4+1 Pricing Mechanism

by Tim Smith, PhD, 23 June 2004

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When businesses charge different customers different prices, what are the determinant factors? Is this pure value-perception pricing or are underlying factors used to justify differential pricing? After reviewing dozens of pricing mechanisms in business markets, I have uncovered four plus one common factors within pricing mechanisms. The basic four are Volume, Complexity, Risk, and Delivery. There are other factors used in pricing mechanisms most of which can be categorized as one of the basic four. The plus one pricing factor arises from the ephemeral forces of supplier and buyer power.

Volume
Volume is the most dominant factor in pricing mechanisms. Per-seat, per-employee, per-customer, per-dollar-under-management, and many other per-unit charges are volume factors in pricing. In many instances, the per-unit price falls as volume increases. While cost structures are typically used to justify volume based pricing, market economics are the stronger driving force.

Volume is a pricing factor because it quickly captures the relationship between value and delivery. Higher volume customers receive greater total value in consummating the commercial relationship and thus the total price increases as the vendor captures a portion of the total value created. For services and intellectual property, the key issue is identifying the right volume metric for estimating the total value created with that customer. Uncovering the primary business function impacted and quantifying the impact according to the number of units within that function reveals the appropriate volume metric.

Volume discounts are common because high volume customers have greater flexibility in their purchasing habits than low volume customers. Flexibility appears in the form of global sourcing, the use of substitutes, or the make versus buy decision. Offering a lower per-unit price to high volume customers is necessary when large customers hold more options in their purchasing decisions.

Complexity
Complexity factors result from solving greater challenges for some customers with the same underlying solution sold to all. Often, complexity factors result from an attribute or functionality that is used minimally in most business processes but is used heavily in more complex ones. Complexity becomes a pricing factor when the value of the solution changes according to the usage of the underlying deliverable.

Complexity factors affect the total price more dramatically than volume factors. While volume will increase the total price in an additive fashion, complexity factors will increase the total price in a multiplicative factor. Complexity factors of two are not uncommon, thus potentially doubling the total price by incorporating the complexity managed by the solution for specific customers in the pricing mechanism. The appropriate size of the complexity factor results from a quantitative understanding of the challenges addressed by the solution and the value of overcoming these challenges.

When incorporating complexity as a pricing factor, many businesses will use different names for the same product depending upon the complexity it addresses with customers. Outside of altering the product name to address price discrimination laws, varying the product name enables the company to position the same underlying solution in different manners, thus targeting multiple customer segments with a variety of forms of the same solution.

Risk
When vendors assume risks that could be borne by the customer, they should also seek associated financial rewards. Common risk factors result from project risks, purchasing risks, or financial risks. Risk factors within the pricing mechanism arise due to the shifting of risks between the vendor and customer to the party that can better manage the risk.

In services, contracting for a fixed-price/fixed-deliverable service over a time-and-effort service shifts project risks from customer to the vendor. Vendors are willing to assume project risk when most of the challenges caused by uncertainties can be mitigated and when the customer is willing to pay for shedding the risk. Fixed price premiums of 20% to 50% are not uncommon in deliverable based service contracts.

Purchasing risks arise when the nature of the commercial relationship shifts from an ongoing service contract to a single purchase. For instance, a customer of professional services may seek to accomplish several tasks of a related nature. That customer may either contract separately for the completion of each task or contract with a single vendor on an ongoing basis for the completion of the entire task list. The sum price associated with contracting separately each individual task will often be greater than that associated with an ongoing contract that delivers the same results. Vendors offer lower prices in exchange for lower purchasing habit risks because it provides greater predictability in managing their business. Customers are willing to pay higher prices for contracting separately for individual tasks in order to reduce their dependency on any single vendor or acquire specific expertise for specific projects. Purchasing risks drive price variances in the range of 20% to 50%.

Financial risk factors result from altering the payment terms. Changing a sale into a lease is the most obvious form of assuming financial risk which consequently changes the overall price of the contract. Another form of assuming financial risks is the delaying of payment towards the project completion. Adjusting prices to incorporate financial risk is a straightforward exercise of interest rates and discounted cash flows.

Delivery
Prices routinely increase as delivery schedules become more demanding. In services, a fundamental tenet of project management is the requirement of making tradeoffs between price, time, and scope. Thus, if customers seek a quicker delivery, they must either shrink the scope of the project or pay a higher price to meet their schedule. In product markets, just-in-time-inventory practices increase the burden of managing deliveries. Prices will increase in proportion to meeting customer’s demanding delivery practices.

Price increases in association with delivery demands share the economic benefits from the meeting customer’s schedule. As a reality check, customers that demand compliance to their delivery schedule must value it or they wouldn’t demand it. The challenge is to put a price on that demand. Price variances associated with meeting a demanding delivery schedule is often small. In product markets, the price variance may be on the order of 1% if it exists at all. In service markets, the price variance may be larger than 10%.

Plus One: Power
Supplier and buyer power affect pricing in manners that are not captured in pricing mechanisms. The ability of customers to extract lower prices through hard negotiation or alternatively the ability of a vendor to extract a higher price through their selling process is best managed on a case by case basis. Yet, to ignore the affects of buyer and supplier power in driving variances away from that which is determined by a pricing mechanism is irresponsible.

A pricing mechanism that captures value proportionately to the value created in delivering the solution to a customer enables the business to profit and acquire satisfied customers. Volume, Complexity, Risk, and Delivery are the most common factors that affect the prices in a mechanistic way while supplier and buyer power will drive prices away from the prescribed.

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Author
Tim Smith, PhD is Editor of The Wiglaf Journal, Principal of Wiglaf LLC, and Adjunct Professor at DePaul Graduate School of Business.

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