Pricing matters. It matters a lot. It is the primary influencer of the gross profit margin – the litmus test to the health of your business.
Before you can even begin to dabble in pricing, you need to understand gross profit margin and your fixed and variable costs.
And this is just the start of what you need to know.
Pricing does not stand on its own.
Rather it is dependant upon your brand, its positioning, your product strategy, where your product is distributed, how customers perceive the value of your product and how your competitors (if you have them) fare in the minds of your customers. Many other marketing facets need to come together to make your pricing work.
Pricing is every bit as critical to your business as your brand and product strategy.
In setting your pricing strategy, give consideration to your brand positioning and your competition, and your product and distribution strategies, since all these elements should, along with your pricing, tell your story.
Make no mistake. Pricing is really hard and critically important so it means it’s pretty scary too.
There is no exact formula for the “right price”. But how products are priced can change entire industries, and the pressure to be aware of pricing grows exponentially in line with the growth in competition and move to cheaper distribution channels, such as the Internet.
Products are increasingly commoditized – where price becomes a major factor in purchase – and brands managers are increasingly looking for ways to differentiate so their products don’t fall into this trap.
The focus on pricing has been led by challengers – not the market leader – and it has been very effective in focusing the customer on using pricing as the primary differentiator between competing brands.
Of course, once the customer becomes accustomed to paying less for a product, and they consider the product to be a commodity, it becomes virtually impossible to charge a premium for it, irrespective of how good the leading product is.
The difference between high and low involvement purchases
The level of importance and intensity of interest in the purchase decision govern the type of purchase behavior.
We refer to this as purchase involvement.
The level of involvement determines the level of motivation in seeking information about competing products and brands.
If you focus solely on price when selling your product or service, so too will your customers.
And, unless you can differentiate your product from other similar products, the cheapest product will get the sale.
So the moral of the story is if you cannot afford a price war, don’t venture there to start with.
Gross Profit Margin
(I cover Gross Profit Margin in other posts too if you’re looking for more information.)
The gross profit margin is the amount that is left over once the costs of what is sold are paid.
Pricing is important because it is the primary influencer of the gross profit margin.
Businesses go broke because of declining gross profit margin – in other words, your sales price is too low relative to the costs of the product you are selling.
The formula for calculating a gross profit margin is as follows:
GORSS PROFIT MARGIN = SALES REVENUE – COSTS OF GOODS SOLD
Tom Smith’s widget business has sales of $100 and cost of goods sold is $50.
Using the above formula, we can calculate that Tom Smith’s Gross Profit Margin is $50.
Or, expressed in terms of the formula:
Gross margin = Sales Revenue – Cost of Goods Sold
$50 = $100 – $50 or as a percentage:
50% = 100% – 50%
To learn more about this topic including the impact of rising costs, check out the Basics of Costs – Fixed and Variable.
What Businesses Do About Pricing
Every business owner, marketing manager, and every entrepreneur struggles with pricing.
It is hard to find the right balance between product or production costs, and the value your customers place on your product or service (in other words, what they are prepared to pay for it).
So businesses make it easy on themselves. They do what everyone else does.
They copy the competition’s pricing models. (Almost, in its entirety, the retail sector uses either a cost-based pricing model or RRP, for example.)
How do they know the competition is right? Well, that’s the rub. They don’t.
It’s a gamble that the competition knows exactly what it is doing.
You might be giving them more credibility than they deserve. Sometimes competitors don’t know anymore than you do.
Since there is no “right” answer to pricing, copying the competition could, in fact, be very detrimental to your profitability.
If they are underpricing, and you are copying, then by default you are underpricing too (assuming all else is equal).
You are also forfeiting opportunities to improve profitability or missing the most important point of all about pricing – and that is that most people do not buy solely on price.
If you are fortunate enough to have no real competition for your product, you can charge almost whatever you like for it (presuming people want it, there are no genuine alternatives, and brand attributes support it).
The moment you make obscene profits, the law of economics suggests a new competitor will enter the market to seek a slice of your action.
Once this happens, a predictable pricing event happens.
You’ll become the industry pricing benchmark that every one else follows.
New entrants are going to copy you. They’ll use your price points as the basis from which to develop their own pricing.
