Entrepreneurship: Value Adding, Costing and Pricing (I)

Some time ago I was involved with a company that was bidding for a project. I worked with them and we submitted both the technical and financial bid components. After scaling the technical stage, the company was invited by the client for negotiations of the contract terms because the company had the lowest financial offer […]

Some time ago I was involved with a company that was bidding for a project. I worked with them and we submitted both the technical and financial bid components. After scaling the technical stage, the company was invited by the client for negotiations of the contract terms because the company had the lowest financial offer among all the companies that bid for the project.

In the course of the negotiations, the client asked why the company had a “low quote” (the next lowest financial bid was over eight times the company’s!) I responded on behalf of the company that, “Even at that seemingly ‘low quote’, the project is satisfactorily profitable to the company.” Simple! The company got the job and successfully executed it. Everyone was happy. And I have no doubt that if the client has a similar project in future the company will be preferred.

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The above “concern” by the client brings out a reality in the costing and pricing philosophies of many individuals and organisations in our environment. Every business opportunity is about maximising profit. But even beyond that, we tend to think that every business transaction is about us making all the money we can to solve all our financial problems at one go! It is like each transaction, irrespective of its details, must take us out of our poverty and make us “stinking” rich!

This costing mindset and pricing model are, sadly, rampant in all strata of our society: from the mechanic that will fix the office car to the carpenter who is asked to quote to produce furniture for a soon-to-be-wedded couple or the contractor that is invited to submit a financial bid for the building of a school block for a state government. We just want to get rich overnight.

While it is legitimate to maximise the profit you can make on transactions, it must be done wisely, taking into consideration three things: first, your pricing should take into account both the value you are actually delivering and the price at which your competitor can also deliver the same service. Second, you should not be too greedy as to risk losing the business entirely because you stupidly believe one transaction should solve all your financial problems! Third, your pricing should be fair in a way that it is acceptable to your client, while, of course, being profitable to you.

If any of those conditions are not met, you risk losing the business, or if you get the business, your relationship with the client can be jeopardised if they (and they can) eventually find out that they could have gotten better pricing for the same service from elsewhere. Remember that unhappy or customers that feel cheated would not come back to you, and neither would they make referral to you.

How do you avoid the risks mentioned?

Long-term relationships are beneficial: We have in this column always expounded that the sustainably successful entrepreneur is one that views and manages their relationships with their employees, clients, regulators, etc. on long-term basis. Having a long-term perspective on business relationships makes us circumspect, cautious and fair in our dealings without losing focus of our business objectives.

Understand the differences of value, cost and price: The entrepreneur needs to have a sound understanding of the differences and linkages among the values they offer, their operational cost structure, costing process, as well as their pricing model. These four variables are key to relationship development, sustainable profitability and wealth creation.

The essence of every business is to provide products (goods and/or services) to a group of customers (individuals and/or organisations) called a “market” and in the process generate wealth. To stand a good chance of generating wealth, a business needs to be able to create a desired value. The value created by a business is represented by the features in the products that the company offers to its customers. “Economic value” is a measure of the benefit that is derivable from a product by a customer. Economic value, however, does not mean that the utility derived by the customer is necessarily financial, no! For instance, a wealthy person could buy a Rolex wristwatch for millions of naira not because of any financial benefit they can derive from the watch, but for, perhaps, the feeling they get from owning the prized item. The point is that the “economic value” we ascribe to a product could be derived from some social, psychological or of course monetary benefit that we enjoy from it.

Profitable pricing of products is critical to wealth creation. Most business operations price their products on a cost plus a margin basis. This means the total cost attributable to the value on offer is established and then a pre-determined margin is added to come up with a price. It should be noted, however, that there may be realistic constraints to this approach. If, for instance, a product you want to offer is already available in the market at some price, you may not just be able to offer yours at a higher price without a corresponding, justifiable and perceptible value differential. Regardless, there are several ways of determining the cost of the value you provide. But your type of business will influence how you establish your costs. The cost components and costing process of a furniture business will be different from those of a restaurant which will also be different from that of a medical facility. The principles are however basically all the same.

The wise entrepreneurs need to entangle themselves from wrong pricing philosophies and models. They also need to understand the difference and relationships between the trio of value, cost and price. We shall continue on these crucial issues next week.