I was recently referred to an article written by Peter Drucker in 1993 entitled Management: The Five Deadly Sins. The third sin is what caught my attention:

The third deadly sin is cost-driven pricing. Most American and practically all European companies arrive at their prices by adding up costs and putting a profit margin on top. And then, as soon as they have introduced the product, they have to cut the price, redesign it at enormous expense, take losses and often drop a perfectly good product because it is priced incorrectly. Their argument? ‘We have to recover our costs and make a profit.’

This is true, but irrelevant. Customers do not see it as their job to ensure a profit for manufacturers. The only sound way to price is to start out with what the market is willing to pay – and thus, it must be assumed, what the competition will charge – and design to that price specification.

Starting out with price and then whittling 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.

This makes sense because it is how most reasonable people put together a budget. People generally start with the price side of the equation ($2,000 in a vacation budget), then prioritize costs accordingly (choosing whether to stay in the Manhattan Crowne Plaza or the Newark Budget Inn).

The issue is not the reasonableness of the approach.

The issue is that it’s a more difficult and initially expensive approach.

It’s hard to figure out what the marketplace says your product or service is worth. You have to decide what your product is and is not, present it to the marketplace, receive and analyze enough feedback to come up with an accurate number, decide to set the price, stick to it and base business decisions on that price. Cost is an important factor in the equation, but not the only factor — and, more importantly in this narrative, not the first factor.

It’s a lot easier to use one of the an online calculator like freelanceswitch.com, add a margin and hope for the best. It’s much harder and, according to Mr. Drucker who is a lot smarter and more experienced than I am, more profitable to start with price and “design to that price specification”.

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