The Four Pricing Methods

The Four Pricing Methods

Money is better than poverty, if only for financial reasons.

-WOODY ALLEN, COMEDIAN, SCREENWRITER, AND DIRECTOR

Let’s assume for a moment you own a house you’re willing to sell. The Pricing Uncertainty Principle says the price could be anything—you have to set it yourself, since houses don’t come with built-in price tags. Let’s also assume you’d prefer to sell the house for as much as possible. How would you go about setting the largest price a customer will actually accept?

There are four ways to support a price on something of value:

(1) Replacement Cost

(2) Market Comparison

(3) Discounted Cash flow/net Present Value

(4) Value Comparison

These Four Pricing Methods will help you estimate just how much something is potentially worth to your customers.

The Replacement cost method supports a price by answering the question “How much would it cost to replace?” In the case of the house, the question becomes “What would it cost to create or construct a house just like this one?”

Assume a meteorite scored a direct hit on the house, and there’s nothing left—you have to rebuild the house from scratch. What would it take to purchase similar land, pay for an architect to draw up plans, acquire identical materials, and hire construction workers to create exactly the same house? Total up these costs, add a bit of margin to compensate for your time and effort, and you’ll have a supportable estimate of how much your house is worth.

Applied to most offers, Replacement Cost is typically a “cost-plus” calculation: figure out how much it costs to create, add your desired markup, and set your price appropriately.

The Market Comparison method supports a price by answering the question “How much are other things like this selling for?” In the case of the house, this question becomes “How much have houses like this, in this general area, sold for recently?”

If you look at the surrounding area, there are probably a few other houses similar to the one you own that have been sold within the past year. They’re probably not exactly the same (maybe they have an extra bedroom or bathroom, a little less square footage, etc.) but they’re close enough. After you adjust for the differences, you can use the sale prices of those “comparable” houses to create a supportable estimate of how much your house is worth.

Market Comparison is a very common way to price offers: find a similar offer and set your price relatively close to what they’re asking.

The Discounted Cash Flow (DCF) / Net Present Value (NPV) method supports a price by answering the question “How much is it worth if it can bring in money over time?” In the case of your house, the question becomes “How much would this house bring in each month if you rented it for a period of time, and how much is that series of cash flows worth as a lump sum today?”

Rent payment come in every month, which is quite handy: you can use the DCF/NPV formulas to calculate what that series of payments over a certain period of time would be worth if you received it in one lump sum. By calculating the NPV of the house assuming you could rent it for $2,000 a month for a period of ten years with 95 percent occupancy and you could earn 7 percent interest on your money by choosing the Next Best Alternative, you’ll have a supportable estimate of what the house is worth.

DCF/NPV is only used for pricing things that can produce an ongoing cash flow, which makes it a very common way to price businesses when they’re sold valuable the business is to the purchaser.

The Value Comparison method supports a price by answering the question “Who is this particularly valuable to?” In the case of the house, this question becomes “What features of this house would make it valuable to certain types of people?”

Let’s assume the house is in an attractive, safe neighborhood with a top-tier public school nearby. These characteristics would make the house more valuable to families who have school-age kids, particularly if they want to attend that school. To potential home buyers in the market, this particular house would be more valuable than the same house in an area with inferior schools.

Here’s another example: assume Elvis Presley previously owned the house. To certain types of people—wealthy people who love Elvis—this house would be extremely valuable. Elvis’s previous involvement with the property could easily triple or quadruple the price you’d be able to support via the replacement, market comparison, or DCF/NPV methods. By looking at the unique characteristics of what you’re offering and the corresponding worth of those characteristics to certain individuals, you can often support much higher prices.

Value Comparison is typically the optimal way to price your offer, since the value of an offer to a specific group can be quite high, resulting in a much better price. Use the other methods as a baseline, but focus on discovering how much your offer is worth to the party you hope to sell it to, then set your price appropriately.

This Article is taken from The Personal MBA

Written by Arshad. A

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