Price is a major determinant of the profitability of your business! A price change of as little as 1% can often lead to profit increases of up to 20%. A consultant study across 1,200 major businesses found that a 1-2% increase in price, assuming demand remained constant, on average would have increased the company’s profit by 11%. Clearly, this could be a quick boost to your company’s profitability.
For a quick example of the impact of a price change, consider a business turning over $500,000 per year. Let us further assume that it makes a 5% profit on that, which gives it a profit of $25,000. If it increased its price by 1%, and assuming demand remained constant, that would lead to an extra $5,000 in income. This extra $5,000 over the original $25,000 is a 20% improvement.
Three Step Approach to Pricing
Pricing specialists advocate a three-pronged approach to maximising income from a well thought out pricing strategy.
The three steps are:
- Set a value based price.
- Activate dormant customers with a plan that suits them.
- Have different versions of your product to suit different types of clients.
First: Setting a Value Based Price
Many businesses choose a price based on some mark up over either:
- Its cost to manufacture.
- The price at which it purchases the product from the wholesaler.
But this is a false understanding of how best to price. Even if you have a mark-up over and above production costs there is no guarantee, and in fact no reason, why someone should pay that price unless they are desperate for your product.
People will usually only pay a price that seems reasonable to them; which gives them value.
Different people attribute a different value to the same product.
Some people will be more swayed by what is called "subjective value" because the product appeals to their sense of taste or identity or some other factor. A choice of clothing is clearly an example of this instance.
Another approach is the so called "objective value". An “objective” analysis means that you look at the dollars involved or some other metric that lets you determine a justifiable value in your mind.
If we take clothing for example, a pair of designer jeans may appeal to your sense of identity because it gives you status, it flatters your figure, or it is just a little indulgence. If you went down this route, you would be buying on “subjective value". Alternatively, an “objective value" buyer might compare what the designer jeans offer versus another similar jean and decide that, at the end of the day, the designer jean is just not worth the extra money.
As another example, a “subjective” buyer might purchase a house because it is in an attractive location and it looks stylish. An “objective” buyer (typically an investor) might be rather more focused on the yield from buying and renting the property. The same house will be worth different sums of money for these different buyers.
Depending on what your present price is, setting a value based price may actually mean that you drop your prices. On the face of it, this seems rather foolish! However, if you end up selling greater volume of the product at the lower price, it is possible that your total profit under the value based method will exceed the value from your mark-up approach.
If it doesn't, you are not obliged to follow the strategy.
The value based pricing process begins with finding the next best alternative (either slightly better or slightly worse) than what you have to offer. You then list its attributes and compare them with the attributes of your product. If you have more and better attributes, all things being equal, you can charge a slightly higher price. If you have a less attractive product you would charge a lower price.
There are 4 basic steps to identifying an ideal base line value for your product. These are:
- Identify the target customers next best alternative. Decide that its price is reasonable, which it probably will be if it has been in the market for any length of time, and then use that price as a starting point for determining your own price.
- Determine the product differences, both better and worse, between your product and your chosen bench mark product.
- Create a demand curve based on the concept that different customers have different valuations for a product's uniqueness.
- Find the profit maximising "sweet spot" on this curve and use that as your estimate of the most profitable value-based price.
For more on this process, we recommend Rafi Mohammed’s book referenced in the Resources section below. This is an excellent read and well worth purchasing if you are serious about your pricing policies.
Second: Offer Purchase Plans
Irrespective of your price, not all customers will take the same approach to the purchasing decision.
If we take, for example, the purchase of a car, some proportion of buyers will be able to buy outright whereas others will want to lease it or go to a bank to get a loan.
It may well be that offering different prices associated with these various plans can offer you more profit.
For example, if you could finance the leases yourself you might make an additional margin from the difference between what you can borrow money for and what you can lease a vehicle out for.
If you are interested in working through these various plans, we recommend the book written by Rafi Mohammed which is referenced at the bottom of this article. This book gives 17 different pricing plans that you might take into consideration when arriving at prices for different types of buyers.
The 17 various pricing tactics are grouped under:
- Ownership alternatives - lease, rental.
- Uncertain value - success fees, licenses and options.
- Price assurance - flat rate and all you can eat.
- Financial and other constraints - financing and prepaid.
For more detail on each of these we encourage you to read the book.
Third: Price Ranges or Versioning
Versioning refers to striking different product lines and price points for people desiring a different experience from your product.
Car manufacturers have long known that slightly different vehicles can be offered for different prices to different markets. Very often, very similar body shapes are available in basic, mid-range and luxury models. See our discussion on The Amazing 80/20 Rule (see The Amazing 80/20 Rule article)
The take home point here is that you might be able to offer your product with slightly different modifications to quite different markets and at quite different prices and thereby increase your sales.
However, keep in mind that there is a down side risk to this. It is very easy to offer so many variations on your basic theme that your production systems choke under the need to manage all the variations.
Another potential risk with offering lower priced versions of your product is that people who might purchase a higher priced version are satisfied with the lower priced version so you have lost out on some extra profit.
One way of minimising how often this happens is to set some "hurdle" that buyers need to pass to get the advantage. An often-quoted example is a discount on a product only available to senior citizens. You also see the same thing with reduced prices for children at movie theatres. Everybody is seeing the same movie but they are paying different prices. It is even possible that the price versions could extend to prime and sub-prime seats in the theatre at differential prices.
Another hurdle that can be imposed is for various attributes of the product to be "disconnected" for people paying different prices. One sees this very often with software products whereby the free version has fewer options available. As you pay more and more, you get access to more and more options with the product. In this case, the product is the same with just a simple "switch" that makes options available depending on the price paid.
