block away, you may be better off paying the additional five cents. Look at the figures. Let’s say your car gets 15 miles a gallon while driving in town. To get back to your starting point is 10 miles. If the gasoline costs $3.50 a gallon at the cheaper gas station, this additional drive cost you 2/3 of a gallon x 3.50 or $2.33. Now if your car holds 15 gallons, you saved 75 cents. Not bad. Your drive was a net loss of only $2.33 - .75 or $1.59. But wait. If your little trip across town took 15 minutes and was made during work hours, you better factor that time in. How much do you make on an hourly basis? Let’s make it easy. If your salary and benefits total $100,000 a year and you have 2000 productive work hours in a year, that’s another negative $12.50. I’m leaving out wear and tear on your tires, engine, insurance, etc. In my own city, one of the local radio stations always announces the cheapest gasoline in town. It’s always a few cents. But heck, even if the gasoline was a dollar a gallon saved you’d barely break even. Congratulations, you have just grasped the importance of chain costing which says simply that you need to consider all of the costs in the chain.
The importance of looking at the entire economic chain is hardly new. This concept was first expressed by economist Alfred Marshall in the 1890s. Marshall was no slouch. He was the one who brought the basic concepts of supply and demand, marginal utility, and costs of production into one coherent theory. Unfortunately, many practitioners thought his work exactly that, pure theory with no practical application. Drucker thought differently.
The notion of chain costing is representative of your total costs for a particular product or service, but it may also reflect costs that your customer may be paying which may or not be understood by him, such as the attraction of saving a few cents at the pump. But as smart marketers setting price should be understood by us if we are to really understand the various factors involved. It may also help us in understanding the advantages, as well as the challenges, in vertical integration of the entire process of controlling the product from planning and design to post sales actions whether or not this is even seen by the ultimate consumer. To put it in Drucker’s terms, "What matters in the marketplace is the economic reality, the costs of the entire process, regardless of who owns what."
Other Important Aspects of Cost
Drucker liked to point out that we are frequently too quick to assume present costs will be forever, whereas smarter marketers and price-setters, take over our markets again and again by looking at things differently. That’s why the U.S. didn’t hold the market for fax-machines even though they were invented in the U.S. The Japanese didn’t look at costs for production of the initial numbers of fax-machines, but at numbers sold several years in the future. Strangely, the process of using a learning or experience curve to develop future costs and apply them today was developed in the U.S.
This came about due to Boeing’s production of the B-17 bomber when analysts at Wright-Paterson Air Force Base in the late 1930s found that every time total aircraft production doubled, labour decreased by 10 to 15 percent and costs went down. Subsequent empirical studies from other industries and products yielded different values. Regardless, the curve of decline could be determined and used to predict future costs. The whole method was good enough to be employed throughout World War II and is still required of those bidding on government defense contracts today.
Drucker’s lesson was that price should determine cost rather than the other way around. Once you have the price, it is only prudent to look at costs to ensure that the product can be sold profitably. But you need to consider all aspects of costs, including the fact that as we produce more of anything, costs will decline.
*Adapted from Drucker on Marketing to be published by McGraw Hill September, 2012