Pricing Reality Check
What businesses should do about pricing:
BUSINESSES WORRY MORE ABOUT PRICING THAN THEIR CUSTOMERS DO.
Their customers may tell them they only buy on price, but 9 times out of 10, it’s not completely true. Would they choose the cheapest plastic surgeon for that new nose job?
MOST PEOPLE SEEK VALUE FOR MONEY.
Most people are prepared to pay for goods and services that represent real value to them. To charge a premium, though, the customer has to believe that you are genuinely better than the cheaper (or free) alternatives.
DON’T BE AFRAID TO TEST PRICING.
Don’t focus on sales volume (the number of sales you make is not the best measure), instead look at the profitability of each sale.
IN MANY CASES, PRICING IS NOT THE PROBLEM.
The issue is a salesperson’s confidence in selling a price to customers. This lack of selling confidence does not seem to affect the businesses engaged in the pricing and selling of luxury items. Businesses need to stop being embarrassed and apologising for their pricing. Instead, they should equip themselves with all the reasons why their price is justified. A salesperson’s job is to help his or her customer to understand the value of the product or service they are about to buy.
WHEN THERE IS NOTHING ELSE TO TALK ABOUT, EVERYONE TALKS ABOUT PRICE.
Pricing becomes a big issue to the average consumer when there is little else about the product for the consumer to focus on. Know that if you focus on your price, your customer will too. They’ll just follow you by example.
SMALL & MEDIUM BUSINESSES SHOULD NEVER COMPETE ON PRICE WITH A LARGER COMPETITOR.
Small to medium sized businesses should never compete head-on in price with competitors that are bigger. There are few exceptions. Instead of slashing price, look to increase value first. Try making it hard to compare prices.
LARGER COMPETITORS HAVE DEEPER WALLETS.
Never forget your bigger competitor can undercut you, cut deeper for longer, and has the resources to sit back while you price yourself out of business. Even consumers don’t win in price wars. Ultimately what happens is that smaller competitors are forced out of the market, leaving only big guns, and then the prices shoot right back up again.
IT’S EASIER TO DROP PRICES THAN TO INCREASE THEM.
It’s much easier to drop your prices than to try to increase them. Therefore, it is always better to overcharge for your products and services (and be on the right side of the “you get what you pay for” ledger) rather than undercharge for them. Undercharging has another major drawback. It can send you broke.
PRICE MATCHING MIGHT SEND YOU BROKE.
If you match your price to a competitor that is under-pricing because you hope to make up in volume, you’ll probably go broke. (Your competitor might beat you to it, however.) Slashing prices does not always result in increased demand (economic theory is plain wrong about this), but it does result in less margin unless you have found a way to reduce your costs by more than the price reduction at the same time.
CUSTOMERS BELIEVE THAT YOU GET WHAT YOU PAY FOR.
There is yet another bad side to discounting your price. Customers have a habit of believing you get what you pay for. If you’re cheap, they wonder why. Pricing is a game of the mind. You wouldn’t choose the cheapest accountant and expect the best tax advice would you? Because consumers associate quality with price, cheap stuff is often thought of as junk. The rationale goes something like this: if you’re cheap, there is something wrong with you. Conversely, if you can sell at a higher price, and your stuff is not junk, you can make a credibility statement about your brand.
PRICE DISCOUNTING BECOMES A HABIT.
The more you run sales and discounts, the more your customers begin to expect it of you. The more they expect it of you, the more they will sit around to wait for it to happen. And the harder it’s going to be for you to make a profit. There are lots of ways to move inventory that do not include heavy price discounts.
COMPETITORS WILL UNDERCUT YOU BY 5%.
Some competitors are like pesky gnats. They set their price point to be a small percentage below your own. If your price moves, so does theirs. Rather than yo-yo your prices about, focus on making price comparisons hard for the customer to do.
PRICE BUYERS WILL ALWAYS EXIST.
There will always be customers that buy on price alone. You have two choices. Run with it if you have the business model to suit the price-driven buyer. If you don’t, encourage them to go waste someone else’s time. Price-driven buyers are notorious for never being loyal despite what lengths you go to for them, they neither respect nor value what you offer, and they have no qualms about wasting your time haggling for an extra dollar off. Then they have the audacity to make you wait to be paid and they complain, a lot. You will be left feeling bitter and twisted by the whole time-wasting experience. So, if you’re not geared up for the price-buyer experience, walk right past.
