It is not uncommon for companies to base their pricing strategy on “cost-plus” approach. However, this is too simplistic and can have a negative impact on profits.
A firm’s approach to price setting has to align with the business goals. Determining the right price for a product or service is a complex problem with many facets. Here are a few thoughts on pricing to give you some ideas.
Customer Value, Not Cost-Plus
Of course, you can’t ignore product cost. It 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 cost-plus approach starts with the product cost and adds a markup, often somewhat arbitrarily.
A better approach to price setting 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 the customer value of your solution – an essential facet of a smart pricing strategy.
Consider Total Cost of Ownership
By taking a Total Cost of Ownership (TCO) 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 quantify these benefits in financial terms.
With the knowledge of the benefits your solution offers, you can demand a higher price over a cheaper competitive product that lacks these benefits. The TCO advantage provides an opportunity to set a higher price, yet still be perceived as a “good deal”.
Also, with insight into customer value and Total Cost of Ownership, you can tell a compelling story to the customer about the benefits of your product and how it’s different. This beats having to compete just on price.
No doubt, this strategic approach to pricing 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 TCO 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 pricing, products are priced close to or the same as the competitors’ products. No differentiation, nothing strategic about this approach. From the customer’s perspective, all products in the marketplace are priced 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 strategic approach to pricing. 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 pricing should reflect these differences between market segment. Rather than using the same price levels across all market segments you can set a different price for each segment. Or, you may even decide to pursue only the most profitable market segment, ignoring those segments where it’s difficult to make a profit.
Fire Unprofitable Customers
Often, detailed sales analysis will show that a firm has a number 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 helps 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 direct impact on the bottom line.
Use Hard Data, Not Anecdotal Information
Too often, pricing decisions are made based on anecdotal information provided by the sales force about customers and competitors. Unfortunately, often this information is not reliable.
A rigorous, strategic approach to price optimization uses hard data and analysis of sound 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. The firm needs to put the proper incentives in place to support that goal. 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. This means that each product has its own optimal price point, and consequently profit margin.
Simply applying the same profit margin across your entire product portfolio for a particular market ignores the importance of the value-based approach. 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 Pricing 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 to pricing actively manage product prices and accustom their customers 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 product launch, or an emerging new technology. Your pricing 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 their reactions to 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 process for price setting based on a pricing strategy that supports the goals of the business.
Price setting needs to be approached with the same effort and rigor as cost control. Remember, pricing is one of the four “Marketing P’s”. 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.
Check out this blog post about pricing: Use Value-Based Pricing to Increase Profits