One also sees versioning at work, although usually not with a differential price, in soda drinks. They have the normal, light, caffeine free, super-caffeine; and so on.
In his book mentioned above, Mohammed provides 17 different versioning price tactics loosely grouped under the headings:
- Strip Down.
- Unique Customer Needs.
If you are interested to understand more about this approach we encourage you to read Mohammed's book.
Other Pricing Titbits
There is a lot of material on pricing. We have extracted some of it in this section to give you a taste of various issues.
Covering Variable Costs
Often we see the example of a business setting the minimum selling price as being a share of the fixed cost of production which is going to be incurred whether or not you sell it and the variable costs associated with that sale. That will at least give them break-even.
Ideally, the price where sales are made successfully should be above this as this is where your profit is made.
If we take the example of a hotel, these fixed costs are the costs of staff and the capital to operate the hotel. The variable costs are things like bed linen, milk and coffee in the room and the cleaning of a used room.
Businesses might argue that providing the fixed cost plus the variable cost is exceeded then it is reasonable to rent that room.
As a starting point, this seems to make sense. You certainly don't want to be letting out rooms at less than the fixed cost plus the variable cost over time or you will not make a profit – ever.
However, what if you were able to rent out at higher than this break-even figure sometimes and sometimes lower? It is likely, that they will average out. There might be times when it is reasonable to rent rooms at less than the fixed cost plus the variable cost providing that, in the long run, you make a profit.
The real cost of the room in the short term is the variable costs (cleaning, coffee etc.). If you can’t cover this, in your pricing you will definitely go backwards.
However, if you can at least cover these variable costs, anything left over is a contribution to your fixed costs like labour and capital investment and therefore helps to cover them. For more on this concept, see the Throughput Accounting article.
We see this at work with airline seat pricing all the time. Early buyers can be sure of a seat but pay more. Late buyers – who take the risk that they may or may not get a seat - pay a lot less but, providing the price covers food and beverages and the extra fuel consumed, these later and cheaper people contribute to reducing the fixed costs of that flight – staff, wear and tear on the aircraft etc.
Your longer term goal is to set a price that makes you a profit but a shorter term and occasional goal might be to ‘harvest’ as much as possible from sales by at least covering variable costs and making a contribution towards fixed costs.
There can be a lot of uncertainty in this pricing because you don’t know how much you might sell and therefore how much of the fixed costs to “charge” each sale. If a product does not sell as well as you planned, you will lose money until you adjust the price (if you can) to reflect demand.
Ironically, this might mean you want to increase price to cover fixed costs but can only increase sales by reducing the price to something more acceptable to the customer (the customer’s perception of the value of the product).
Price Elasticity of Demand
This is a term that economists use and it sounds very daunting. But it need not be. It simply means that we plot on a graph how many units of a product we are likely to sell at a particular price. Then we move the price up and plot the likely sales and then we move the price down and again plot the likely sales. This gives us a curve on that graph which indicates how sensitive people are to price.
There is a "sweet spot" on this graph which is the place where you will make the maximum profit on the product. We have sales volume and we can calculate a profit at that point on the graph as being the selling price minus the cost. The point on the graph where this profit is the greatest is the "sweet spot" for that version and plan for the product.
There will be other "sweet spots" for other versions of the product. Clearly, the price of a luxury vehicle will move up the curve whereas the price of a basic version will move down the curve.
Also, the "sweet spot" for the profit will vary as different "plans" are offered to buyers; purchase, free trial, lease and so on.
If you are not sure how to estimate how many people might buy your product at the various price points, you can read more about how the 80/20 rule may be able to assist you in our article "How to do an 80/20 Data Analysis" (see our article on How to do an 80/20 Data Analysis here).
Market Share versus Maximum Profit
In businesses where the pricing is not done very subtly, they use a measure of market share as a metric to determine how successful they are.
In their mind, the bigger the market share, the better they are doing.
Alternatively, a smart business manager looking at how to apply price to greatest effect is more likely to look at maximising profit. Maximising profit quite likely means that you would leave market share on the table but not until after trying different pricing plans and different versions of your product to cream as much as possible from the available customers.
Economies of Scale
It is also often the case that you can produce additional product comparatively cheaply once you have the production systems going and have covered the overhead costs of setting it up.
At the start, you have to cover the fixed cost of setting up the production system plus the variable cost of producing one unit of the product.
As you produce more and more, the fixed cost should remain the same (unless you have to increase production capacity) and is spread over more and more of the product making the fixed cost component of each less and less. Economists call this “economies of scale”; the bigger your production the cheaper the unit cost for each product becomes.
If you keep the same price, and production costs fall, you make more profit per unit.
This is also a concept in Throughput Accounting (see Throughput Accounting article)
By this point in this article it should be very clear that there are many different pricing strategies that you can use rather than simply one price suits all.
By providing different payment plans and different versions of the product, you can appeal to many more people over a wide range of prices. Almost certainly, some of these price points will be more popular than others. Even if you are making a lower profit on some permutations, you could still be much better off.
In his book, Mohammed instances an example of a full-service hotel which might offer as many as 500 different room rates. This works out to be some 20 rates for each of its primary room types - low, middle and high floor rooms, standard deluxe, corners, suites and various views.
Also, based on historical data for room bookings they can offer discounted prices 60 days out, prime prices in the middle and again lower prices very close to the night of the booking when there is surplus stock.
The material in this article on pricing draws heavily on the "1% Windfall: How Successful Companies Use Price to Profit and Grow" by Rafi Mohammed (Harper Collins) available as an eBook.