Do you take a strategic approach to pricing your products? Do you make pricing decisions in reaction to competitors or are price levels carefully determined to take advantage of strategic opportunities in the marketplace? Value Based Pricing can make a significant impact on corporate profits.
Pricing not only impacts short-term profitability, but you also need to consider the longer term effects of the reactions of customers as well as competitors to price changes. Pricing is a ‘marketing tool’ and impacts your branding and positioning.
Few companies are strategic and proactive about price setting. As a result, they see lower profits and do not fully take advantage of pricing as an important element of their branding and positioning efforts.
Price Setting: Marketing and Finance Working Together
The difference between simply setting a price and strategic pricing is the difference between reacting to market conditions and proactively shaping the market.
A strategic approach involves the coordination of marketing, competitive, and financial decisions to set prices for profitability. For most companies, strategic pricing requires more than just a change in attitude. It requires a change in when and how pricing decisions are made and who are involved in making these decisions.
Strategic pricing requires that management takes responsibility for establishing pricing policies and procedures, consistent with financial, branding and positioning goals. Leaving the sales force or distributors to set price levels is abandoning responsibility for the strategic direction of the business.
A strategic approach to pricing requires Marketing and Finance departments to work together in finding the right balance between the customer’s desire to obtain a good value (low price) and the firm’s goal of earning a sound profit (high price) as well as the impact of pricing on branding and positioning.
Cost-Plus Pricing Doesn’t Work
Traditionally, Cost-Plus pricing is the most commonly used pricing method because it appears to be based on a sound financial consideration. However, Cost-Plus pricing leads to prices that are too high in weak markets and prices that are too low in strong markets – exactly the opposite of a sound pricing strategy.
The typical Cost-Plus approach to pricing follows this sequence:
Product —> Cost —> Price —> Value —> Customers
In this approach the company wants customers to buy their product at a price that does not necessarily reflect the customers’ perception of ‘Value’. Price levels end up either too high, resulting in reduced demand or too low, resulting in the company leaving money on the table. Rarely is the cost-plus based price ‘just right’.
When sales volumes then remain below expectations, prices are dropped to improve demand, but at the expense of lower margins.
Value Based Pricing for Higher Profits
A strategic mindset about pricing involves anticipating price levels that customers are willing to pay even before the development of a new product has started. If you know that you’ll not be able to sell the product at a profit, why develop it in the first place?
Product development and pricing decisions based on customer needs and their perception of value follow this sequence:
Customers —> Value —> Price —> Cost —> Product
The company produces what the customer wants to buy; selling at a price that customers are willing to pay because they recognize the value. In other words, Value Based Pricing pricing essentially rests on these basic considerations:
- Investigate what the customer’s problems are
- Determine how much they value a solution
- What price are they willing to pay for this solution?
- What is the cost of producing this solution?
- If the anticipated gross margin meets targets you can start the development of the product
- If the gross margin is too low, the product cannot be sold profitably. It makes no sense to invest in product development.
Questions to Ask Before Changing Prices
You should take a similar, strategic approach when you’re considering changing prices of existing products and services. A strategic, value-based approach to pricing starts by asking the right questions:
- Which sales volume increase is needed to earn greater profits from a lower price?
- Which sales volume decrease will still let us earn more profits from a higher price?
The answers to these questions depend on how demand changes with price and on the product costs – production volume relationship.
Additional questions to consider deal with marketing strategy, branding and customers’ perception of value:
- Can we deploy a marketing strategy to keep sales volume changes within acceptable range?
- What costs can we afford to incur, given the price levels in the market, and still earn a profit?
- Is our price justifiable given the customers’ perception of value?
- How can we better communicate the product value to justify the price?
- How can we better segment the market to justify pricing differently when the value is different?
- What level of sales or market share can we most profitably achieve?
- What marketing tools should we use to win market share most cost-effectively?
Review Your Pricing Process
The best way to become more strategic about product pricing it to review your current pricing processes and marketing:
- Review your current pricing process
- Review your customer segmentation and target markets
- Identify opportunities for segment refinement based on price sensitivity and ‘value perception’
- Conduct detailed profit analysis of your customer segments and products
- Determine your Pricing Power
- Increase your value and Pricing Power
Pricing decisions have a direct impact on your bottom line. You can improve your company’s profitability with a strategic approach to pricing. Don’t let product pricing be an afterthought.