Whatever a price is attached to is called the product. It is the thing sold; it is what the customer is asked to pay for. Vendors affix a price tag to hardware or software or a system that combines both of them. Consultative sellers eliminate the concept of price, replacing it with an investment to apply products, services, or systems at a profit to their customers. In this way, the investment is repaid by the value that comes out of it. The cost to the customer—the price—is zero.
Once price is eliminated, cost vanishes. So does fair market value set by competitive prices as a pricing standard. Value to the customers becomes the basis point for their investment, a way of doing business that Becton Dickinson has discovered about its hypodermic needles sold to hospitals. When purchasing agents were the customers, they complained that 10 cents was too much to pay for needles that they bought from competitors for 7 cents. Becton's vendor reflex was to wage a profitless price war. But a value analysis showed that accidental needlesticks cost a hospital an average $400 each in time and paperwork charges even if there were no complications or legal expenses.
What if Becton could reduce the costs contributed by needle-sticks by more than the 3 cents difference in the price of needles offered by a competitor? What is Becton's value to the customer? What is a fair investment for a customer to make to acquire it—fair in proportion to the value of the return, not to the price of the hypodermic needles? Should Becton sell needles on price or on the value of needlestick prevention derived from advanced needle technology, training programs for hospital staff, and consultative expertise in safety program implementation?
Hewlett-Packard made a similar discovery. In the same quarter that its earnings fell 46 percent because "pressure on gross margins prevented revenue growth from being translated into earnings"—in other words, price competition was eating up margins—an analysis of H-P's added value showed how much margin potential H-P was leaving on the table by vending its computer systems on price and performance:
For one customer, each $100,000 paid to H-P contributed $1.2 million in reduced costs, for a value-to-price ratio of 12:1.
For another customer, each $250,000 paid to H-P contributed $8.75 million in new revenues, for a value-to-price ratio of 35:1.
The alternative to knowing your value and selling it is discounting your price. Once you give away your margin to make a sale, you never get it back. Discounting is relentless in the way it destroys profits:
If you start out with a 50 percent margin and you discount it by 10 percent, you must sell 25 percent more product in order to realize the same revenues.
If you start out with a 35 percent margin, you must sell 40 percent more.
If you start out with a 20 percent margin, you must sell 100 percent more.
Another way to look at it is if a product's costs remain steady at 91.9 percent of its $1.00 sales price, a 3 percent discount reduces profit from 8.1 percent to 5.1 percent—a 37 percent loss on the new price of 97 cents.
It is a myth that you can "make it up on volume." The cost of sales goes up with volume, nullifying increases in revenues. If a 3 percent discount produces an average 5 to 6 percent increase in volume, for example, it takes four cycles of 3 percent discounts to get a 20 percent increase in volume when unit costs first begin to fall. In other words, sales must increase by one-fifth just to get back to where you started.
Companies that do not understand price-value relationships go out of business. When Digital Equipment began to fall from its number two position in the computer industry, founder Ken Olsen thought he saw the reason. "We were selling computers while the customers wanted solutions to business problems," he said. "You can see at DECWorld that we've addressed that." But press service reports of DECWorld described it as "a showcase of the company's innovative technology and product line."
Even innovative technology cannot help to maintain margin when the technology itself and not its problem-solving value is sold. Digital's Alpha AXP microprocessor was the fastest high-performance computer chip of its time. Yet Digital was forced to successively discount its price by as much as 31 percent per cut over several rounds of cuts. All the while, the Alpha AXP remained the world's fastest chip and its manufacturer remained the most ignorant about its value.
Assessing value before assigning price, and then basing price on value, is bedrock Consultative Selling strategy. Otherwise, money—often sums that are even greater than the volume of sales that are made—will surely be left on the table.
David Liddle, CEO of Metaphor Computer Systems, made this discovery after retroactively calculating the value added to nine major customers where Metaphor systems had been in place for two to three years. He found that the average revenue gain in just the 12 prior months was $8.7 million that could be directly attributed to Metaphor. For the next three years, the same customers were projecting an even greater average 15:1 annual return on their systems. Liddle's reaction was to kick himself for having sold to all nine customers at 30 percent to 40 percent discounts from his $1.25 million price.
If Liddle had known his value beforehand and simply maintained his price, his customers would have realized more than $8 for every $1 they paid him. Instead of discounting, he could have reclaimed even more of his value at an even higher price.
If you are not prepared to improve a customer's profits, the customer will always be prepared to reduce your own profits. After one year of operation of a Xerox Advanced Document System, Continental Insurance of Canada was approached by a Xerox competitor who offered to buy out the Document System from Continental and replace it with its own system at half the Xerox price. In order to keep the business, Xerox met the offer at a loss of over $500 thousand.
After doing the deal, Xerox went into Continental's operations to learn what it should have known all along: in 12 months, Continental's use of the Advanced Document System had added $17.7 million in incremental revenues at a net operating margin of $1.9 million. Yet without knowing its value, Xerox was required to compete on price.
A customer's improved profitability should immunize his supplier against having to discount price. A manufacturing customer who is able to apply a supplier's product to decrease his R&D's contribution to a new product's development cost by $1.60 million has no justification for discounting a $1.00 million price. But when the savings come from reducing the innovation cycle by 6 months so that incremental revenues of $1.5 million accrue in year one that would have otherwise been zero, it is the supplier who is justified in value-basing price.
The only way to avoid discounts is to sell your added value and not your product or service. In the same way that you cannot make it up on volume, you cannot get around it by other, less visible price offers such as sweetened payment terms, additional warranty coverage, or free training giveaways that are simply discounts in disguise.