PRODUCT BUNDLING CAN CREATE BRAND STICKINESS.
In some industries, the more products a customer has, the less likely they are to move away. Getting this breadth of product into a customer to create “brand stickiness” should be a primary motivation for every business. You should always be looking to up-sell or cross-sell to other products. Every contact with customers should be a breadth of product opportunity. It may even be worth offering a small enticement for the second purchase.
CUSTOMERS WILL ALWAYS WANT A LOWER PRICE.
Just because your customers tell you that they want you to lower your price doesn’t mean you necessarily should. Most people buy on factors other than price. In the business-to-business (B2B) world, on time delivery is almost always more important than price. On the subject of B2B, you can be really creative with term contracts such as renegotiating them ahead of time to lock out competitors. If you can keep the business from going to tender, do it. While you may take a cut in margin, it may be less than the hit if it goes to the open market.
GIFT CARDS AND LOYALTY SCHEMES ARE RECORDED AS A BUSINESS LIABILITY.
The problem with gift cards and loyalty schemes is that they are recorded as a liability on your accounts. This is why so many companies are trying to extract themselves from it (especially airlines that keep changing the rules of the program). If you’re going to enter the loyalty game, set time limits for use points and the like. Once the time expires, get it off your books. Your accountant will be very relieved.
COMMODITY ITEMS DO NOT COMMAND A PREMIUM PRICE.
It doesn’t matter how good you believe your product is. If your product is a genuine commodity that the customer doesn’t care about (so long as it works and is available when needed), you cannot expect to charge a premium for it (and you will have to set a price that is in line with your competition or lose market share to them). Do consumers care which brand of electricity they buy or do they just care that the light works when the switch is on? What about the water that comes out of their tap? Does it matter what brand it is or that it’s clean and available on demand?
COMPLY WITH PRICING LEGISLATION.
There are laws that apply to pricing. For example, if you’re the market leader you cannot undertake predatory pricing to drive smaller competitors out of business. Nor can an industry get together (collude) to fix pricing. In most countries, including Australia, it’s illegal. Mostly, though, the regulators are much more interested in large companies than smaller ones and, while you shouldn’t break the law, small competitors normally have a greater degree of flexibility with pricing than a larger competitor does.
Traditional Pricing Models:
Traditionally, bricks-and-mortar world pricing has been set under one of four main structures. Below is a brief overview of each of the models, but for more information about them, head to Pricing Models Explained.
Cost based pricing is commonly used in retail and by some manufacturers. To price using a cost based pricing model you need to understand your product costs. Add the amount of profit you want to make to determine your product price.
Then you’ll need to calculate the breakeven so you know how many you’ll have to sell in order to make a profit.
Some of the common techniques in which cost based pricing are expressed are:
- Cost plus markup
- Keystone pricing
The intent of customer based pricing models is to use price to attract customers.
This can be through using price to establish a brand image of prestige, or conversely to use it to increase product sales.
Some models, like those that typify the software industry, use tiered structures to appeal to different niche markets.
Others, like telecommunications, use bundles (or packages) of product.
Some of the common techniques in which cost based pricing are expressed are:
- Membership or trade pricing.
- Product bundling and quantity discounts.
- Single versus multiple payment options.
- High value goods purchased through third party financiers.
- Using brand positioning to determine pricing.
- Loss leading.
- Special offers to encourage short-term inventory movement.
- Auctions which allow the market to decide the price of the goods.
The intent of value-based pricing is to quantify the benefit the customer derives from the product you supply and to use this as the basis for pricing the product.
For example, what is it worth to a manufacturer to have its raw materials turn up on time? (Especially when a failure may result in factory closure or production lines being halted.)
The elements of value are typically non-product related. So these may include such elements as:
- Making a difficult job easier therefore less time-consuming.
- Removing manual labour components (thus potentially reducing staffing requirements).
- On-time, reliable delivery (especially if products are essential to the ability to produce).
Competition based pricing occurs when you use your competitor to set the benchmark for your price. This can be charging the same, just above or just below competitor prices.
Some of the common ways in which competition based pricing is expressed are:
- RRP – manufacturers recommended retail price.
- Penetration pricing.
