In yesterday’s edition of PurchTips, I gave you 19 questions you should know the answer to if you are truly thinking strategically.
But they weren’t the only questions.
There’s one I’ll address all on its own in this post: What is your organization’s pricing strategy for the products and services it sells?
You see, pricing on the sales side isn’t just a sales function. It is one of the most important components of the organization’s overall strategy. And it drives the “micro-strategies” used by other departments, including the procurement department.
There are a few different approaches your organization can take to deciding on its pricing. The market will dictate which of them your organization can get away with. They include:
- Cost-Plus Pricing: This approach simply means that your organization will charge its customers whatever its costs are, plus a markup. This approach is often used in situations where (a) the scope of work is so unclear that the customer really has no way of knowing what the final price will be, and (b) there isn’t a ton of competition that would drive better estimation and persuade the supply base to quote fixed prices. Where an organization can use cost-plus pricing and get all of the business it can handle, there isn’t much incentive to apply the most disciplined procurement practices. If your organization pays too much for purchased products and services, that’s OK. It will simply add its markup on top of the cost and bill the customer accordingly, without much pushback. And if the markup is a percentage of cost, heck, the more you pay for time and materials, the more profit your organization makes.
- Value-Based Pricing: This approach means that your organization bases its pricing on the quantifiable value that its customers receive from an engagement, job, etc. It is an approach often used for customers who are looking for a “luxury” type product or service and have the money to afford it. For example, if a supplier’s work will save a company $3 million in a year, they will have little problem justifying an appropriate expenditure that would “only” cost $1 million. In organizations that use value-based pricing, there may be a little more pressure on the procurement department than there is in organizations that use cost-plus pricing. But there’s still not a lot. In luxury markets, there’s usually plenty of profit margin.
- Market-Based Pricing: This approach means that your organization can only charge up to a certain amount for its products or services because there are enough competing products and services to have established an acceptable range of prices in the minds of consumers. Let’s talk about an example. Think about a TV dinner. Some cost more than others, depending on the amount of food included, the quality of the food included, and the reputation of the brand. Yet, there is still a very finite range. One may pay as little as $1 for a budget TV dinner. Or pay as much as $5 for a huge TV dinner that only individuals with the heartiest appetites could finish in one sitting. So, if someone tried to sell a TV dinner that cost $15 with similarly-sized proportions and comparable food choices and quality, consumers just wouldn’t buy it. When you manage procurement for an organization that uses a market-based pricing approach, there is usually a high degree of pressure to ensure that costs do not exceed a certain target. And because of competition, that target can be challenging to hit. For the TV dinner, you simply cannot overpay for any ingredient: green beans, brownie mix, etc.
Those aren’t the only type of pricing approaches. But they should be enough to convince you that understanding your organization’s pricing strategy is one of the keys to truly strategic procurement thinking.
So, add the above question to the list in yesterday’s PurchTips!