The Price is Right – Part 1
The news that last month’s consumer price index posted its largest monthly increase since 2008 has many businesses concerned. That, against a backdrop of acute supply chain shortages and escalating cost increases (which includes everything from lumber, steel, pulp, plastics) plus a shortage of qualified labor, make our environment an unusual one. As a result, operating costs for businesses are on the rise – even for those in non-manufacturing and service industries who have been impacted indirectly.
This means that most businesses are currently considering price increases, or have already implemented them.
In situations like our present time, we find those who have a pricing strategy in place perform better than those who only reactively adjust prices. Do you have a pricing strategy for your business?
In this two-part series, we will cover your options with pricing and considerations when implementing price changes.
A quick online search will show you there is no shortage of books, journals, websites, blogs on the topic pricing. It can all be overwhelming so I will try to distill it down to the basics. To start, there are a few essential concepts you need to be familiar with:
- A primary goal of all pricing strategies is to maximize profit and revenue. Price is in the top three levers to improve profitability, but is seldom among the first to be considered. Consider this simple math: for a 10% margin business, if you can pass along a mere 1% increase and keep your sales volumes, it can result in a 10% increase in profitability.
- Price and demand are correlated. At some point, increasing prices will reduce the number of people interested in buying your product. The degree to which price and demand are correlated is called price elasticity, and can be determined using testing and data analytics.
- In a competitive environment, price changes can trigger your competitors to also act. Your decision to drop prices can cause your competitors to do the same, and vice versa. In this respect, pricing moves are analogous to chess moves – winners always think a few steps ahead.
- Your pricing conveys the value not just of your product or service, but also your brand. Wines and luxury goods exploit this attribute of pricing very well. Hence it is important to align pricing with brand and product strategy.
- A good pricing strategy requires work, which includes gathering market data, conducting competitive research, and collecting customer insights. Also, pricing strategies will change over time and are influenced by the operating environment.
I’ll now share a few different types of pricing methods employed. It from these that the building blocks of pricing strategies are formed.
1. Cost-plus (or markup) pricing
This is the simplest and most common starting point for most businesses. You calculate your COGS (cost of goods sold) and then apply a standard markup. While it might seem to be a “safe” way to price, it seldom produces optimal results. Cost-plus is commonly used by retailers and manufacturers but is not advised for SAAS sellers where costs are much lower than the value provided.
2. Competitive pricing
After performing competitive research, you set prices that match those for similar offerings from your competitors. When executed well, this method results in higher revenues and increased customer adoption compared to cost-plus pricing alone. However, it is very important to compare apples to apples when applying this method. Any points of differentiation between competing offerings (might include features, service, durability) will have to be factored in. Competitive pricing is applied extensively to products sold in online stores.
3. Price Skimming and Penetration Pricing
These are two methods used typically by new entrants in competitive technology markets. With price skimming, the initial price is set high to attract innovators and early adopters. It is then gradually reduced over time to attract other buyer segments. A benefit of this strategy is that it allows businesses to recoup their initial investment early on. However, it is risky in that it might not attract enough customers out of the gate to move the venture forward.
Penetration pricing is the opposite – initial prices are set significantly lower than other competitive offerings to encourage widespread adoption and then raised gradually. This might be used to lure customers from an incumbent market leader who maintains a loyal base. The downside is that the low prices are not sustainable until costs of production are covered.
4. Dynamic Pricing
With this method, companies set and adjust prices continually based on changes in the selling environment – customer segments, market conditions, demand levels, and supply chain constraints. Prices are determined algorithmically and updated as conditions change. If you have purchased airline tickets or seats at sporting events, you have experienced dynamic pricing. It is also commonly used by Walmart, Uber, and Amazon. This McKinsey article describes it well: to be implemented effectively, dynamic pricing requires a strong IT infrastructure with analytics, robust organizational processes, and a shift in mindset and capabilities.
5. Value-based pricing
Simply put, value-based pricing is based on the value of your offering as perceived by your customer; perceived in this case is the operative word. It is the most that your customers are willing to pay for your product at any given time, and is considered as the gold standard for pricing.
When applied successfully, value-based pricing maximizes revenues and profits. However, it requires a deep understanding of your customers’ pain points, which your product or service must clearly address. It is also important to clearly differentiate your product from your competitors.
Calculating the monetary value of your differentiated offering is no trivial task. Data analysis tools like conjoint analysis can be used, but good market research is also required for support. Finally, the importance of sales and marketing excellence in developing and communicating strong a brand cannot be overstated. Without these building blocks in place, attempting value-based pricing is not recommended.
By now, I hope you appreciate that there is no one-size-fits-all approach to pricing. And if you find your business to be in a reactive cycle and constantly accommodating for market changes, here are some of my recommendations:
- Evaluate your pricing strategy.
- Invest in data analytics to make the most of the information you already possess.
- Equip your sales and marketing teams to build and sell strong value propositions that differentiate you from the competition.
- If you do not have the talent internally, consider bringing in experts (like ECS) who will guide your team through the pricing process and implementation.
And most importantly, do not hold off on making important pricing decisions today, as the negative impact on your bottom line could be severe.
Now that we have covered the basics of pricing and pricing methods, we will look at how to implement a pricing strategy. This is where the biggest challenge lies for most businesses. We will cover this in Part 2.
Pricing a topic many of the ECS team members love to discuss. Our team is available to help and can discuss your pricing opportunities and challenges, and answer any questions you have. Reach out to Ajay Joshi – email him at firstname.lastname@example.org, and connect with him on LinkedIn here.