We can often confuse price with cost. Fundamentally, price and cost have many similarities. However, understanding how to price your product or services beyond consideration for standard costs will prevent you from leaving profits on the table.
Chad Jardine is the CEO and a founding partner at CMO Zen, a fractional CMO firm specializing in early-stage companies. He has an MBA from the University of Utah and has spent 20 years as a marketing executive and CEO building and growing micro-cap companies. He has also been a mentor for startups at VentureCapital.org and Boom Startup. He teaches FINAN 6300 and 6310, two graduate courses in venture capital at the David Eccles School of Business.
Jardine uses his experience and knowledge of pricing to explain how companies can determine their value. Jardine reviewed the definitions of price and cost, different pricing methods used for valuation, and how to determine which method to use for your business in a recent workshop provided in the Lassonde for Life program, which is open to all University of Utah alumni and provides free, lifelong entrepreneurial support.
Defining Price, Cost & More
Cost is what you are paying to produce whatever you are selling. This includes manufacturing, labor, and other production costs. Price is what the buyer pays you for the finished good or service. Buyers may be willing to pay differently for products that offer a particular value.
Jardine said, “In layman’s terms, ‘price’ and ‘cost’ are often interchangeable. However, in startup terms, they are distinct.” He explained that price is bigger than cost; if you subtract cost from price, you are left with gross margin. “Pocket price” is a term coined by McKinsey and represents the amount a customer pays that may be reduced by various things before it’s collected, including discounts, promotions, trade credits, shipping, or rebates.
Margin is the percentage of the price that is profit, i.e., price minus cost, divided by price. It represents the amount we can realize from selling our product to our customers at the appropriate price. Markup is the percentage of your cost added to arrive at the price, i.e., price minus cost, divided by cost. It represents the amount we are recovering from paying to produce and sell our product.
It is important to understand what constitutes our complete costs before we can determine price.
Pricing is determined by demand, value, and willingness to pay. Jardine explained, “[Demand] is a customer research way of capturing what the customer values and what they are willing to pay.” If we understand this concept for our own businesses, pricing becomes much more interesting, and we can capture more value from our customers.
Jardine compared the concept of willingness to pay to the Bruce Lee quote, “Be like water,” which recommends that martial artists are flexible in terms of filling the space. He said, “An effective pricing policy is where you’re charging everything the customer is willing to pay.” This means that we may not benefit or profit as much if we don’t effectively absorb the customer’s full willingness to pay. We must afford ourselves the flexibility to expand our thinking from objective pricing methods to more subjective ones that account for the unique value proposition we offer customers.
Pricing Methods for Valuation
Cost-Based
Asset/Replacement Cost Approach – This method is when a company is valued at what it costs to replace it. In other words, all of a company’s assets and what they are worth is what the company is worth. An equivalent of this method for product pricing is a cost-plus pricing model, which is common when there is a lot of competition in an industry. In this example, markup may be determined as a fixed percentage and added to standard costs. This method is often used when flexibility is not available, and there is high competition and low differentiation. Jardine cautioned that if your margin is high, you may undercharge using this method.
Market Comparison Approach – This method determines value by comparison. Uniqueness is difficult to capture when determining value, and we often use comparable products or services to decide what something is worth. Jardine illustrated the example of home sellers researching home prices within a close radius and with similar size, age, or other characteristics to determine a selling price. For a company valuation, one would look within the same industry and sector to understand the average value for companies of similar scope and size. This can apply to startups all the way through IPO. This option is available in almost every industry but may not completely capture a company’s unique value.
Income (DCF/NPV) Approach – This method values a company by its net present value of cash flows. “Time value of money” explains that a dollar today is worth more than a dollar tomorrow because we can invest and multiply that money today to earn more tomorrow. The difference between money earned today and money earned in the future is called the “discount” and can be applied into the future to understand your opportunity today. Companies that have adopted a subscription model leverage this approach and have ongoing cash flows that can increase their valuation. This method requires cash flows that position the company to be valued fairly and may not be applicable to every business.
Value-Based
Value Comparison Approach – Described by Jardine as a “subjective niche willingness to pay,” value-based pricing prioritizes subjective value over objective value. He explained that value-based pricing considers what the people that love your product think it’s worth and said, “If you are only selling to your ideal customer, their willingness to pay is disproportionately higher than if we try to average willingness to pay across the entire market.” If your company offers unique value and you can identify key differentiators that your customer base can’t find elsewhere, you want that to be considered in your valuation. This method is likely the strongest approach to pricing but requires data on what customers are willing to pay for your product. This proof of concept and testament of value can help you realize your full profit potential.
Learn about the next Lassonde for Life workshop and about the program at lassonde.utah.edu/life.
