In Software Value of something is totally unrelated to Cost

This is a popular fallacy in the #Noestimates advocates vocabulary. Let’s look at the principles of cost, price, and value to the customer from the point of view of the business funding the development of the software, the customer buying the software, and the financial models needed to know if the firm producing the software can stay in business over time. 

Knowing the difference between cost, price, and value in the software development domain is critical to producing profitability for the project or product, and the firm.

First some definitions:

  • The cost of our product or service is the amount the firm spends to produce it.
  • The price is our financial reward to our balance sheet top line when our customers buy our product or service.
  • The value is what our customer believes the product or service is worth to them in some monetary measure that matches or exceeds what they paid to receive that benefit.

Let’s Look at a Non-Software Example First 


The cost for a plumber to fix a leaking pipe at our house could be $25 for travel, materials with an hour’s labor at $70 for $95 in cost to fix the leak. The value of the service to me – who may have water leaking all over our kitchen – is far greater than that $95 cost. So the plumber may decide to charge a total of $150. Leaving the plumber with $55 of profit. 

The gross margin for the plumber is

  • Cost of Goods Sold (COGS)(a service as well as material in this case) – labor (assuming salary paid to the employee), materials, travel = $95
  • Revenue = $150
  • Margin = 36.6%
  • Profit after expenses = $55

The price the plumber charges me should be in line with the value of the benefits I receive. This is true for plumbing as well as software. Both provide value to the customer.

But pricing must also consider the prices the competitors charge for similar functionality. Our plumber knows us and has worked at our house before. He’s a local guy, so has low overhead and gives us a friends and family rate.

To maximize profitability for any product or service, be it a plumbing fix or a software product,  we must determine:

  • What benefits do our customers gain from using our product or service?
  • What are they willing to pay for this benefit?
  • How can those benefits be monetized in some way so they can compare value versus price?
  • What are the criteria our customers use to make buying decisions – for example, the Features and Functions, the convenience of procurement, performance or reliability?
  • What value does our customer place on receiving the benefits we provide through the software?

Usually, the price reflects the value we provide. This must cover our cost if we’re hoping to make a profit and stay in business. The decision process here usually starts with some target margin compared to the industry in general and the local conditions supported by the margin. High labor rates, cost of operations and other costs.

This means covering the fixed and variable costs to produce the product or service. And then assesing what the market price could be above these costs to determine the margin needed to stay in business.

Every business needs to cover its costs to make a profit. Working out costs accurately is an essential part of working out pricing. These costs are covered under two headings:

  • Fixed costs are those that are always there, regardless of how much or how little we sell, for example, building rent, salaries, and business capital rates.
  • Variable costs are those that rise as the sales increase, such as additional IT assets or facilities, extra labor.

Let’s stop here and restate this concept

Value Can Not be determined for our software product without knowing the cost to produce that product. No matter how many times the original quote at the top of this post is stated, it’s simply not true. 

When the price is set, it must be higher than the variable cost of producing the product or service. Each sale will then make a contribution towards covering our fixed costs and moving us along the path to making a profit.

For example, a software firm has variable costs of $18,000 for each product sold and total fixed costs of $400,000 a year that must be covered.

If the software company sells 80 instances of the software a year, it needs a contribution towards the fixed costs of at least $5,000 per instance ($400,000 divided by 80) to avoid a loss.

Using this structure, the framework for setting different price levels can be assessed:

  • If the software costs $18,000 (the variable cost per instance), it makes a loss on each installation it sells and does not cover any of its fixed costs
  • Selling 80 installs at $18,000 means a loss of $400,000 per year since none of the fixed costs are covered.
  • Selling the software at $23,000 results in breaking even, assuming the target 80 installs are sold (80 contributions of $5,000 per licenses = $400,000, i.e. the fixed costs)
  • Selling software licenses at $24,000 results in a profit, assuming 80 licenses are sold (80 contributions of $6,000 = $480,000, i.e. $80,000 over the fixed costs).
  • If more or fewer than 80 licenses are sold, profits are correspondingly higher or lower.

Cost-Plus Versus Value-Based Pricing 


There are two basic approaches of pricing our products and services: cost-plus and value-based pricing. The best choice depends on our type of business, what influences our customers to buy and the nature of our competition.

Cost-Plus Pricing 


This takes the cost of producing our product or service and adds an amount that we need to make a profit. This is usually expressed as a percentage of the cost. The Gross Margin.

It is generally more suited to businesses that deal with large volumes or which operate in markets dominated by competition on price.

But cost-plus pricing ignores our image and market positioning. And hidden costs are easily forgotten, so our true profit per sale is often lower than we realize.

Value-Based Pricing 


This focuses on the price we believe customers are willing to pay, based on the benefits our product or service offers them.

Value-based pricing depends on the strength of the benefits we can prove we offer to our customers.

If we have clearly-defined benefits that give us an advantage over our competitors, we can charge according to the value we offer customers. While this approach can prove very profitable, it can alienate potential customers who are driven only by price and can also draw in new competitors.

So another conjecture heard from #Noestimates advocates of Focus on Value not on Cost must be assessed from the Managerial Finance point of view, informed by the market dynamics of the offering.

In The End The Original Quote is a Fallacy


No value can be determined until we know the Price of that Value. That Price cannot be determined until we know the cost to produce that value. The fixed and Variable costs. 

This is an immutable principle of business managerial finance, and it must be followed if we have any hope of staying in business.


Source de l’article sur HerdingCats

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