Some Obvious and Useless Rambling about Pricing Models

I’m in the process of starting a business.  My tasks for today and tomorrow are to come up with business plans. A core question is how to set prices. My business is custom software development (at the moment, at least).  The production of software is mostly about time. Time and ‘business knowledge’. Business knowledge is your understanding of what the application should do and how. It’s the understanding of how to add value to a process or enterprise.  

So you get a pot, add business knowledge, water and time – bam – there’s your application. If you did it correctly that application now has some value of it’s own. So now how do you figure out how to price it? Depending on your perspective you can asses value from the production side or the consumption side. From a producers perspective, you add up all the costs, add some profit and maybe a premium to support R&D and you got a price. But to look at it from a consumers perspective you need to understand how that application is used and asses the value in that context. If the application, for example, allows the user to reduce operating costs by $200,000 yearly in reduced salarys, That 200 large will occupy a prominent position in your pricing calculations.  Now if your business is viable, then the price you calculated as your cost is less than the price you asses as the value to your potential customers.  

Of course if you have competitors, that will affect the price as well – their prices help define a market price, which influences how much folks will pay, regardless of the value to them. If you’re the only game in town, perhaps you can sell for 200k, since customers, on average, recoup that cost in a year. But if they can recoup that same cost with a competitor of yours that costs half as much, then you don’t look so attractive anymore.

Now I’ve been contracted to build an application for a customer where the application will essentially run their business.  This is a startup targeting a very specialized market.  If they are moderately successful the business will be profitable. If they find real traction a *lot* of money will be generated.  I have problems on both sides of the price equation. My costs are hard to quantify mainly because It involves answering the question “how much am *I* worth”. Necessarily the question requires some extrapolation, based on my previous worth to Oracle, my skills in relation to others in the marketplace, my particular set of skills and proclivities in relation to those needed to bring this particular project to fruition, etc.  But once I get past that, the next question is harder – how much is the finished product worth to them. And how much does my application contribute to the final whole ball o’ wax. How much does this app save in expense, or enable in revenue. If someone else can make this app, how much would they charge?  Both difficult questions. 

anyhoo - some doodles on compensation philosophies (or put another way, resource pricing)-

basis for compensation level

• historical cost of resource and adjust for inflation - while this is fairly common, it actually seems pretty silly. as an employer i could care less how much you made at your last job unless I expect you to provide me exactly the same amount of value as you did them, and I judge your historical rate to be consistent with market rates for your services. the only legitimate information this gives me that I can’t get elsewhere is a feel for what you would accept. if this is below market you’re a bargain.
• resources’ standard of living requirements - again, from an employers perspective your standard of living has no functional relationship to the amount of value you may provide them. it may however place a lower bound on what you might deem acceptable.
• market rates for similar resources  - this model seems valid however it suffers from one problem. no two people are actually alike. while market pricing seems fair, be sure to adjust for the specific value proposition you bring to the table. hypothetically market pricing is the balance of two extremes – maximizing employer profits and maximizing employee salary. 
• relative percentage contribution to total value proposition, e.g.  revenue sharing – the expectation would be that a ‘fair’ level of revenue sharing would almost always be more beneficial than ‘market rate’ – but this assumption needs proof. Also, it’s not always a good thing – e.g. what about companies that lose money. While companies are often designed to lose money during the startup phase, maybe you can’t go more than a couple months without a paycheck. so while this does have side effect of closely aligning org revenue/profit with workers, the downside can be unacceptable levels of risk for employees.
• expenses resources incurs in creating contribution, plus some percentage of sales enabled by contribution – kind of like above, but with a safety net…
• organizations ability to pay, or the  ”I’ll take everything you have that you don’t need to stay in business” strategy – seems reflective of some ceo pay packages. as unfair for organization (stockholders) as exploitive wages are of workers. Note however that salaries are sensitive to the perceived value of money. in good times salaries are bettern than in bad. big companies tend to pay more than small. 

Principles that should apply to any “fair” compensation model

1. Nobody starves.
2. Compensation has a positive correlation with resources contribution to profitable activities.
3. Consistency – Compensation relative to peers with similar contributions is similar.
4. Goal Oriented – Compensation increases significantly based on achievement of predefined goals
5. Performance Based – Compensation varies with measured performance criteria.

Note the last two aren’t really about fairness – they’re more about goal alignment and incentivization.

Postscript

Writing helps me think. So pardon the wasted bandwidth if you’ve run across this semi-essay and after reading it regret the waste of time. After writing it however I think I understand what will work for me. And if you’re of a mind to, leave a comment telling me why it sucked (or rocked;).

Cheers

~ by kindablue on August 6, 2008.