It is not uncommon for companies to base their pricing strategy on a “cost-plus” approach. However, this is too simplistic and can have a negative impact on profits.
A firm’s approach to how it set prices has to align with its business goals. Determining the best price for a product or service is a complex problem with many facets that should not be neglected.
Here are a few thoughts on setting prices to give you some ideas.
Use Customer Value, Not Cost-Plus
Does your product cost include labor and manufacturing overhead? Just adding up the part costs from the Bill of Materials is not sufficient. By the way, is that BOM complete and up to date?
With a cost-plus approach, you usually end up with a price that’s either too low or too high. Price too low and you leave money on the table. Price too high and you miss out on closing the deal.
Of course, you can’t ignore the product cost. It simply establishes a lower limit for the price. Sometimes there may be a valid strategic reason for selling a product below cost as a “loss leader”, but most of the time the goal is to make a profit.
The typical approach to price setting using cost-plus starts with the product cost and then adding a markup, often somewhat arbitrarily.
A better pricing strategy is based on an understanding of how customers perceive the value of your product or service. Keep in mind, you can’t get this insight from behind a desk. You have to go out and talk to your customers. You can start the conversation by asking questions such as:
- Which problems does this product solve?
- How often do you use it?
- When and where do you use it?
- What is the business (financial) impact?
- If this product were not available. what would you do?
- Any substitutes or alternatives?
- What do you think of competitive products?
The answers to these questions provide you with insight into how customers value your solution – an essential facet of a smart pricing strategy.
Consider Total Cost of Ownership
By taking a Total Cost of Ownership approach you’ll get even more insight into how the customer values your solution.
Let’s say your product improves productivity, is more reliable, requires less setup time, is more energy-efficient, and requires less maintenance. It does not take too much effort to put these benefits in terms of dollars and cents.
With the knowledge of the benefits your solution offers, you can demand a higher price over a cheaper competitive product that lacks some of these benefits. The Total Cost of Ownership advantage provides an opportunity to set a higher price, and still be perceived as a “good deal”.
Also, with insight into customer value and the Total Cost of Ownership analysis, you can present a compelling story to the customer about the benefits of your product and how it’s different. This beats having to compete on price.
No doubt, this pricing strategy is more complex than simply using cost-plus and picking a somewhat arbitrary margin. It takes effort to find out the perceived customer value and doing a Total Cost of Ownership analysis. But, as a result, you’ll be able to sell at a higher price and that goes straight to the bottom line.
Don’t Use Market Pricing
With market-based prices, products are usually priced close to or the same as competitors’ products. No differentiation, nothing strategic about this approach. As far as the customers are concerned, all products in that particular category are pretty much the same.
You can escape this commodity trap by creating a unique Value Proposition that sets your product apart. This will allow you to command price levels above the market average.
Segment the Market
Segmenting the market is a key element of a smart pricing strategy. Market segments are different in their needs for your products, how and where they use it, and how they buy. Also, you can expect each segment to have a different price sensitivity. As a result, each market segment has its own customer perceived value.
Your approach to price setting should reflect these differences between market segments. Rather than using the same price levels across all market segments you can set a different price for each segment.
You could also decide to pursue only the most profitable market segment, ignoring those segments where it’s difficult to make a profit.
A Total Cost of Ownership analysis can also be helpful in segmenting the market by getting a better understanding of how your product is used in each segment as well as the perceived benefits and value.
Fire Unprofitable Customers
Often, detailed sales analysis will show that a firm has a considerable percentage of customers who are only marginally profitable or even unprofitable. This is especially true if the costs of customer acquisition, warranty, shipping and handling, customer support, etc., are taken into account.
Identifying your (most) profitable customers enables you to concentrate your sales efforts and resources on that segment. On the flip side, knowing your unprofitable customers allows you to take steps to improve their profitability, e.g., by raising prices, cutting out ‘freebies’, charging more for S&H or customer support, and so on. In the end, you may decide to stop serving these unprofitable customers altogether.
Firing unprofitable customers or exiting an entire market segment that’s unprofitable is an important strategic decision with a direct impact on the bottom line.
Use Hard Data, Not Anecdotal Information
Too often, price decisions are made based on anecdotal information provided by the sales force. Unfortunately, often this information is not reliable or based on a single case, making it difficult to generalize and distill a pricing strategy.
A rigorous strategic approach to price optimization uses hard data and analysis of in-depth market intelligence about customers, competitors, and other marketplace metrics.
Price optimization requires, and deserves, the same level of attention and effort as cost reduction.
Structure Incentives for Profitability, Not Revenue
The way you incentivize the sales force can have a negative impact on profits. When salespeople are rewarded for pushing volume, at any price. they will do just that. This can be especially costly when salespeople have the authority to offer discounts. The result could be sales that are marginally profitable, or perhaps even unprofitable, due to aggressive discounting.
A different approach is to have the sales force focus on maximizing profitability, not revenue. To support that goal the firm needs to put the proper incentives in place. In order for these incentives to get accepted, the sales force has to become educated about profit margins, perceived customer value, TCO, and product cost.
Allow Different Margins for Different Products
Within a particular market segment, your customers will likely have a different value perception of each of your products. Not each product line is valued the same way. This means that each product has its own optimal price point, and consequently profit margin, for that specific market segment.
Simply applying the same profit margin across your entire product portfolio for a particular market ignores the importance of the value-based approach. Once again, you’ll end up with products priced too high or too low.
You need to accept a different profit margin for each product, rather than applying the same gross margin across the board.
Adjust Prices When The Market Changes
Raising prices is something managers try to avoid as long as possible for fear of customer backlash. However, companies with a strategic approach actively manage prices and accustom their market to price changes. The process of keeping customers informed of price changes ahead of time can be part of good customer service.
The marketplace is very dynamic. A lot can change in a short period of time. How customers perceive the value of your products is not static but moves up and down with events in the marketplace such as a competitor’s price change, a new product launch, or emerging new technology. Product prices must be adjusted to reflect these changes in the marketplace. Failing to do this impacts your competitiveness and your bottom line.
Anticipate Competitor Reactions
From a pricing strategy perspective, be aware that a price change will likely be met with a competitive response. You need to know enough about your competitors to anticipate how they will react to your price changes. Anticipating competitor reactions can avoid costly price wars that can destroy an entire industry in the race to the bottom.
Develop a Price Management Process
Companies put a lot of effort into cost tracking and cost reduction. Yet, at the same time, managers often overlook the importance of a formal pricing strategy that supports the goals of the business.
Determining price levels needs a multi-disciplinary approach. It’s no longer the purview of accounting or finance alone but requires the active involvement of the marketing department.
Pricing is a complex topic. Many books and scholarly articles have been written on the subject. Hopefully, this post got you thinking. I’m looking forward to your feedback.