Performance-based Pricing

By : Jim Pinto,
San Diego, CA.

Conventional cost-based pricing is stuck in a trap because global companies are prepared to compete with lower profit margins. Performance-based pricing is the answer. The seller is paid based on the actual performance of its products and services.

This article was published by:
May 2008

Products in the automation industry have traditionally been sold with "cost-based" pricing - selling price is based on manufactured cost, with target gross and net profit margin multipliers.

For most automation suppliers, conventional cost-based pricing is stuck in a trap. Products manufactured offshore at a lower cost are not the answer, because global companies are prepared to compete with lower profit margins.

U.S. automation companies typically work with gross-profit margins of about 50 percent and plan for net pre-tax profit of about 15 percent. In other countries, typical gross profit of about 40 percent results in net profit of 5 percent to 10 percent, which is considered acceptable. In China, expected gross margin is about 5 percent to 10 percent and net profit is miniscule. This is because Chinese businesses take a long-term view, offering low price to gain market share. It is this - not presumed low-cost labor - that has made China the world's manufacturing powerhouse.

Exiting the treadmill

Western suppliers endeavor to maximize profit margins by emphasizing proprietary products with design features that can command higher margins. But the fast-moving technology treadmill quickly demolishes that lead; few high-volume products cannot be quickly copied.

The tactical response by the large automation suppliers is to offer broader ranges of products, software, systems and services. But this still has the effect of reducing overall profit margins. My contention is that the problem lies in obsolescent cost-based pricing.

In today's changing global markets, no other marketing decision highlights the double-edged conflict/cooperation nature of the buyer-seller relationship. Pricing is a zero-sum game in which one's gain is the other's loss. The focus must move to a win-win business relationship -simultaneously providing greater customer value and higher supplier profitability.

Performance-based pricing is the answer. The seller is paid based on the actual performance of its products and services. This is becoming popular in the advertising industry; agencies have been traditionally paid 15 percent of the cost of the media they buy for a client. Now, agency/client relationships are moving to performance-based pricing - payment based on achieving measurable advertising goals.

Performance-based pricing is "insurance" that the seller does not undercharge the buyer - it guarantees that as the seller provides more, it is paid more. Significantly, the buyer also receives insurance that it will not overpay - it pays only for the amount of performance that is actually delivered on a measurable basis. This means that the performance and expected results of the product must be immediately measurable.

Performance-based pricing must include service and maintenance - because performance is attained only when the product or system is operating. Further, it allows the up-front cost to the buyer to be relatively low, offering the seller a high return based on performance.

It is useful to consider the risk/reward trade-off embodied in various pricing approaches. Pricing for services based on costs plus a predetermined profit margin - often referred to as "time and materials" - involves no vendor cost risk. The customer pays for all cost overruns and the supplier's profit is established before delivery. Typical fixed-price, cost-based sales involve only cost risk for the seller. The price is set before the product or service is made or provided.

Performance-based pricing moves both the cost and price risk to the seller. Neither is established before the deal is made. But the supplier then gets the opportunity to manage the value to the customer, and be closely involved to generate additional profits for both sides. With the risk comes added revenue and profit opportunity. In today's competitive global business environment, traditional cost-based pricing is seriously flawed. Performance-based pricing should be examined as a viable alternative.

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