INTERNET PRICE MODELS
The major difference between the Internet and the bricks-and-mortar world is that the Internet is almost solely price-driven.
Users of the Internet expect that products are cheaper to buy online than through a bricks-and-mortar store equivalent (even though this is not always the case given the additional postage and handling charges that are usually passed on to the buyer).
Since the Internet is a price-driven channel, if you can source products at low wholesale rates, the Internet may be a good channel through which to sell them.
In addition, the Internet is also suitable for overstock, end of season runs and other products that the business categorises as old inventory that needs to be moved on.
The Internet is also well suited to products that can be delivered electronically. This includes music, movies, books, tickets and recharge products amongst others.
Finally, the Internet is suitable for products that are otherwise hard to find or access (and thus may command a premium price even on the Internet).
So, for example, hard to find art and antiques, vintage or one-off pieces of apparel, or non-standard sized clothing, are all examples of suitable online businesses.
When the consumer buys online, depending on the product, the consumer may make a tradeoff. While agreeing to the convenience of 24/7 shopping for product at a cheaper price, they inadvertently agree to wait for the goods to arrive. For some products, this is an important distinction since purchasing is often about immediate gratification.
Of course, there are those products that are delivered electronically and therefore instant gratification occurs. If you have products that can be reformatted in a way that makes them suitable as downloads from the Internet, it would be worth exploring whether you offer them this way.
What You Need To Know To Price Products.
YOUR COSTS – FIXED & VARIABLE.
Know about costs. Your price must, at its rock-bottom minimum, cover all your variable costs and make a contribution to the overheads of the business. You need to know these costs per product or per line of product. Don’t listen to desperate sales people who want you to sell on variable cost models only. How will you pay your rent or salary that way? If your costs are captured at a total business level, how will you be able to accurately identify the gross profit margin of each product (and this is important so you know which products to exit if they are unprofitable)?
YOUR DEVELOPMENT PAYBACK PERIOD.
If you have invested in development, someone has determined a payback period for that investment. This payback period will need to be factored into pricing. A popular model for recovering development costs (which can be expensive) is price skimming or using patents and other legal devices to protect copycats from entering the market.
You should know what your competition is charging for similar or comparable products. This is not to copy their pricing models, by the way, since it may be more advantageous to price differently to competitors and make your prices hard to compare. As a minimum, you should know what your competitors charge so that you can arm your salespeople with customer responses to competitive pricing questions.
THE VALUE YOUR CUSTOMER ATTRIBUTES TO THE SOLUTION YOUR PRODUCT PROVIDES.
Every product or service must solve a problem or why does it exist? For some products, this value can be very easy to quantify. For others, it may be a harder exercise to undertake. Use the Calculating Customer Value model to get some help if you need it.
THE DEGREE OF IMPORTANCE OF THE PURCHASE DECISION.
Some purchases are important (like a car or a home, for example) where others simply aren’t. If you are off to buy staples for the office, are you going to care about the brand you buy? If you are buying an office fire extinguisher that has the potential to save your life would you care a bit more?
At one end of the scale is commodity or homogenous products. Consumers don’t care what electricity company they are with so long as their lights work. In the absence of caring about anything else, price becomes an important, often defining, factor in the purchase of one brand over another. For some products it is almost impossible to charge a premium price and expect people to pay it.
At the other end of the scale are the highly specialised, personalised or customised (unique) products where consumers do care about the brand (because it engenders trust and confidence which are important prerequisites in the purchase decision). They are much less likely to focus solely on price.
WHERE YOUR PRODUCT IS IN ITS LIFE CYCLE.
Products that are new and have no competition can be priced differently to cash cows (those products that have been around for many years and service a mature market). The types of pricing tactics deployed differ based on product life cycles.
YOUR PROFIT OBJECTIVES.
How much money do you want to make over what period of time?
Is this a one-off purchase or an ongoing relationship? If it is an ongoing relationship you may consider contracting the customer to a term purchasing commitment. This has a few advantages. One, it keeps the business off the market (so incontestable by competitors), guarantees the revenue (so you can upscale if necessary and have confidence about the income coming in to support it). The downside is that you will have to reduce your margin since almost without exception contracts offering term commitment use the inducement of reduced rates to incentivise the customer to sign.
READ: More about Pricing Strategy.