There are several sub-chapters covering this theme
Ensure Cost <= Price <= Value
Companies need to determine what price to charge for their products and services. In the world of consulting we often had to come up with a proposal and determine a suitable price for our services. The default starting point was often the time taken (person days) to perform the activities.
One simple formula would have saved many hours of activity in pursuing things that were not winnable: Cost <= Price <= Value.
Unless we can do the work for lower cost than the price we charge, it’s not going to work.
Unless the value to the customer is higher than the price we charge, it’s not going to work.
The first of these was usually not a problem. The second sometimes was. “But that’s what it would cost to do what you want” is not a great mantra. If it’s only worth £10k to a customer to have a problem solved, then unless we can change their perception of value (eg through an alternative Value Proposition to which we gain Informed consent) there is no point looking at solutions that would cost more than £10k.
Heritage: Too many bids were sent out based on what it would take to do the work we thought was implied without sufficient consideration of what the answer was worth to the client.
When you can charge what you like
Many years ago (when petrol was 35p per gallon[1]) there was a period of petrol shortage. Prices went up and many forecourts ran out of fuel.
I recall being driven by my father past a petrol station in Nether Green, Sheffield. They were advertising petrol at pre-shortage prices and he remarked how cheap their petrol was. I noticed that the station was actually closed and replied “they can charge what they like if they haven’t got any”.
More generally – price is irrelevant if you are not obliged to deliver.
Pricing of Real Options
In financial dealings an “Option” represents a right to do something up until (or at)[2] a particular date. A “Call Option” gives the holder the right (but not the obligation) to buy at a given price (the Exercise or Strike Price). A “Put Option” gives the holder the right (but not an obligation) to sell an item at a particular price (Strike Price).
Most things can be reframed through the lens of Options but the question is , does it help? (noting that All models are wrong but some are useful). In most cases cited to be “Real Options”[3] the likelihood of different outcomes must be known to be able to determine what it’s worth to have the option. In such cases, without detailed knowledge of the likelihood of the outcomes, it is impossible to assess the value of the option.
A radically different approach (pioneered by Black and Scholes) is to model the value of an option without the need for an explicit assessment of the relative probabilities of different outcomes. This is achieved by finding combinations of other things that behave the same way as the option when valued.
There is a big difference between the two approaches here. One relies on predicting the future, the other provides a way to be indifferent to the future. It’s the difference between making a bet and hedging a bet. “Securing indifference” may not sound as appealing as “buying flexibility” but it may be a better metaphor and more rational to price. (see appendix for a worked example)
(see Scenario Planning for other aspects of securing indifference – making minor investments to avoiding having to accurately predict the future)
(note also the difference between accepting greater risk to drive maximum output vs paying a premium to reduce risk and be indifferent to outcome – see Russian Moon Landings).
Note also the parallel with the definition of measurement: the act of comparing something unknown against something known.
Although elegant, pricing of real options (independently of assessing probability of outcomes) has practical difficulties. Finding a suitable model can be hard. The calculations (if realistic) are complex and results not intuitive, so can be hard to estimate if the answer looks right.
Software pricing
One of the hardest places to address the question “what should this cost?” is software licenses (whether SaaS or on premises) . It is a clear example of value pricing – charging what the market will bear. But there are numerous arguments that can be considered:
- What did it cost the company to develop the software? (and how big a market can it share those costs between?)
- What would be the cost to produce and maintain an alternative yourself (or commission others to do so)?
- For what price is similar functionality available from established alternative suppliers?
- How much value do we get from the software? (time saved, additional revenue generated etc) – or perhaps how much more value do we get from this particular product (compared with similar products or compared with not having a product)
Typically these questions give radically different answers and there is a lot of subjectivity in terms like “similar functionality”.
Software pricing negotiations are an example of value being a social convention and often seems to have some similarities to the game Mornington Crescent (See the Mornington Crescent Theory of Management)
[1] Less than £0.08 per litre, for those unfamiliar with the old gallon
[2] “Until” generally referred to as an American Option, at a specific date generally referred to as a European Option
[3] Implicit options on real assets – such as having rights to use land but where it isn’t known if the land will economic or not.