GETTING TO THE RIGHT PRICE – PART 1
We know that price is important in determining revenue potential, profitability, financial growth and expected return on investment. It is also widely shared that a 1% increase in price, if volumes remain constant, translates into an 8% increase in operating profit. McKinsey & Co. goes even further. They state the price impact is nearly 50% greater on an organization than a 1% fall in variable costs such as materials and direct labor and more than 3 times greater than the impact of a 1% increase in volume for profitability gains. No wonder companies are increasingly pursuing pricing optimization strategies with such ferocity.
Yet pricing continues to be both an art and a science. It can vary based on customer demographics such as regional and age of population expectations, timing (i.e. overnight vs. ground delivery), venue, and supply and demand. For example, a Coney at a street vendor may be $2. That same Coney is $4 at the airport and a monstrous $6 at a New York Mets baseball game. So, what is the right price for your products and services? The short answer is, it depends.
Pricing signals convey many facets to the customer about your offering and organization. They include, your market positioning (i.e. High-end vs. Low-end); degree of market dominance, brand strength, the value you attach to your product portfolio and the customer’s acceptance of that value and channel expectations And unfortunately there is no one size fits all or universal formula for pricing.
The Three Legs of Pricing:
Let’s begin the process by exploring the three legs of pricing and their priority in importance to realizing overall business and financial goals. The key to successful pricing is to factor in three pricing parameters into the decision-making process. They are market value pricing, organizational margin target pricing, (often referred to as cost-plus pricing) and competitive pricing. See diagram.
Out of the three pricing pillars, market value pricing takes precedence. If the price is higher than the customer’s perception of value, simply put, it will not sell. Therefore, the first step in any pricing strategy is to find ways to enhance perceived customer value. This takes precedence to all other considerations, including cutting product costs to achieve margin targets. Suggested ways to do this involve strengthening branding, increasing brand awareness (spurring demand), increasing product functional versatility in the minds of customers, simplifying the purchasing process or adding other conveniences, choosing more selective channels and enhancing packaging design.
Next in importance is target margin pricing. This is where the cost to produce the product is calculated and a price is set that reflects the margin realization needed to make the selling of the product worthwhile. Many in Industry fall prey to making this their first pricing priority. Internal pricing focus such as this, often stems from the desire to recoup the high investments made in R&D and product engineering. However, there is no denying that getting a positive return on a product or bundled portfolio is also vital. As the adage goes, you cannot make up losing margin with volume. Organizational profitability is important for increasing overall market competitiveness. Robust earnings allow the organization to further invest in product R&D, spend on elaborate marketing campaigns and devote expenditures for front office technology and manpower that’s required to boost customer acquisition and retention programs. The solution to balancing market value pricing and target margin pricing is in-depth market research. The market research should be used to uncover customer price expectations based on product attributes they value. While it is nice to have product ‘bells and whistles,’ if the customer is not willing to pay for them (a demonstration of recognized value) then this must be factored into the product design. Focus Groups, customer surveys and one-on-one customer conversations on their business and equipment requirements are a must in product pricing.
Lastly, your competitors’ product and service prices matter. The degree of importance depends on the transparency of the market for customers. This is often experienced if there are a few large competitors operating in the same space and where pricing information is readily available. Competitive prices weigh heavily on the minds of customers when evaluating your price to value ratio. Competitive pricing may also impact the trust and loyalty of customers to your offering which is necessary to drive repeat business. For example, if a competitor is offering a very similar product (much less the same offering!) at a much cheaper price, keeping all other parameters the same, customers may believe you are price gouging them. Rarely do they investigate the causes behind this, such as whether you have a more expensive manufacturing process or higher raw materials costs from your supplier. Frankly, I don’t believe they are concerned with it. Hence, it’s critical to keep your prices in the range of your traditional competitors (of course avoiding any concerns of price fixing). If you break from the pack on price, it is imperative that you justify why your prices are significantly higher. This holds true for prices that are significantly lower as well. In this case, the customer may believe there is a ‘catch’ to your offering and you will find a way later to recoup costs or make a profit.
In summary, pricing is a complex and dynamic process that often is determined as much by the situation as the business goals. It is highly recommended to seek full understanding of the market message your pricing is presenting to customers. This requires continuous reflection of your customer value proposition, an understanding of product cost contributors and consistent awareness of competitive value creation and pricing movements. For further pricing considerations, read ‘Getting to the Right Price – Part 2.’ Happy hunting!
Read my article on “Staying Ahead of the Competition,” to learn of other areas related to increasing market competitiveness in addition to pricing. Access all blog articles at www.industrialprosperity365.com.
I wish you all Happy Holidays. Enjoy the time with family & friends.
See you in the New Year!